Category Archives: Chapter 7

How Does a Bankruptcy Filing Affect the Sale of Delinquent Real Estate Taxes?

An owner of real property receives protection from creditors immediately upon filing a bankruptcy case pursuant to 11 U.S.C. §362(a), which provides an “automatic stay” or injunction against creditors’ actions against the owner and the owner’s property.  As to real property, the automatic stay prohibits mortgage lenders from foreclosing on delinquent mortgage notes, and it prohibits governmental taxing authorities from selling any delinquent real estate taxes without leave of court.

An order granting relief from the automatic stay is typically granted in a bankruptcy case if the secured party is not receiving adequate protection, or the owner has no equity in the property and the property is not necessary for an effective reorganization. See 11 U.S.C. §362(d).

But what do taxing authorities do about delinquent taxes when a homeowner files bankruptcy?  It depends when the bankruptcy case was filed in relation to the sale of the delinquent taxes.  First, let’s assume a sale is imminent but did not occur prior to the bankruptcy filing, then let’s assume a sale occurred prior to the bankruptcy filing.

Imminent Sale:  The filing of a bankruptcy case automatically prohibits the sale of the delinquent real estate taxes.  In a Chapter 7 case, the taxing authority typically stands-down and postpones the tax sale  until after the bankruptcy case is concluded.  The taxing authority could file a motion to lift the automatic stay to allow the tax sale, but typically does not file such a motion because of the cost to do so.  A Chapter 7 case typically lasts only 100 days or so.  Thereafter, the taxing authority thereafter conducts the tax sale.

A Chapter 13 case is different because it could last 5 years.  The filing of the Chapter 13 stays the sale of the delinquent real estate taxes just like a Chapter 7 filing.  However, the owner of the real estate must make a decision whether the owner wants to retain the real property or surrender it.  If surrendering the real estate, the owner’s Chapter 13 plan should expressly provide for the surrender of the real estate pursuant to 11 U.S.C. §1325(a)(5)(C) and treat any secured creditor’s deficiency claim as an “unsecured” claim by reason of the surrender.  If retaining the real estate, then the owner’s Chapter 13 plan should provide to cure mortgage arrearage and maintain the mortgage payments, and provide for the full repayment with interest of any delinquent real estate taxes.

Post Sale: The issues are more complicated when a real estate owner files a bankruptcy case after the delinquent real estate taxes have already been sold.  Some states allow an owner to “redeem” the sold real estate taxes within a certain statutory time period.  The Bankruptcy Code allows a Chapter 7 trustee to exercise the homeowner’s redemption rights by paying the delinquent taxes (plus interest) provided the bankruptcy case was filed prior to the redemption period expiring.  Similarly, the Chapter 13 bankruptcy laws allow the home owner to repay the sold real estate taxes over the 5 year period provided the bankruptcy case was filed prior to the redemption period expiring.  Unfortunately, a homeowner cannot save real estate sold for delinquent real estate taxes by filing bankruptcy after the redemption period has expired.

Violating the Automatic Stay:  Sometimes a real estate tax buyer who properly purchased delinquent real estate taxes unknowingly violates the automatic stay by foreclosing a homeowner’s equity of redemption despite a bankruptcy filing.  Such was the case in In re McCrimmon 536 B. R. 374 (Bankr. D.MD. 2015). The tax purchaser bought the delinquent real estate taxes before the homeowner filed bankruptcy.  There was no automatic stay violation at the time of purchase because the bankruptcy case had not yet been filed.  Maryland law required the tax purchaser to give certain notice to the property owner and lienholders at least two months prior to filing an action to foreclose the right of redemption.  The tax purchaser conducted a title search and gave proper notice to the owner and known lienholders prior to filing the foreclosure action in the county court.

Later, the McCrimmon homeowner filed bankruptcy but failed to provide any notice to the real estate tax purchaser.  Subsequently, the tax purchaser filed suit in the county court and foreclosed the homeowner’s right of redemption in accordance with Maryland law.  The mortgage lender objected to the tax purchaser’s foreclosure because it violated the Bankruptcy Code’s automatic stay protections because the foreclosure occurred after the bankruptcy filing and without leave of the bankruptcy court.

The tax purchaser filed a motion to “annul” the automatic stay.  The McCrimmon court granted the tax purchaser’s motion because: (1) the tax purchaser was not noticed and had no actual or constructive knowledge of the bankruptcy filing; (2) the court would have granted a motion to lift the automatic stay had the tax purchaser filed such a motion prior to the foreclosure sale; and (3) the equities favor the tax purchaser because the financial loss to the purchaser by denying the motion to annul far outweigh the financial loss to the mortgage lender by granting the motion to annul.  Therefore, the court annulled the automatic stay so that it had no effect upon the tax purchaser’s foreclosing of the homeowner’s right of redemption.

Practice Pointer:  An individual who files bankruptcy should give notice of the bankruptcy filing to all creditors, including a real estate tax purchaser.  Creditors who violate the automatic stay protections could “annul” the stay if the equities are in their favor.  This is a factual determination.  Annulling the automatic stay would not have occurred in the McCrimmon case had the tax purchaser been given notice of the bankruptcy case and chose to ignore that notice.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can the IRS Intercept a Tax Refund to Pay Non-Tax Debts Owed to Other Federal Agencies?

Absent bankruptcy, the federal Treasury Offset Program (“T.O.P”) allows the IRS to offset a non-tax debt owed by a taxpayer to a federal agency against a federal income tax refund owed to the taxpayer.  See 26 U.S.C. §6402.  The right of offset (aka “setoff”) allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making party A pay party B when party B owes party A.

The IRS’ Treasury Offset Program authorizes the Secretary of the Treasury to intercept a taxpayer’s tax overpayment and apply it to preexisting debts.  Section 6402(a) of the US Tax Code provides that the Treasury “may” credit a taxpayer’s income tax overpayment against any tax liability.  Whereas, §6402(d) provides that Treasury “shall” credit a taxpayer’s income tax overpayment against a non-tax debt owed to another federal agency other than the IRS.

However, a taxpayer objected to the IRS intercepting a tax refund in the bankruptcy case of In re Addison, 533 B.R. 520 (Bankr. W.D.VA 2015).  There, the taxpayer argued that the US Bankruptcy Code’s automatic stay provisions of 11 U.S.C. §362(a)(7) prohibited the IRS from offsetting the tax refund against the non-tax liability owed by the taxpayer to the US Department of Agriculture, which related to a mortgage foreclosure deficiency.  The IRS countered and argued that §362(a)(7) did not apply because it was superseded by 11 U.S.C. §362(b)(26)’s negation of the automatic stay for setoffs by the IRS.

The Addison court rejected the IRS’ argument and held that §362(b)(26) did not apply to the facts of this case because §362(b)(26) only applied when the IRS was setting off tax debts owed to the IRS.  In the Addison case, the IRS was setting off non-tax debts owed to the US Department of Agriculture.  Specifically, the court stated §362(b)(26) constrains the reach of the automatic stay by excepting from violating the automatic stay the setoff under applicable nonbankruptcy law of an income tax refund…against an income tax liability.  (emphasis added).

Practice Pointer:   The IRS has broad tax intercept powers to collect debt on behalf of the federal government.  However, these powers are not unlimited.  In the bankruptcy concept, the IRS has the power to intercept tax refunds to offset tax liability relating to a taxable year that ended before the bankruptcy filing date, but the IRS does not have the power to intercept tax refunds to offset non-tax liability owed to other departments of the US Government.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can a Taxpayer Discharge Loan Debt Incurred to Pay an Otherwise Non-Dischargeable Tax Debt?

Yes and no, depending on what type of bankruptcy case is filed.  Sometimes a taxpayer has a tax debt that the taxpayer cannot afford to pay, but it cannot be discharged in bankruptcy because of the dischargeability prohibition of 11 U.S.C. §523(a)(1).  So, one strategy is for that taxpayer to obtain a bank loan to acquire capital and then tender the bank loan funds to the taxing authority to pay off the tax debt.  Then, that taxpayer files bankruptcy in an attempt to discharge the non-tax bank debt.

Such a taxpayer who files chapter 13 bankruptcy would have an easy time discharging the bank debt as long as the taxpayer waits a sufficient period of time.  The Bankruptcy Code does not expressly prohibit the Chapter 13 discharge of debts incurred to pay non-dischargeable tax debts.  However, an immediate bankruptcy filing after acquiring the bank loan would trigger issues of bad faith and fraud with a bank alleging the taxpayer had no intention of ever repaying the bank loan.  See 11 U.S.C. §§523(a)(2) or (a)(4). So a taxpayer should wait a period of time before filing bankruptcy, and make the required monthly payments on the loan until the bankruptcy filing to show good faith and act as a prophylactic.

A taxpayer who files chapter 7 bankruptcy would be out of luck and find non-dischargeable pursuant to 11 U.S.C. §§523(a)(14) or (a)(14A) the bank debt incurred to pay off the tax debt.  These Bankruptcy Code sections except from Chapter 7 discharge debt incurred to pay a non-dischargeable tax owed to the United States or any other governmental unit.

These issues were addressed in Brown v. Link (In re Link), 2015 Bankr. LEXIS 3248 (Bankr. E.D.MO 2015).  In Link, a restaurant seller owed delinquent state sales tax at the time the restaurant was sold.  The seller sold the business to the buyer (and the buyer ultimately filed Chapter 7 bankruptcy) for an amount sufficient to pay the seller’s state sales tax obligation.  The buyer did not have sufficient capital so the buyer secured a loan.  The lender tendered funds to the buyer in the form of three checks: (1) a check made payable to the state sales taxing authority in the exact amount of the sales tax debt owed by the seller; (2) a check made payable to the state sales taxing authority in an amount the buyer was required to pay the state taxing authority as a bond for prospective sales taxes; and (3) a check made payable to the buyer for additional capital. Ultimately the restaurant failed and the buyer filed bankruptcy seeking to discharge the loan provided by the lender that had been used to pay money to the state sales taxing authority.

The first issue the Link court had to address was whether the 11 U.S.C. §523(a)(14A) non-dischargeability exception applied to loans incurred to pay tax debts owed by someone other than the person filing bankruptcy.  In Link, this issue related to the buyer’s loan incurred to pay the state sales tax owed by the seller.  The Link court held that the 11 U.S.C. §523(a)(14A) non-dischargeability exception applied to the payment of all non-dischargeable tax debts and was not limited to just the tax debts owed by the person filing bankruptcy.  Therefore, the buyer’s loan was deemed non-dischargeable because the court found a direct connection between the loan incurred and the immediate application of those funds to seller’s tax obligations.

The second issue the Link court had to address was whether the 11 U.S.C. §523(a)(14A) non-dischargeability exception applied to loans incurred to pay a bond for prospective sales taxes.  The court found that buyer’s use of the loan to pay the sales tax bond resulted in the loan being rendered non-dischargeable.  This issue appears more complicated than the first issue and the court’s analysis is debatable.  The Link court interpreted expansively the non-dischargeability statute’s language of “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” 11 U.S.C. §523(a)(1) incorporating 11 U.S.C. §507(a)(8)(C).  This interpretation appears to be overly expansive and subject to an appellate attack because the buyer’s bond was not a “tax,” but merely collateral to be used by the state sales taxing authority in the event the buyer fails to pay to the taxing authority the required sales tax in the future.  If the buyer pays the appropriate sales taxes in the future, then the bond would be returned to the buyer.  As such, the bond may be interpreted by an appellate panel as not “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.”  11 U.S.C. §523(a)(1) incorporating 11 U.S.C. §507(a)(8)(C).  Under this alternative interpretation, the loan proceeds used to pay the bond would not be deemed a payment of a “tax” and would therefore be dischargeable. But, the buyer never appealed the decision so the issue has to wait for another case.

Practice Pointer:   A taxpayer should file Chapter 13 bankruptcy instead of Chapter 7 bankruptcy if that taxpayer is attempting to discharge a loan incurred to pay otherwise non-dischargeable taxes owed to the IRS or another taxing authority.  Chapter 7 is a poor choice.  Instead, a Chapter 13 bankruptcy with a limited dividend to unsecured creditors would be a better strategy.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can a Bankruptcy Trustee Force the IRS to Surrender Trust Fund Taxes Paid by a Bankruptcy Payroll Company?

It is not uncommon for a for-profit corporation to outsource payroll services to an independent payroll company (“Payroll Provider”) to help administer payroll tasks.  A corporation typically advance funds to the Payroll Provider near the end of a payroll cycle, which are in turn used by the Payroll Provider to pay wages to the corporation’s employees and pay corresponding trust fund obligations to the various taxing authorities.

But what happens when the Payroll Provider files bankruptcy within 90 days of paying trust fund obligations to the IRS?  The issue is one of “preferential transfer.”  This issue was addressed in Slobodian v. United States of America, 533 B.R. 126 (Bankr. M.D.PA 2015), where the Payroll Provider paid $32,297 to the IRS within the period 90 days prior to the Payroll Provider filing bankruptcy.

In Slobodian, The Chapter 7 trustee filed an adversary complaint against the IRS alleging that the IRS payment was a preferential transfer because it was made within 90 days of the bankruptcy filing.  The trustee sought disgorgement of the $32,297 so that the funds could be redistributed to all creditors according to their statutory rights.

The Slobodian court ruled that in order to disgorge a purportedly preferential transfer, a trustee must demonstrate a (1) transfer of an interest of the debtor in property (2) to or for the benefit of a creditor (3) for or on account of an antecedent debt owed by the debtor, and (4) made while the debtor was insolvent.  11 U.S.C. §547(b).

So the big issue for the Slobodian court to determine was whether the $32,297 payment constituted a “transfer of an interest of the debtor in property.”  The IRS argued that the Payroll Provider never possessed an interest in the property for preference action purposes, and instead held the transferred funds in trust, to be transmitted to the United States pursuant to the Payroll Provider’s payroll service agreement with the corporation that provided the funds to the Payroll Provider.  The IRS asserted that the funds were held in a special statutory trust for the United States pursuant to 26 U.S.C. §7501(a), which states “Whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States.”  The special trust applies to Social Security, Medicare, and income taxes that Congress requires employers to withhold from employees’ paychecks, commonly referred to as “trust-fund taxes.” Id. at 134, citing Begier v. Internal Revenue Service, 496 U.S. 53, 54 (1990).

The Slobodian court agreed with the IRS and found that corporation’s channeling of trust fund taxes through the third-party Payroll Provider did not dilute the protections of the 26 U.S.C. §7501(a) trust.  The corporation tendered the funds to the Payroll Provider which collected the funds pursuant to its payroll services agreement and withheld both trust fund and non-trust fund taxes from the collected funds before ultimately distributing employee paychecks.  Therefore, the Payroll Provider did not own an equitable interest in the property it held in trust for the corporation, and thus the $32,297 payment was not “property of the estate” for purposes of preferential transfers of 11 U.S.C. §547(b).

The IRS was allowed to retain the payment and the corporation received full credit for the trust fund payments.

Practice Pointer: Be careful when dealing with payroll providers.  Perform due diligence on the providers before tendering money to them.  Make sure the funds tendered by the corporation to the payroll service are made from a segregated trust fund account and not from the corporation’s general operating account.  The preferred method would be two separate payments being made to the payroll service: one payment for employees; and one payment for the taxing authorities.  This preferred method would buttress a corporation’s argument that the trust fund payments were tendered to the payroll service in trust as part of a 26 U.S.C. §7501(a) trust fund. It may not be “convenient” but it is following best practices.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can Income Taxes be Eliminated if the IRS Still Has the Right to Assess a Deficiency?

No, income taxes cannot be discharged or eliminated in bankruptcy if the taxing authority still has the right to assess a tax.  Section 523(a)(1)(A) of the Bankruptcy Code identifies certain types of income taxes that are non-dischargeable in bankruptcy by incorporating §507(a)(8)(A) of the Bankruptcy Code.  Section 507(a)(8)(A) excepts from discharge any income taxes that are assessed within 240 days of the bankruptcy filing, or are assessable under applicable non-bankruptcy law after the bankruptcy case is filed.

The US Court of Appeals for the Seventh Circuit addressed this issue in U.S. v. Frontone, 383 F.3d 656 (7th Cir. 2004).  In Frontone, a taxpayer had filed a tax return and paid the tax owed as required by the IRS Code.  However, the IRS made an error and wrongly tendered a tax refund to the taxpayer.  The IRS later realized its error and issued a supplemental assessment for the deficiency caused by the tax refund.  The IRS compounded the error by making another error—namely, issuing a supplemental assessment without issuing a notice of deficiency.

The taxpayer filed bankruptcy in an effort to discharge the tax debt caused by the tax refund.  The Frontone court denied the taxpayer’s quest for a discharge because the tax obligation was assessable at the time the bankruptcy case was filed. First, the court found that the IRS’ supplemental assessment was in error because it had not followed a “notice of deficiency.”  But that did not save the taxpayer because the court found that the IRS eventually filed the required notice of deficiency within the time period allowed as provided by the IRS Code (even if it was after the bankruptcy filing).  Therefore, since the notice of deficiency was finally issued correctly, the Frontone court found the tax refund obligation non-dischargeable because the tax debt was “assessable” on the date the bankruptcy case was filed.

Practice Pointer:   Best practices requires a careful analysis of the tax filing deadlines and the Bankruptcy Code’s statutory waiting periods.  Taxpayers must wait to file bankruptcy at least 240 days after the IRS assesses the tax, AND wait beyond the statutory assessment period if the IRS has not yet assessed a tax so that the tax becomes non-assessable.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Does a Bankruptcy Filing Stop the IRS from Levying Assets? 

Yes, filing bankruptcy immediately stops the IRS from levying assets or even threatening to levy assets while the bankruptcy case is pending.  Section 362 of the Bankruptcy Code provides that a bankruptcy filing immediately protects a taxpayer by an automatic injunction called the “automatic stay” from any act by a taxing authority to collect, assess, or recover a claim against the taxpayer that arose before the bankruptcy case was filed. 11 U.S.C. §362(a)(6). The conduct prohibited ranges from that of an informal nature, such as by telephone contact or by dunning letters, to more formal judicial and administrative proceedings.

In the IRS context, the automatic stay prohibits the IRS from sending a Notice of Intent to Levy and a Notice of Levy. However, the Bankruptcy Code does not prohibit all communications by the IRS.  Despite the fundamental importance of the automatic stay, Congress provided taxing authorities an exception to the automatic stay provision for “(A) an audit by a governmental unit to determine tax liability; (B) the issuance to the debtor by a governmental unit of a notice of tax deficiency; (C) a demand for tax returns; or (D) the making of an assessment for any tax and issuance of a notice and demand for payment of such an assessment. See 11 U.S.C. §362(b)(9).

The §362(b)(9) exception has its own limitations and is narrowly construed.  The IRS may be permitted to make an assessment and a demand for payment. However, the IRS cannot couple that demand for payment with a Notice of Levy or other collection effort, or a Notice of Intent of Levy or other threat of a collection effort, including IRS pamphlets entitled “Understanding the [IRS] Collection Process (IRS Publication 954).

The limits of a §362(b)(9) exception was addressed recently in the non-IRS case In re Gonzalez, 532 B.R. 1 (D. PR 2015). The Gonzalez court had to determine if the Treasury Department of Puerto Rico violated the automatic stay by sending a debtor a “Final Notice” regarding the taxpayer’s prepetition income tax debt. That notice also included an assertion that the law empowers the taxing authority to use collection steps like wage garnishments and asset levies. The Gonzalez court rejected the taxing authority’s argument that such communications are excepted from the automatic stay by §362(b)(9).  Instead, the Gonzalez court ruled that the threat of collection efforts is outside the creditor protection of §362(b)(9) and is an automatic stay violation of 11 U.S.C. §362(a)(6).  The tax authority’s actions were enjoined and the violation subjected the taxing authority to sanctions, costs, and attorney’s fees.

PRACTICE POINTERS: A tax professional should recommend a taxpayer seek the advice of a bankruptcy attorney whenever the IRS or other taxing authorities are threatening collections action like levies and garnishments.  The automatic stay protections afforded by the Bankruptcy Code give taxpayers breathing room to orderly address the tax collection issues jointly with the tax professional and bankruptcy attorney.  The automatic stay stops the IRS from collecting, including levies and garnishments.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Are Excise Taxes Dischargeable in Bankruptcy? 

Excise taxes assessed against an individual are dischargeable in a Chapter 7 case if the taxpayer waits three years to file bankruptcy.  The waiting period begins on the date of the transaction that incurs the excise tax if the taxpayer is not required to file a tax return reporting the excise tax.  However, the waiting period begins on the date of the tax return “due date” if the taxpayer is required to file a tax return reporting the excise tax transaction.

The excise tax is deemed a “priority” tax within the first three years of the waiting period pursuant to  11 U.S.C. §507(a)(8)(E) and rendered nondischargeable pursuant to 11 U.S.C. §523(a)(1)(A).  But the excise tax transforms into a “general unsecured” tax after the three year waiting and becomes dischargeable period pursuant to 11 U.S.C. §§727(a) and 1328(a).

So, the individual taxpayer who waits the three years can obtain a Chapter 7 discharge of the excise tax without paying any money to the taxing authority pursuant to 11 U.S.C. §727(a).  However, filing one day too early would cause the excise tax to be a non-dischargeable priority debt pursuant to 11 U.S.C. §523(a)(1)(A) incorporating 11 U.S.C. §507(a)(8)(E).

Similarly, the individual taxpayer who waits the three years can obtain a Chapter 13 discharge of the excise tax debt pursuant to 11 U.S.C. §1328(a) by paying only the percentage of the general unsecured debt required by the “liquidation analysis” of 11 U.S.C. §1325(a)(4).

Excise taxes assessed against a corporation are never dischargeable by filing Chapter 7 since corporations cannot receive a Chapter 7 discharge.  Similarly, corporations cannot receive a Chapter 13 discharge because they are not eligible to file Chapter 13.  However, a corporation could file a Chapter 11 case and pay less than the full amount of the excise tax if the corporation waits longer than the three year waiting period.

The dischargeability of an excise tax by an individual was addressed in In re Carpenter, 519 B.R. 811 (Bankr. D.MT 2014).  There, a corporation failed to pay required unemployment insurance taxes. The state taxing authority then assessed the tax against the corporate president as a “responsible party” because the president failed to cause the unemployment taxes to be paid.

The Carpenter court identified the issue as whether a corporate president’s personal liability for the corporate excise tax retains the status of “excise tax” when applied to the president individually.  The Court noted that all parties stipulated that the corporation’s obligation to pay the unemployment insurance tax was an “excise” tax. However, the president argued his tax obligation under the “responsible party” rule does not constitute an excise “tax” and is therefore not a priority debt.  Id. at 813.

Before ruling the court quoted Collier on Bankruptcy as stating the “first step in determining whether a claim is entitled to priority is determining whether the claim asserted by a governmental entity is a tax or is another type of obligation.”  4 Collier on Bankruptcy Sec 507.11[6].  The court determined that the obligation owed by the president as a “responsible party” was a tax.  Then, the court rejected the president’s argument and found that the president’s obligation to pay as a responsible party was an obligation to pay an “excise” tax and thus was a priority debt.  The logic of the opinion is somewhat confusing and could have been challenged on appeal.

PRACTICE POINTERS: A tax professional should analyze whether the obligation imposed by the government is a “tax” or merely a debt.  Any debt would be dischargeable in an individual Chapter 7 bankruptcy.  Any excise “tax” would be nondischargeable within the three year waiting period, but would be transformed into a dischargeable debt after the three year waiting period.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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The IRS Seized the Corporation’s Assets. Can a Corporation File Bankruptcy and Discharge Tax Debts? 

I’m often asked how a corporation can eliminate its tax debts.  Typically, the corporation has withheld taxes from its employees’ paychecks but has not tendered these “trust fund taxes” to the IRS or state taxing authority.  These withheld funds are referred to as “trust fund taxes” because the employer withheld the money “in trust” for the benefit of the IRS or other taxing authority.

An employer who is struggling financially uses the trust fund taxes as a source of hard currency, much like it would if granted a bank loan.  An employer hopes the use of the trust fund taxes would defuse a business crisis or at least keep the business afloat until brighter days (entrepreneurs always see a brighter tomorrow).  The problem is the IRS is not a lender and did not voluntarily give the employer the money —and certainly has not granted the employer authorization to use the trust fund taxes.

The IRS is typically aggressive in collecting the trust fund taxes.  The IRS can intercept tax refunds, lien, levy, seize, and exercise other collection tactics.  Seizure of the corporation’s asset could terminate the business.  For example, what would a restaurant owner do if the president arrived at the restaurant one morning to find the IRS had seized all the tables, chairs, refrigerators, freezers, etc.? Panic of course!

So what is the corporation to do?  Call its lawyer of course!  But there is only so much a lawyer can do in such an emergency.

The corporation is generally not in a position to repay the IRS the full amount of the trust fund taxes in a quick lump-sum payment so that the assets are returned.  Lawyers can contact the IRS and try to negotiate an installment agreement or an offer-in-compromise— but that takes time and the IRS would be in no hurry to relieve the taxpayer’s pressure by returning the assets.  An emergency bank loan would be nice, but that is not realistic because of the pending tax obligation and the fact that the restaurant is not operating since the IRS seized the tables, chairs, refrigerators, freezers, etc.

So bankruptcy becomes the obvious solution.  Chapter 13 is not available because the tax debt is owed by the corporation and Chapter 13 is available only to individuals.  Chapter 11 is a great option. Filing the Chapter 11 bankruptcy case would grant the corporation with the “automatic stay” protections of the US Bankruptcy Code.  The attorney would contact the IRS to negotiate a return of the assets for the company’s promise to pay adequate protections payments to the IRS going forward.  If negotiations are unsuccessful, then the court should rush to the courthouse to file an adversary proceeding to force the IRS to return the assets… again, the company would have to provide the IRS adequate protection.  But at least the company could return to regular business operations.

Some clients ask if the taxes could be discharged by filing Chapter 7 bankruptcy without the need to pay any adequate protection payment to the IRS. The answer is NO.  That strategy was tried by a convenience store operating in Senatobia, Mississippi in the case of In re Sarfani, Inc., 527 B.R. 241 (Bankr. N.D.MS 2015).  In Sarfani, the company attempted to discharge unpaid sales taxes collected from customers as “trust fund” taxes.  The court rejected the company’s attempt to discharge the taxes because Sarfani, Inc. was a corporation and Chapter 7 bankruptcy discharges are only available to individuals (human) and not corporation, partnerships, LLCs, LLPs, trusts, etc.  11 U.S.C. §727(a)(1).  So, Chapter 11 would be the best bet.

PRACTICE POINTERS: The best tax planning is advanced tax planning. Bankruptcy lawyers are frequently contacted in emergencies after the IRS collectors have struck and struck hard—shuttering a business.  The IRS can be agreeable if the company negotiates before the issue comes to a boil.  But once the IRS collectors have taken action a company would typically need court intervention and the bankruptcy protections to survive.  How long can a company survive that is shuttered?  NOT LONG!  Customers find competitors, suppliers and vendors get frightened, and employees quit and find other jobs.  Immediate Chapter 11 bankruptcy protection would be warranted.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can a Bankruptcy Trustee Seize an Inherited IRA?

A Chapter 13 trustee cannot seize any IRA.  The worst the trustee can do is insist that the Chapter 13 plan provides to unsecured creditors an amount equal to the non-exempt value of the inherited IRA.  Whether the inherited IRA is exempt is a question of federal law for those states that have not opted-out of the federal exemptions (11 U.S.C. §522(b)) and a question of state law for those states that have opted-out.

A Chapter 7 trustee has greater powers than a Chapter 13 trustee.  A Chapter 7 trustee can seize and force the turnover of non-exempt inherited IRAs.  So the question is whether the inherited IRA is exempt or non-exempt from seizure.  This issue was addressed in In re Everett, 520 B.R. 498 (E.D.LA 2014).  In Everett, the taxpayer inherited an IRA from her ex-spouse and transferred the inherited IRA into a new IRA in her name. Later, a creditor obtained a $245,000 judgment against the taxpayer and claimed an interest in the inherited IRA.  Taxpayer responded by filing bankruptcy to discharge the debt. Taxpayer identified the inherited IRA as an asset and claimed the asset was exempt from collection.  Creditor objected to the exemption.

The Everett court found that the inherited IRA was NOT exempt under federal law.  The court cited the U.S. Supreme Court’s ruling in Clark v. Rameker, 134 S.Ct. 2242 (2014) that held inherited IRAs are not “retirement funds” within the meaning of §522(b)(3)(C) and therefore are not exempt assets.  The Supreme Court distinguished IRAs from inherited IRAs.  Inherited IRAs do not operate like ordinary IRAs.  Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time without paying a tax penalty.  Indeed, the owner of an inherited IRA not only may but must withdraw its funds.  The owner must either withdraw the entire balance in the account within five years of the original owner’s death or take minimum distributions on an annual basis.  And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account.  Consequently, the Everett court found that the taxpayer’s inherited IRA cannot be exempted under federal exemption laws of §522(b)(3)(C).

The Everett court next noted that that Louisiana had opted out of the federal exemption statute of §522(b).  The court then analyzed Louisiana exemptions and found that the inherited IRA was not exempt under Louisiana law because the inherited IRA was not a “tax-deferred arrangement” within the meaning of the Louisiana statutes and therefore not exempt from the bankruptcy estate under Louisiana law.

Therefore, the Everett court reversed the lower court’s order denying the objection to taxpayer’s exemption, which will result in the taxpayer losing the inherited IRA to creditors.

PRACTICE POINTERS:  Determine whether the taxpayer’s state has opted-out of the federal tax exemptions.  If opted-out, then determine the exemption status of inherited IRAs under the state law of taxpayer’s residence.  This analysis will help you advise the taxpayer whether the inherited IRA would be protected from the Chapter 7 trustee’s attempt to seize the property or force a turnover of the property.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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How Long Does a Bankruptcy Filing Stay on My Credit Report?

Some people say a bankruptcy filing stays on the credit record for 7 years and other say 10 years.  Who is right?  This issue was addressed by the U.S. Court of Appeals for the Seventh Circuit in Childress v. Experian Information Solutions, Inc., 790 F.3d 745 (7th Cir. 2015).  In Childress, the court found the Fair Credit Reporting Act requires a reporting agency to purge bankruptcy records 10 years after the bankruptcy filing date, but noted that the credit-reporting agencies voluntarily purge them after seven years instead.  Id. at 746-747.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can Bankruptcy Discharge Income Taxes Filed More Than 2 Years Before the Bankruptcy Filing?

Short Answer:  Yes, income taxes can be discharged in bankruptcy if the taxpayer satisfies all of the bankruptcy requirements.  One of the contested issues is whether tax liability relating to a late-filed return can ever be discharged.  Another issue is whether the paper filed with the taxing authority is deemed a “return” for bankruptcy purposes.  These issues were addressed in In re McBride, 534 B.R. 326 (Bankr. S.D.OH 2015).

Facts: The taxpayer filed multiple city tax returns for taxes imposed by the City of Kettering, Ohio (“City”).  Some returns were filed on a timely basis and at least one return was filed after the due date. The tax liability due on these returns was calculated in relation to the IRS tax liability.  This liability was dramatically understated as a result of the taxpayer’s scheme to minimize tax liability through a now discredited “abusive trust arrangement.”  The US Tax Court found taxpayer’s self-reported returns dramatically deficient and increased the tax liability substantially, which caused the City tax liability to be increased proportionately.

Argument: In response, taxpayer filed chapter 7 bankruptcy to discharge the tax liability more than 2 years after the original City returns were filed. Taxpayer then filed an adversary proceeding to determine the dischargeability of the tax and filed a motion for summary judgment to obtain a judgment.  City objected asserting that the taxes owed are nondischargeable under 11 U.S. C. §523(a)(1)(B)(i) because the taxpayer never filed qualifying “returns.”  City argued the documents filed do not constitute “returns” because one return was untimely and all of the tax documents significantly under-reported the taxpayer’s income.

Analysis: The McBride court was forced to resolve the issue. There, the court addressed the two competing arguments regarding whether a late filed return can ever be a “return” for bankruptcy purposes.  The McBride court noted that the hanging paragraph in §523(a)(*) attempts to define the term “return.”  However, the court found the statute’s definition unclear and begged the question “Is §523(a)(*) pointing to the definitional provisions in state or local tax law to define the term ‘return’ for §523(a) purposes or, instead, must the document satisfy all aspects of the relevant nonbankruptcy ta law, including filing requirements, in order to be a ‘return’?” (Emphasis added).

The McBride court considered and rejected City’s bright-line test adopted by the Fifth Circuit in McCoy v. Miss. State Tax Comm’r (In re McCoy), 666 F.3d 924 (5th Cir. 2012) and followed by the Tenth Circuit in Mallo v. Internal Revenue Service (In re Mallo), 774 F.3d 1313 (10th Cir. 2014) and the First Circuit in Fahey v. Mass. Dept. of Revenue (In re Fahey), 779 F.3d 1 (1st Cir. 2015).  This test looks strictly at the tax statute’s filing deadline and would render taxes nondischargeable if the return was filed even one day late.

Instead, the McBride court applied the simplest meaning to §523(a)(*)’s definition of “return” as it relates to the nondischargeability of income taxes. The court held that §523(a)(*) required the court to look to relevant nonbankruptcy law to determine what qualifies as an acceptable return under that law. The court believed that if a document filed with the federal, state, or local taxing authority meets the applicable tax code’s DEFINITION of an acceptable return, then it is a return under §523(a)(*) even if the document does not fully comply with all aspects of the relevant tax code.

When a formal definition of return in the applicable tax statute is absent, the court must look to another source for determining whether the taxpayer’s tax documents qualify as a return.  The Sixth Circuit applied a four-part test to determine whether a tax form qualifies as a tax “return” for bankruptcy purposes: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of the tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of tax law.  See Beard v. Commissioner, 82 T.C. 766 (1984) adopted by United States v. Hindenlang (In re Hindenlang), 164 F.3d 1029 (6th Cir. 1999).

The McBride court applied its analysis to the case and bar and concluded that questions of fact existed and these facts had to be determined before the Beard test could be applied.  Therefore, the court denied the taxpayer’s motion for summary judgment and allowed the parties to present evidence to determine if the tax returns filed with the City were “returns” for bankruptcy purposes.

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis.  Wait the two years after filing the tax returns (and meet all other requirements) before filing bankruptcy.  Then expect to battle the taxing authority if the returns were filed late or substantially understated the tax liability.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

How do I Sue the IRS for Taking Assets After my Taxes were Discharged in Bankruptcy?

A taxpayer can sue the IRS for collecting taxes eliminated in a Chapter 7 bankruptcy case—but not immediately.  So what are the rules and limitations?

That issue was addressed in In re Broos, 534 B.R. 358 (8th Cir. BAP 2015).  There, the taxpayer filed bankruptcy and obtained a bankruptcy discharge before the IRS levied the taxpayer’s assets and filed a Notice of Federal Tax Lien. The taxpayer filed an adversary lawsuit in the bankruptcy court and sought damages for violating the automatic stay and/or the bankruptcy discharge injunction. The IRS sought to dismiss the lawsuit because the taxpayer had failed to exhaust the “administrative remedies” before filing the lawsuit.

The Broos court agreed with the IRS. First, taxpayers can sue the IRS only to the extent the United States has waived its sovereign immunity per 26 U.S.C. §7433(a).  But, taxpayers may not bring a direct action for damages against the IRS until the taxpayer exhausts the administrative remedies provided in 26 U.S.C. §7433(d).  The Tax Code requires the taxpayer to adjudicate the issues before an administrative law judge and plead a case for damages; thus keeping the IRS out of court as much as possible.  There, the taxpayer can seek damages for the IRS’ willful violation of the bankruptcy automatic stay protections under 11 U.S.C. §362 and the bankruptcy discharge injunction under 11 U.S.C. §524.  See 26 U.S.C. §7433(e)(1).

What are the procedures for exhausting the administrative remedies?  The procedure a taxpayer must follow in order to exhaust the remedies under §7433(d) for violating the bankruptcy discharge is enumerated in 26 C.F.R. 301.7430-1 and 301.7433-2(e).  A litigant must file a written administrative claim for damages or for relief with the Chief, Local Insolvency Unit for the corresponding judicial district in which the bankruptcy petition was filed.  The claim must contain the taxpayer’s name, identification number, current address, current home and work telephone number, the location of the bankruptcy court in which the underlying bankruptcy case was filed, the case number of the bankruptcy case in which the violation occurred, a description of the violation and injuries, the dollar amount of the injuries, and the signature of the taxpayer or taxpayer’s representative.  26 C.F.R. 301.7433-2(e).  The taxpayer must then wait until the earlier of six months or the date on which the IRS has rendered a decision on the claim.

In Broos, the taxpayer failed to seek damages and administrative remedies before filing the adversary lawsuit in the bankruptcy court.  Therefore, the bankruptcy court dismissed the lawsuit against the IRS as premature.

Note that damages can never include punitive damages against the IRS for violating the automatic stay or bankruptcy discharge injunction.  Punitive damages are unavailable as a matter of law. 11 U.S.C. §106(a)(3).

Practice Pointer: Suing the IRS is very complicated.  The law forces claims to be addressed administratively within the IRS by an administrative law judge. Only afterwards can a taxpayer seek damages in the bankruptcy court for violating the Bankruptcy Code.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can I Sue IRS Employees for Collecting Taxes Eliminated in Bankruptcy?

IRS employees make mistakes like everybody else.  But the IRS employees have special protections that average citizens do not enjoy. So, what can a taxpayer do if the IRS wrongfully attempts to collect income taxes discharged in bankruptcy by levying assets or filing notices of federal tax liens?

That issue was discussed in In re Broos, 534 B.R. 358 (8th Cir. BAP 2015).  In Broos, the taxpayer filed bankruptcy and received a chapter 7 bankruptcy discharge long before the IRS attempted to levy the taxpayer’s assets and before the IRS filed a Notice of Federal Tax Lien.  The IRS was provided notice of the bankruptcy and presumably notice of the chapter 7 bankruptcy discharge.  Nonetheless, the IRS levied and liened.

The taxpayer filed an adversary lawsuit in the bankruptcy court and sought damages for violating the automatic stay and/or the bankruptcy discharge injunction.  The lawsuit named as party-defendants the individual IRS employees involved in the levies and liens.  The IRS opposed arguing that the employees should not be the named defendants and the IRS should be substituted as the proper party defendant.

The Broos court agreed with the IRS.  The court noted the general rule that a taxpayer may not sue the United States or any of its officers and employees without a waiver of sovereign immunity.  Congress provided such a wavier in 26 U.S.C. §7433(a) but only as to the United States and not as to its individual employees.  Individual federal employees may not be sued for actions taken in the performance of their official duties.  Any claims filed against the individual employees would be barred by sovereign immunity.  Thus, the court granted the United States leave to be substituted as the property party defendants because Congress had waived sovereign immunity as to it.

Practice Pointer: Name the United States, and not the “Internal Revenue Service,” as the proper party defendant.  Also, do sue the individual IRS employees who performed the objectionable acts because the employees are protected by sovereign immunity.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Will I Lose my Tax Refund if I File Bankruptcy?

Here’s a common fact pattern.  A taxpayer files bankruptcy in June of a tax year and receives an IRS tax refund in April of the following calendar year.  What happens to the non-exempt portion of the IRS tax refund?  The taxpayer would want to keep the refund, but the Chapter 7 trustee would want a turnover of the refund for the benefit of the unsecured creditors.

That issues was addressed in In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, the parties agreed that the taxpayer should be allowed to keep the portion of the tax refund representing income earned after the bankruptcy case was filed to December 31.  The IRS argued that the taxpayer should be allowed to keep the same percentage of the tax paid after filing bankruptcy to the total tax refund; so if 25% of the tax payments were tendered after filing bankruptcy, then the taxpayer would be allowed to keep the same 25% of the total refund.

The Mooney court, rejected the IRS’ approach and adopted a “pro rata by days approach.”  Id. at 428.  The court held that the refunds should be prorated to the date of filing based on the number of calendar days before and after the bankruptcy filing date.  So, since the taxpayer filed bankruptcy on the 177th day of the year with 188 days remaining, then the trustee would be allowed to seize the percentage of the total refund that reflects 177/366, or 48.49%.  Similarly, the taxpayer would be allowed to retain the percentage of the total refund that reflects 188/365, or 51.51%.

Practice Pointer:  File as early in the calendar year as possible if a taxpayer is expecting a large refund. An early filing preserves the argument that the income was earned after the bankruptcy filing and the maximum share of the tax refund would be protected by the taxpayer.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are Estimated Tax Payments Paid to the IRS Protected from Seizure in Bankruptcy?

Yes, estimated tax payments made to the IRS immediately before filing bankruptcy could be protected from seizure by the Chapter 7 trustee, according to In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, an individual taxpayer tendered to the IRS $36,700 in estimated tax payments two days before filing Chapter 7 bankruptcy.  The Chapter 7 trustee wanted to seize those payments and filed a motion for turnover pursuant to 11 U.S.C. §542(a), arguing that the estimated tax payments were credits against the future tax liability and constituted “credits” that are property of the bankruptcy estate which are subject to turnover.  The taxpayer opposed the turnover motion and argued that the tax payments/credits are not within the taxpayer’s “control” because those payments can only be refunded by the IRS after the payments are applied to taxes due for the year in which the payments were made, citing Rev. Rul. 54-149, 1954-1 CB 159-60.

The Georgia bankruptcy court noted that the Eleventh Circuit in which it sits has never published a decision on the issue. But, the court noted that the Ninth and Tenth circuits have published conflicting opinions.  So the bankruptcy court analyzed both approaches.

Adopting the reasoning of the Tenth Circuit in the case of Weinman v. Graves (In re Graves), 609 F.3d 1153 (10th Cir. 2010), the Mooney court started its analysis by finding the tax credits were property of the bankruptcy estate.  But, the court noted that the Chapter 7 trustee succeeded only to the title and rights in the tax credits that the taxpayer had at the time the bankruptcy case was filed, nothing more.  The Mooney court believed the trustee’s interest in the tax creditors were limited to the same extent as a taxpayer’s interest in the application of a prior year tax refund, by the strictures of 26 U.S.C. §6513(d), which makes a taxpayer’s refund application election irrevocable.  A taxpayer would have no right to any cash refund of the estimated tax payments until their current tax liability is determined and then only if they are entitled to a further refund.

Finally, the court held that the bankruptcy estate’s interest in the pre-payment is limited to the taxpayer’s contingent reversionary interest in the pre-payment attributed to pre-petition earnings.  Stated differently, if the taxpayer is entitled to a refund after their current year tax liability was satisfied, then the Chapter 7 trustee is entitled to demand turnover of any amount of such refund attributable to the prepetition earnings.

Practice Pointer:  Tendering estimated tax payments to the IRS for the current year (or applying a tax refund from a prior year) prior to filing bankruptcy is a clever strategy to deplete non-exempt assets that would otherwise be seized by the trustee and distributed to the unsecured creditors.  Step two of the strategy would be to minimize the tax refund in the current year since the Chapter 7 bankruptcy trustee would be entitled to demand turnover of any amount of the refund attributable to the prepetition earnings. Taxpayers receiving a paycheck could reduce their tax withholdings in an effort to minimize the tax refund.  Self-employed taxpayers could seek to minimize refunds by minimizing net income from delayed income recognition and expedited expense recognition.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Does a Criminal Conviction Prevent a Taxpayer from Discharging Tax Debt?

Criminals who have been convicted of tax fraud or other tax crimes typically have tax liabilities.  But not all tax crimes are the same.  Some crimes relate to filing fraudulent tax returns with the intent to evade paying taxes.  Other tax crimes relate to willfully submitting to the IRS false returns, statements, or other documents that may or may not relate to any intent to evade paying taxes.  From a bankruptcy point of view, these crimes are not equal.

The question arises whether a taxpayer convicted of willfully submitting to the IRS false “returns, statements, or other documents” pursuant to 26 U.S.C. §7206(1) can discharge the related tax liabilities by filing Chapter 7 bankruptcy.  This issue was addressed in U.S. v Parker, 578 Fed.Appx. 669 (9th Cir. 2014).  In Parker, the IRS filed a summary judgment motion seeking to reduce to judgment the taxpayer’s income tax liability after taxpayer received a bankruptcy discharge.  The taxpayer objected claiming there was a triable issue of fact that precluded the entry of a summary judgment on the issue of bankruptcy dischargeability, namely whether the taxpayer ever intended to evade paying the tax. Taxpayer asserted that the tax conviction (and tax liability) resulted from the embezzlement of funds to save a business from bankruptcy and not to evade paying IRS tax.

The 9th Circuit Court of Appeals began its analysis by noting that a taxpayer’s discharge in bankruptcy may be excepted “for a tax… with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. §523(a)(1)(C).  The government must demonstrate (1) a knowing falsehood; (2) an intend to evade taxes; and (3) an underpayment of tax.

The Parker court determined that the  26 U.S.C. §7206(1) criminal conviction proved conclusively that the taxpayer had satisfied the first and third element (“a knowing falsehood” and an “underpayment of tax”), but did not conclusively prove the second element (that the taxpayer had intended to evade the payment of taxes).  So the court denied the IRS’ motion for summary judgment because an intent to evade taxes creates a credibility determination that is prohibited at the summary judgment stage.  A trial is required to determine the taxpayer’s intent.

Practice Pointers: A tax professional must realize that not all tax crime convictions are the same.  The tax professional must review the specific elements of the crime committed.  Some criminal convictions necessarily would result in the denial of a bankruptcy discharge, while other crimes do not.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are IRS Tax Liens Removed by Filing Bankruptcy?

An IRS lien can be eliminated in a Chapter 13 bankruptcy case, but tax liens cannot be avoided by filing a Chapter 7 bankruptcy case.

A taxpayer unsuccessfully attempted to avoid the IRS’ tax liens by filing chapter 7.  In U.S. v Parker, 578 Fed.Appx. 669 (9th Cir. 2014), the court found that a chapter 7 case discharged the taxpayer of personal liability for old taxes, but the prepetition tax liens on the taxpayer’s property remained enforceable after the discharge—citing the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992).

Practice Pointers: A Chapter 7 bankruptcy case is designed to eliminate personal liability, but not the lien against real estate or personal property.  A chapter 13 case would be a better strategy if the goal is to strip or avoid a lien.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Spouse Who Signs a Joint Tax Return Without Reviewing it be Denied a Bankruptcy Discharge?

Sometimes one spouse takes the financial reins and handles all the financial aspects of a marriage (like banking, buying cars, preparing tax returns, etc.) while the other spouse handles the day-to-day family issues (like cooking, cleaning, children, etc.).  It is not uncommon for the non-financial spouse to sign a tax return without reviewing it.  It is a matter of trust.  The non-financial spouse trusts the other spouse to prepare an accurate tax return.

In In re Birkenstock, 87 F.3d 947 (7th Cir. 1996), the court was confronted with the issue of whether a wife who signs a joint tax return without reviewing it can be denied a bankruptcy discharge of tax liability for “willful attempt to evade” taxes.  The Birkenstock court had no problem finding the husband to be a chronic tax evader who took extraordinary steps to willfully attempt to evade paying the taxes. The husband’s taxes were excepted from the bankruptcy discharge and survived intact at the conclusion of the bankruptcy.

The Birkenstock court had a more difficult time deciding whether the wife also willfully attempted to evade paying the taxes.  The court noted that the only relevant evidence upon which the bankruptcy court had determined that the wife had acted willfully was the fact that she had signed the joint tax return.

The Birkenstock court set out the rules for non-dischargeability of tax liability in bankruptcy. The court noted that a Chapter 7 debtor is typically granted a general discharge of all debts owed as of the bankruptcy filing date.  However, 11 U.S.C. §523(a)(1)(C) creates an exception to the dischargeability of income taxes when the taxpayer makes “a fraudulent return or willfully attempts in any manner to evade or defeat” the tax.

So the question in the Birkenstock case was what constitutes “willfully attempts … to evade or defeat” the payment of taxes.  The 7th Circuit held that §523(a)(1)(C)’s exception comprises both a conduct requirement (that the taxpayer sought in any manner to evade or defeat his tax liability) and a mental state requirement (that the taxpayer did so willfully).  The court found that a “willful” determination requires a taxpayer’s attempt to avoid tax liability to be voluntary, conscious, and intentional.  In other words, the taxpayer must both (1) know that she has a tax duty under the law, and (2) voluntarily and intentionally attempt to violate that duty.  The willfulness requirement prevents the application of the bankruptcy discharge exception to taxpayers who make inadvertent mistakes, reserving nondischargeability for those whose efforts to evade tax liability are knowing and deliberate.

After reviewing the law and apply the law to the facts, the court ruled that the bankruptcy had erred in finding the spouse had willfully attempted to evade the tax liability.  The only evidence presented at trial regarding the wife’s willfulness was the fact that she had signed the tax returns.  Therefore, the bankruptcy court order was reversed and the wife was granted the bankruptcy discharge as to the tax liability.

 

Practice Pointers:  A spouse should consider not filing a joint tax return if the spouse has any reason to believe the other spouse may be filing a fraudulent return or may be willfully evading the tax liability.  Instead, a spouse should consider filing a separate tax return, especially if the spouse has little to no income as the spouse in Birkenstock.  The wife in Birkenstock would not have had any tax liability, because she did not work, had she filed separately.  The husband would have had all the tax liability and the wife would not have had to worry about any court ruling that her share of the tax liability was nondischargeable.  There are some tax disadvantages by filing separately, but none of the those disadvantages would compare to the disadvantage of the wife being held jointly and severally liable for the husband’s tax liability that could later be deemed nondischargeable in bankruptcy.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Did a Parent Willfully Evade Paying Taxes by Paying College Tuition Instead?

Section 727(b) of the Bankruptcy Code provides for the discharge of an individual chapter 7 debtor’s prepetition debts unless such debts are excepted from discharge pursuant to 11 U.S.C. §523. Section 523(a)(1)(C) excepts from discharge any debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The issue of willful evasion was addressed in In re Looft, 553 B.R. 910 (Bankr. N.D.GA 2015).  In Looft, an IRS audit resulted in the disallowance of partnership losses taken by an individual taxpayer on Form 1040. The IRS then assessed tax liability of approximately $319,000.  The taxpayer struck back by hiring attorneys to sue the tax professional who advised the taxpayer to include the partnership losses on the tax returns.  Taxpayer submitted a request for a collection due process hearing and filed a petition in the US Tax Court.  The IRS issued notice of intent to levy.  Taxpayer filed an offer in compromise to settle the tax liability.  Ultimately, taxpayer sought bankruptcy relief to discharge the tax liability.

The Looft court considered the taxpayer’s behavior after the IRS audit to determine if the taxpayer willfully attempted to evade paying the taxes.  On the negative side, and instead of paying the tax liability assessed, taxpayer paid more than $88,000 in college tuition so his child could attend the University of Virginia.  Taxpayer also purchased an $18,500 BMW for taxpayer’s daughter to use during college and another BMW for $9,800 when she graduated.  Taxpayer also gave cash gifts to his children and bought them cell phones and a laptop computer.  Taxpayer also spent $68,000 on his country club and more than $16,000 on trips and vacations.

On the positive side, the court noted the following about the taxpayer: (1) asserted he was victim of bad tax advice; (2) made voluntary payments towards the assessed taxes, including $2,500 obtained through a home equity loan; (3) took no action to stop the IRS from intercepting taxpayer’s refunds; (4) did not change tax withholdings to reduce future refunds; (5) withdrew money from a 401(k), paying tax penalties to do so, and paid $22,000; (6) took no effort to change bank accounts or withdraw money from bank accounts after receiving the IRS’ notice of intent to levy; (7) taxpayer continued to direct deposit his paychecks into the same bank account after the levy; (8) did not avoid keeping money in the bank account; and (9) timely-filed tax returns and timely-paid tax obligations relating to all tax years after the tax assessment resulting from the audit.

The Looft court noted that the IRS has the burden of proof and that exceptions to discharge are strictly construed in favor of the taxpayer. The Looft court identified IRS burden.  The IRS must show that taxpayer engaged in (1) evasive conduct with (2) a mental state consistent with willfulness.

Evasive conduct requires a showing that the taxpayer engaged in affirmative acts to avoid payment or collection of the taxes, either through commission or culpable omission.  The conduct requirement is not satisfied by mere nonpayment of taxes.

The 11th Circuit in Zimmerman v. IRS (In re Zimmerman), 262 Fed. Appx. 943, 946 (11th Cir. 2008) supported a finding of nondischargeability when the conduct included: (1) failure to timely-file tax returns: (2) failure to pay taxes; (2) intra-family transfers for little or no consideration; (3) titling a house solely in the spouse’s name while the debtor remains on the mortgage and makes all the payments; (4)  characterizing earnings so they are not subject to tax withholding; (5) making large discretionary expenditures; (6) failure to file tax returns while maintaining a luxury lifestyle. Other issues to consider are: (6) use income to pay off other burdensome debts; (7) behavior intended to prevent IRS from reaching taxpayer’s assets; (8) under-withholding of taxes from paychecks; (9) failure to pay estimated taxes; (10) failure to accrue assets by opting to lease assets instead; (11) dealing primarily in cash transactions; (12) excessive spending; and (13) discontinuance of direct deposit of wages into an account subject to a levy.

The Looft court considered all these factors as they related to taxpayer and found that the tax payer did not willfully attempt to evade paying the taxes.  Important to the court was the fact that the only steps the taxpayer took to prevent the IRS from collecting the tax liability were through official channels (i.e. offer in compromise, tax court, collection due process hearing). The court found that taxpayer’s actions were not consistent with an intentional failure to pay.

Practice Pointers: Whether a taxpayer willfully evaded paying taxes is a fact intensive analysis.  If in doubt, a taxpayer should establish a pattern of action that would support a conclusion that the taxpayer has the desire to pay without the ability to pay.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Who Has the Burden of Proof in a Tax Dischargeability Dispute Relating to Fraudulent Returns or Willful Attempt to Evade Paying Taxes?

Certain tax liabilities can be discharged in bankruptcy provided they are not excepted from discharge pursuant to 11 U.S.C. §523.  Section 523(a)(1)(C) excepts from discharge any tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

Taxpayers or the IRS can file an adversary proceeding in bankruptcy court seeking an order determining whether the taxpayer’s tax obligations are discharged.  The factual question in these cases is whether  a taxpayer filed a fraudulent return or willfully attempted to evade or defeat a tax.

Who has the burden of proof: the taxpayer or IRS?  That issue was addressed in In re Looft, 553 B.R. 910 (Bankr. N.D.GA 2015), citing Griffith v. United States (In re Griffith), 206 F. 3d 1389, 1396 (11th Cir. 2000). The Looft court found that the burden of proof is on the government to prove nondischargeability by a preponderance of the evidence. Exceptions to discharge are strictly construed in favor of the debtor.  In determining whether the government has met its burden, the court considers the totality of the circumstances.

Practice Pointers: The taxing authority has the burden of proof, but the analysis is fact intensive.  The bankruptcy court would be given wide discretion in determining whether the government met its burden.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer Eliminate Tax Debt if He Failed to File a Return Until After the IRS Assessed the Tax?

An old case is instructive for taxpayers who live in Illinois, Indiana, and Wisconsin.  See In re Payne, 431 F.3d 1055 (7th Cir. 2005).  This case is more than 10 years old and applies pre-BAPCPA law, but it is the only case addressing the issue issued by the US Court of Appeals for the Seventh Circuit. Other circuit courts have ruled on the issue. SEE BLOGS. Again, the 7th Circuit has not yet ruled on the issue for taxes due after the 2005 BAPCPA law was enacted.

In Payne, the taxpayer failed to file the 1986 tax return until 1991, which was one year AFTER the IRS had assessed tax liability for income tax due.  Taxpayer offered to compromise his tax debt in 1992, but the IRS rejected the offer.  Five year later taxpayer filed for Chapter 7 bankruptcy relief in 1997.

The court correctly noted that Section 523(a)(1)(B)(i) of the Bankruptcy Code forbids the discharge of federal income tax liability with respect to which a “return” was required to be filed but “was not filed.”  The taxpayer argued that the return filed in 1992 was a “return” as used in the statute, albeit filed six years late and after the IRS had gone to the trouble of figuring out what the taxpayer owed.  The IRS argued that an untimely post-assessment return is not a “return” within the meaning of the statute and that therefore taxpayer never filed a 1986 “return” and so cannot be discharged from liability for the taxes that the taxpayer owes for that year.

The Payne court noted that the Bankruptcy Code had not defined the term “return” pre-BAPCPA.  However, cases held that to be deemed a return, a document filed with the IRS must (1) purport to be a “return,” (2) be signed under penalty of perjury, (3) contain enough information to enable the taxpayer’s tax liability to be calculated, and (4) “evince[] an honest and genuine endeavor to satisfy the law.  Id. at 1057, citing United States v. Moore, 627 F.2d 830, 834-35 (7th Cir. 1980). The Payne court further declared that a purported return that does not satisfy all four conditions does not play the role that a tax return is intended to play in a system of self-assessment.  So while a “return” that satisfies the first three conditions comports with the literal meaning of the word, it does not comport with the functional meaning.

The whole dispute in Payne was whether the taxpayer satisfied the fourth prong of the test and “endeavored to satisfy the law” by filing the 1986 tax return in 1992.  The court rejected a line of reasoning used by other courts that the a late-filed return after the IRS assessed the tax does not serve the purpose of the filing requirement.  The Payne court expressly stated that the legal test is not whether the filing of a purported return has some utility for the tax authorities, but whether it is a reasonable endeavor to satisfy the taxpayer’s obligations.  So the bankruptcy courts should not look through the eyes of the IRS to determine usefulness; rather, the court should look through taxpayer’s eyes to determine if the taxpayer’s efforts constituted a reasonable endeavor to satisfy the taxpayer’s obligations.

The majority of the Payne court reversed the lower court and found that the taxpayer had not reasonable endeavored to satisfy the taxpayer’s obligations.  Hence the tax debt was excepted from discharge.  However, a persuasive counter argument was asserted in a dissent by Circuit Judge Easterbrook, who argued that the return was a “return” for bankruptcy purposes.  The judge believed taxpayer’s failure to timely file the return was distinct from the definition of “return.”  Instead, the judge believed motive may affect the consequences of a late-filed return, but not the definition of “return.”  Motive was an issue relating to Section 523(a)(1)(C) and whether taxpayer “willfully attempted… to evade or defeat” the tax.  Remember, however, this case relates to pre-BAPCPA law established in 2005.  Judge Easterbrook, in dicta, suggested the result would be different if the BAPCPA law was applicable.

Practice Pointer:  This is an old case and several circuit courts have recently ruled that a late-filed return does NOT constitute a “return” for bankruptcy purposes.  So file those returns on time.  The Seventh Circuit has yet to issue a ruling, but a future circuit court panel could agree with Judge Easterbrook’s dissent.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer who Files a Tax Return After the IRS Assesses the Tax Eliminate the Tax Debt in Bankruptcy?

A Chapter 13 debtor could discharge the tax debt by paying the tax liability through the repayment plan.  However, most people are interested in the dischargeability of the tax debt in a Chapter 7 bankruptcy case without any payment to the IRS.

In In re Mallo, 774 F.3d 1313 (10th Cir. 2014), the taxpayers filed a Chapter 7 bankruptcy case to discharge tax debt relating to an IRS assessment made prior to the taxpayers filing the bankruptcy petition.   The taxpayers failed to file the returns for 2000 and 2001.  The IRS issued statutory notices of deficiencies pursuant to 26 U.S.C. §§ 6212 and 6213 for those years.  The IRS began collection efforts in 2006.  In response, the taxpayers filed joint Form 1040s for the missing years in 2007.

The Mallo court defined the issue as follows: whether an untimely 1040 Form, filed after the IRS has assessed the tax liability, is a tax return for purposes of the exceptions to discharge in 11 U.S.C. §523(a)(1)(B)(i) of the US Bankruptcy Code. The Court began its analysis by examining the Bankruptcy Code’s definition of “return,” which states a return “means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”  Id at 1318.

Second, the Mallo court noted that prior to the BAPCPA amendments of 2005  most courts determined whether a document qualified as a tax return by following the four-pronged test approved in Beard v. Commissioner, 793 F.2d 139 96th Cir. 1986).  This Beard test consisted of: (1) there must be sufficient data to calculate tax liability; (2) the document must purport to be a return; (3) there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) the taxpayer must execute the return under penalties of perjury. The majority of courts have held that tax forms filed after the IRS assesses the taxpayer’s liability have no valid purpose and therefore cannot satisfy the 3rd prong of the Beard test— there being no honest and reasonable attempt to satisfy the requirements of the tax law.  See In re Payne, 431 F.3d 1055 (7th Cir. 2005).

The Mallo court side-stepped the Beard test and held that 11 U.S.C. §523(a)(*) of the US Bankruptcy Code excludes late-filed Form 1040s from the definition of “return” because the “applicable filing requirement” includes filing deadlines—and late-filed returns do not satisfy applicable filing deadlines.  The court rejected the taxpayers’ argument that the “applicable filing requirements” refer not to the filing time, but to whether a tax form qualifies as a return upon form and content per the Beard test.  Apparently, the Mallo court would hold that no late-filed tax returns would ever be deemed a “return” for bankruptcy purposes.

Consequently, the Mallo court held that the taxpayer’s liability was excepted from the general Chapter 7 discharge order after finding the taxpayers’ Form 1040s were not “returns” for bankruptcy purposes of 11 U.S.C. §523(a)(1)(B)(i).

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis. There appears to be a growing trend to side-step the Beard test and find that late-filed tax returns can never be deemed a “return” and therefore can never be discharged in a Chapter 7 bankruptcy case.  The US Court of Appeals for the Seventh Circuit has not ruled on this issue directly. But read In re Payne, 431 F.3d 1055 (7th Cir. 2005).  The 7th Circuit covers all of Illinois, Indiana, and Wisconsin.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer “Strip Off” an IRS Lien From a Home by Filing Chapter 7?

Did you say Chapter 7 or Chapter 13?  It makes a difference.  Keep reading…

It is not uncommon for a taxpayer’s home to be “underwater,” meaning the fair market value (FMV) of a taxpayer’s home is less than the amount owed on the senior mortgage loan. Sometimes a taxpayer with an underwater home fails to pay income taxes, causing the IRS to file a Notice of Tax Lien against a taxpayer’s property with the Recorder of Deeds for the county in which the real property is located.  This lien gives public notice of a “secret lien” that previously existed pursuant to 26 U.S.C. §6321, which attached automatically to all of a taxpayer’s property and rights to property, both real and personal, upon assessment.

These taxpayers are prevented from filing Chapter 7 bankruptcy and “stripping down” the tax lien value from the full face amount of the tax obligation to the amount that would be recoverable after the senior liens are paid in full.  The U.S. Supreme Court rejected any attempt to “strip down” a lien in a Chapter 7 bankruptcy case in Dewsnup v. Timm. Until recently, the Supreme Court had not decided whether a lien could be “stripped off” in a Chapter 7 case.

So a clever taxpayer in In re Blackburn, 525 B.R. 153 (Bankr. N.D.FL 2015) attempted to reclassify an otherwise impermissible “strip down” of a tax lien into a “strip off” by arguing the IRS’ tax liens were divisible between real property and personal property.  If divisible, the taxpayer argued, then the tax lien could be “stripped off” as to the real property while preserving the tax lien as to the personal property.

The Blackburn court stated the issue as whether the IRS tax liens were divisible. The court ruled that the IRS tax liens were NOT divisible.  Therefore, the IRS’ claim was partially secured by the personal property.  The fact that there is no equity in the taxpayer’s real property over and above the senior mortgage did not render the IRS’ tax lien totally unsecured.  The IRS’ tax lien remained, at least in part, secured by the taxpayer’s personal property.  Consequently, the court rejected the taxpayer’s attempt to “strip off” the tax lien finding the taxpayer was actually attempting to “strip down” the tax lien, which was prohibited by the US Supreme Court in Dewsnup v. Timm.

Practice Pointers:  A taxpayer should attempt to file a Chapter 13 case instead of a Chapter 7 case if the taxpayer’s goal is to “strip down” a tax lien.  It is permissible to both “strip down” and “strip off” a tax lien in Chapter 13 bankruptcy cases.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

A Taxpayer Can Eliminate Tax Liability Relating to a Late-Filed Tax Return

The courts are divided regarding the dischargeability of tax obligations relating to a late-filed tax return.  An earlier blog discussed the First Circuit’s conclusion that a late-filed tax return is deemed NOT A RETURN for bankruptcy purposes solely because it was filed after the tax filing deadline.  See In re Fahey, 779 F.3d 1 (1st Cir. 2015).

However, a different conclusion was reached by the bankruptcy court in In re Biggers, 528 B.R. 870 (Bankr. M.D.TN 2015).  In Biggers, the court rejected Fahey’s rational and ruled that a late-filed return can be deemed a “return” if it meets the definition of “return” as set forth in Beard v. Commissioner, 82 T.C. 766, 1984 WL 15573 (1984), affirmed 793 F.2d 139 (6th Cir. 1986).  In order for a Form 1040 to qualify as a “return” pursuant to the Beard test: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law.  In re Biggers, 528 B.R. 870, 872 (Bankr. M.D.TN 2015).

The Biggers court agreed with the IRS and those decisions that define “applicable non-bankruptcy laws” (11 U.S.C. Section 523(a)(*)) as the pre-BAPCPA Beard test and found a Form 1040 is a “return” if it satisfies the Beard test. The court rejected the idea that the reference to “applicable non-bankruptcy laws” relates to the filing deadline imposed by the taxing authority per statute.

In Biggers, the taxpayers had filed multiple returns AFTER the filing deadline and AFTER the IRS had already assessed the tax.  The court found that the late-filed returns served no purpose on all but one return because the tax liability disclosed on the late-filed return was less than the amount assessed by the IRS and therefore did not “represent an honest and reasonable attempt to satisfy the requirements of the tax law,” as required by the fourth prong of the Beard test.  However, the court allowed the discharge of tax relating to the one late-filed return that disclosed liability greater than the amount assessed by the IRS.  The Court allowed the discharge as to the tax liability that exceeded the IRS’ assessed liability that return.

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis. It is a risky landscape on this issue.  The courts are split and no definitive ruling exists for Illinois taxpayers. So, a taxpayer seeking to discharge tax debts in a Chapter 7 bankruptcy should file all returns on a timely basis and then file bankruptcy after the two-year waiting period has expired (plus satisfy all other Section 523 requirements).

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer who Filed a Tax Return After the Filing Deadline Eliminate the Tax Debt in Bankruptcy?

Certainly a taxpayer could file a Chapter 13 bankruptcy case and discharge the tax debt by paying the tax liability through the repayment plan.  The real question is whether a taxpayer who files a tax return after the filing deadline could file a Chapter 7 bankruptcy case and discharge the tax debt without paying the tax liability.

Until recently, the issue appeared clear that the tax debt could be discharged in Chapter 7 if the taxpayer waited to file bankruptcy at least two years after the date the tax return was filed (assuming all other factors being satisfied). The prior court cases usually related to whether the document filed with the IRS was a “return” or some other document filed with the IRS (e.g. protest letter or something less than a statement as to gross and net income).  Another issue related to whether the return was filed by the taxpayer after the IRS had already prepared a substitute for return (aka “SFR”), which rendered a taxpayer’s later-filed return moot.

Now the issue is whether any return filed after the tax filing deadline is deemed NOT A RETURN for bankruptcy purposes solely because it was filed after the tax filing deadline—even one day late.  That issues was addressed by the U.S. Court of Appeals for the First Circuit in In re Fahey, 779 F.3d 1 (1st Cir. 2015).

In Fahey, the court was confronted with taxpayers who had failed to file their Massachusetts income tax return before the deadline imposed by the state statute.  The taxpayers filed their returns late and then waited two years before filing bankruptcy.  The taxpayers sought to discharge their tax obligations by filing Chapter 7.  The Massachusetts Department of Revenue objected arguing that the tax debt was non-dischargeable because 11 U.S. C. §523(a)(1)(B) excepts from discharge any tax obligation relating to a return that “was not filed or given.”  The Department then argued that the late-filed returns were not deemed “returns” for bankruptcy purposes even though the same returns would be considered “returns” for tax purposes.

The Fahey court agreed with the Massachusetts Department of Revenue, holding that the late-filed tax returns could not be deemed “returns” for bankruptcy purposes.  Therefore, the tax obligations would not be discharged in the Chapter 7 bankruptcy because 11 U.S. C. §523(a)(1)(B) excepts from discharge any tax obligation relating to a return that “was not filed or given.”

This case is very bad for taxpayers seeking bankruptcy protection. The only good news is that the U.S. Court of Appeals that incorporates the Chicagoland area has not ruled on the issue. Hopefully, the 7th Circuit Court of Appeals would render a contrary holding and create a conflict between the circuits so the U.S. Supreme Court would decide the issue once and for all.

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis. The Fahey case may not be limited to filing obligations. It could be interpreted expansively to apply to all tax obligations other than payment obligations. So, a taxpayer seeking to discharge tax debts in a Chapter 7 bankruptcy should file all returns on a timely basis and then file bankruptcy after the two-year waiting period has expired (plus satisfy all other Section 523 requirements).

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer Keep an IRS Tax Refund Received Shortly Before Filing Bankruptcy?

An Illinois taxpayer received a $10,000 refund about a month before filing bankruptcy.  The taxpayer identified the tax refund in amended Schedule B as “2013 Tax Refund (Earned Income Credit) -$4,989.00; 2013 Tax Income Refund (Child Care Credit)-$3,000.”

The taxpayer sought to keep that money and protect it from seizure by the Chapter 7 trustee.  The trustee wanted to include the tax refund as a non-exempt asset that should be added to the “bankruptcy estate.” The taxpayer attempted to exempt the tax refund from the bankruptcy estate by claiming it was “public assistance benefits” protected under the Illinois exemption statute 735 ILCS 5/12-1001(g)(1).  The trustee did not object to the taxpayer’s characterization of the tax refund as “public assistance benefits.”  But, the trustee objected because the taxpayer received the refund before the bankruptcy filing date, and argued that the Illinois exemption statute cited by the taxpayer did not apply.

The court resolved the issue by sustaining the trustee’s objection to the taxpayer’s claimed exemption, thus causing the tax refund to become property of the bankruptcy estate for redistribution to the unsecured creditors.  In re Frueh, 518 B.R. 881 (Bankr. N.D.IL 2014)(Lynch, J).  The court made a distinction between a taxpayer’s Section 5/12-1001(g)(1) “right to receive…public assistance benefits” in the future and a taxpayer’s Section 5/12-101(h) “right to receive, or property that is traceable to…” an asset.  The Frueh court’s distinction clarified the Illinois legislature’s desire to exempt public assistance benefits to be received in the future and not public assistance benefits already received. The court noted that the legislature knew how to protect already received assets when it wanted to do so (citing Section 5/12-101(h)), and chose not to protect public assistance benefits already received.

Practice Pointer:  A taxpayer anticipating a tax refund relating to the Earned Income Credit and/or the Child Care Credit should file a Chapter 7 bankruptcy case PRIOR to filing the IRS tax return— to ensure the tax refund would be received AFTER the case filing.  If needed, a taxpayer could request from the IRS an automatic extension to the tax return filing deadline to ensure the refund would be received after the bankruptcy case was filed.  To do otherwise results in the loss of the tax refund to the Chapter 7 trustee for re-distribution to the bankruptcy creditors.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Doctor File Bankruptcy and Eliminate Unpaid Business License Fees Assessed Against Professionals?

That issue was addressed in In re Perry, 521 B.R. 370 (Bankr. N.D. AL 2014).  In Perry, a medical doctor sought a determination that the $46,461 business license fees assessed against the doctor were discharged when the doctor received the Chapter 7 general bankruptcy discharge.  The City assessing the business license fees argued that the fees constituted an “excise tax” that was excepted from the general discharge and had to be paid after the bankruptcy.

The Perry court started its analysis by noting the language in 11 U.S.C. §523(a)(1) excepts certain tax obligations from the general bankruptcy discharge.  This U.S. Bankruptcy Code (“Code”) section incorporates a different Code section that identifies which types of taxes are excepted from the general bankruptcy discharge, including the “excise tax.”  See 11 U.S.C. §507(a)(8)(E).

The first issue raised is whether the business license fee was a “tax” as used in the U.S. Bankruptcy Code.  However, the term “tax” is not defined in the Code.  The U.S. Supreme court considered a tax to be a “pecuniary burden laid upon individuals or property for the purpose of supporting the government.”  United States v. Reorganized CF & I Fabricators of Utah, 518 U.S. 213, 220 (1996).  Therefore, a court must look to the substance of the statute or ordinance that establishes the obligation to determine whether the obligation bears the characteristics of a tax.  The statute’s mere characterization of the obligation as a “tax” is not controlling.  A measure is considered a “tax” when the enacting statute or ordinance’s purpose is to raise revenue and not to regulate and not to defray costs of a specific service.

The Perry court found that the business license fees assessed against professions like the debtor-doctor were “taxes” since the revenues raised by the license were placed in the City’s General Fund to be used for the City’s general obligations and not set aside to defray the costs of a specific service.

The second issue raised is whether the tax was and an “excise tax” as contemplated in 11 U.S.C. §507(a)(8)(E).  The Code does not define “excise” either.  But, the Perry court incorporated the definition used in Black’s Law Dictionary as a tax imposed on the performance of an act or the engaging in an occupation.  Doctors are definitely professionals and the court found that the license fees were excise taxes.

The third issue raised by the doctor is whether the excise tax was an “excise tax on a transaction” as contemplated in 11 U.S.C. §507(a)(8)(E).  The debtor-doctor argued that the business license fee was an occupation tax calculated on the doctor’s gross revenues and was not based on any “transaction.”  The court disagreed and found that debtor’s medical practice involved multiple transactions, from receiving payment for the care and treatment of patients to employing and paying others to work for the doctor.  The court chose to interpret the term “transaction” broadly.

Consequently, the court found the business license fees not discharged by the doctor’s bankruptcy because the fees were “excise taxes on a transaction” as contemplated in 11 U.S.C. §507(a)(8)(E).

because the fees were “excise taxes on a transaction” as contemplated in 11 U.S.C. §507(a)(8)(E).

Practice Pointer:  A proper analysis of the dischargeability of certain license fees begins with an analysis of the statute or ordinance that creates the fees.  The purpose of the legislation should be examined as well as the utilization of the collected fees.  Are the fees earmarked for a special purpose or deposited into the General Revenue Fund?  Next, examine whether the fees are an “excise” tax and also whether the tax related to a “transaction” or merely a status (e.g. license fee assessed against retired doctors who no longer practice would probably NOT be a “transaction” tax).

Finally, an issue not raised in the Perry case should be considered.  The business license fee found to be non-dischargeable  by the Court could have been discharged if the debtor-doctor had waited to file the bankruptcy case.  An “excise tax on a transaction” is excepted from discharge only if it’s a tax on a transaction occurring before the date of the bankruptcy filing for which a return, if required, is last due, less than three years before the date of the bankruptcy filing.  See 11 U.S.C. §507(a)(8)(E)(i).  Stated in reverse, an excise tax is discharged if the tax return that reports the excise tax was due more than three years before the bankruptcy case was filed.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Is the IRS “failure to file” penalty discharged in bankruptcy?

A taxpayer can discharge an IRS “failure to file” penalty assessed per 26 U.S.C. §6651(a)(1) for failure to file a tax return.  A taxpayer has two choices.

Option 1: A taxpayer with income can choose to file a Chapter 13 bankruptcy case and establish a repayment plan addressing all creditors, including the IRS.  The IRS “failure to file” penalty would be treated as an unsecured claim and paid on the same level as credit card debt, medical debt, and personal loans.  The IRS and other unsecured creditors could receive as little as 10 cents for every dollar owed and less in some jurisdictions.  At the completion of the repayment plan, any unpaid unsecured debt would be discharged and the IRS penalty obligation eliminated per 11 U.S.C. §1328(a).

Option 2:  A taxpayer without income or with insufficient income to fund a Chapter 13 bankruptcy case, instead, could file a Chapter 7 bankruptcy case.  No repayment is required in a Chapter 7 case and the IRS could be entitled to distribution from property of the bankruptcy estate on a prorate basis with all other unsecured creditors.  However, there is typically no property to distribute in a normal Chapter 7 case.

At the conclusion of a Chapter 7 case the taxpayer would receive a general discharge of debts pursuant to 11 U.S.C. §727(a).  This general discharge does not necessarily cover the IRS’ “failure to file” penalty because 11 U.S.C. §523(a)(7) creates an exception for penalties payable to a governmental unit. So a deeper analysis is required.

The exception to the bankruptcy discharge applies “to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit.   11 U.S.C. §523(a)(7).  The IRS is clearly a governmental unit.  But this exception to discharge is limited when it relates to a “tax penalty.”

Section 523(a)(7)(B) provides that the exception to discharge does not apply and the IRS tax penalty is discharged if it was “imposed with respect to a transaction or event” that occurred more than three years before the bankruptcy petition.  Therefore, a taxpayer may not be discharged of an income tax penalty imposed less than three years before the bankruptcy petition is filed.  But, a taxpayer would be discharged of an income tax penalty imposed more than three years before the bankruptcy petition is filed.

So the question becomes: “when is an income tax penalty “imposed with respect to” a failure to file penalty imposed by the IRS pursuant to 26 U.S.C. §6651(a)(1)?”  That issue was addressed in  In re Wilson, 527 B.R. 635 (Bankr. N.D.CA 2015).  In Wilson, a taxpayer was granted a filing extension for his 2008 tax return from April of 2009 to October of 2009.  That taxpayer did not file the return until 2011.  The taxpayer filed for bankruptcy in July of 2012, which was more than three years after the April 2009 filing deadline and less than three years after the October 2009 filing deadline.

The taxpayer argued that the penalties should be discharged because they were imposed with respect to his 2008 tax liability, due April of 2009, and therefore were more than three years old when he filed his bankruptcy.  The IRS argued that the penalties should not be discharged because they were imposed in October of 2009, when the taxpayer missed his extended filing deadline, and were therefore less than three years old when the bankruptcy petition was filed.

The Wilson court agreed with the taxpayer and found that §523(a)(7)(B) is to be applied according to its plain meaning, so that a penalty imposed on unpaid taxes accruing more than three years before the filing of the bankruptcy petition is dischargeable.  Interestingly, the court stated that “penalties imposed on account of failure to file a return are computed by reference to the tax obligation itself,” and not by reference to the filing date. Id. at 638.

Practice Pointer:  A tax professional should have counseled the taxpayer to postpone the bankruptcy case filing date from July of 2012 to a few months later and after October 16, 2012 to ensure the case was filed more than three years after the due date.  The tax professional would have saved the cost of litigation had the taxpayer strategically timed the bankruptcy filing date.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Bipolar Disorder Protect a Taxpayer from Being Accused of Willful Failure to Pay Taxes?

Taxpayers generally have the right to discharge certain income tax liability relating to old tax returns. For example, a taxpayer may have the right to discharge in bankruptcy income tax liability relating to tax returns due and filed more than three years before the bankruptcy case was filed. An exception to that rule exists when the taxpayer “willfully attempted in any manner to evade…” paying the taxes. See 11 U.S.C. §523(a)(1)(C).

That exception was explored in United States v. Stanley, 595 Fed App. 314 (5th Cir. 2014). In Stanley, an osteopathic doctor filed Chapter 7 bankruptcy in an effort to discharge income taxes due more than three years prior to the date the bankruptcy case was filed. The United States objected to the discharge alleging the tax liability was non-dischargeable because the doctor willfully attempted to evade paying the taxes.

The doctor argued that he suffered from Type II bipolar disorder and was thus incapable of forming the requisite “willful” mental state. At trial, the doctor called a psychologist as a witness to testify that the doctor suffered periods of depression and irresponsible conduct. However, the psychologist also stated that the doctor had other periods when the doctor was functioning normally.

Pursuant to 11 U.S.C. §523(a)(1)(C), a discharge in bankruptcy does not discharge tax liability where the debtor “willfully attempted in any manner to evade” the tax liability. This provision ensures that the Bankruptcy Code’s “fresh start” policy is only available to honest but unfortunate debtors.

The 5th Circuit employed a three-pronged test to determine willfulness in the tax evasion context, considering whether the debtor (1) had a duty to pay taxes under the law, (2) knew he had that duty, and (3) voluntarily and intentionally violated that duty. The court held that the third prong could be satisfied by either an affirmative act or culpable omission that, under the totality of the circumstances, constituted an attempt to evade or defeat the assessment, collection, or payment of a tax.

The Stanley court noted that a mere failure to pay the tax did not automatically constitute “willfulness,” since a taxpayer may not have the financial wherewithal to pay the tax. However, the failure to pay combined with the ability to pay may constitute “willfulness.” The court reviewed many factors before determining that the doctor in the case at bar “willfully” attempted to evade paying the tax liability, including: ability to successfully carry out duties in a demanding profession, maintaining a lavish lifestyle, major purchases made by the doctor, payment of other long-term debts obligations, forming corporations, and transferring money to the doctor’s spouse who did not share the tax liability. Consequently, the court found the tax liability non-dischargeable because the doctor willfully attempted to evade paying the taxes.

Practice Pointers: Before filing bankruptcy, a practitioner should identify a taxpayer’s job status, disposable monthly income, major purchases since the tax liability was incurred, history of paying other long-term obligations, ability to pay the tax liability since the tax liability was incurred, and choices made to utilize net income in manners other than paying tax liability. If factors weigh against a taxpayer, then the practitioner should consider an installment agreement to demonstrate a taxpayer’s desire to repay the tax liability. Then installment payments should continue until a pattern is shown demonstrating a desire to pay taxes.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.