With the downturn in the economy and massive job losses, personal bankruptcy filings have exploded. According to the National Bankruptcy Research Center, approximately 1.4 million bankruptcies were filed in 2009, a 32% increase over 2008. They included Chapter 7 bankruptcy filings, which increased 42%, and Chapter 13 filings, which increased 12%. Bankruptcies in 2010 may be fewer than last year. However, in early January, The Wall Street Journal reported that bankruptcy attorneys had not yet experienced a slowdown in their workload.
CPA clients may be among those needing bankruptcy protection. Many of these clients may benefit from including federal tax debts in their petition. CPAs can play a key role by assisting clients and their attorneys in determining if and when bankruptcy is a viable alternative for resolving federal tax liabilities, by determining the composition of tax amounts owed and which tax liabilities might be dischargeable, and by exploring the many bankruptcy alternatives for dealing with tax debts. Besides being aware of the tax resolution options of bankruptcy described in this article, CPAs should be familiar with administrative tax resolution methods, which the client should pursue first. These include innocent spouse relief, a request for abatement of penalties, an installment agreement or an offer in compromise (OIC).
If those options are insufficient, bankruptcy may be the best way for your clients either to secure a reasonable payment plan (Chapter 11 or Chapter 13) or to liquidate their assets to pay off all or a portion of their tax debt (Chapter 7). Using administrative tax resolution methods instead of bankruptcy may help clients avoid having a “black mark” on their credit history. However, a federal tax lien listed on the debtor’s credit report may damage his or her credit rating as much as a bankruptcy notation. Clients who may benefit from bankruptcy protection should be promptly referred to an attorney who specializes in bankruptcy law.
NOT ALL TAX DEBTS DISCHARGEABLE
To be dischargeable, individual income tax liabilities must meet the following “mechanical” rules of 11 USC §§ 523(a)(1) and 507(a)(8):
- More than three years must have elapsed since the tax return generating the liability was due, including extensions. Various acts such as prior bankruptcies, collection due process (CDP) hearings, innocent spouse relief and tax assistance orders can extend the three-year time frame.
- The tax return must have been filed more than two years earlier than the bankruptcy petition (generally applicable to late-filed returns). Note, however, that IRS-prepared “substitute for returns” are not considered filed returns for this purpose, and thus a tax liability assessed from them would not be subject to discharge (IRC § 6020(b)). Therefore, it is almost always advisable for the client to file all delinquent returns and, if possible, let the mechanical time frames pass before the bankruptcy petition is filed.
- At least 240 days must have elapsed since the date of an IRS assessment (generally applicable to audit adjustments and amended returns). This time frame is extended by an OIC.
Filing fraudulent returns or willful attempts to evade or defeat tax also can prevent such taxes from being discharged (11 USC § 523(a)(1)(C)). Certain other types of taxes, including withheld payroll taxes, the trust fund penalty under IRC § 6672, most state sales taxes and certain excise taxes, are never dischargeable. Such nondischargeable taxes may also be priority debts under 11 USC § 507(a)(8).
Tax debts that meet the three-year and 240-day rules of 11 USC § 507(a)(8) but do not satisfy the two-year filing rule of 11 USC § 523(a)(1)(B) are not priority debts, but they are nonetheless nondischargeable. Unpaid nonpriority tax debts used to be dischargeable upon completion of a Chapter 13 payment plan, but the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 repealed the Chapter 13 “superdischarge.”
DETERMINING POTENTIALLY DISCHARGEABLE TAXES
When consulting with a client who has unpaid tax liabilities, the CPA should obtain directly from the IRS the client’s transcript of record. This document will show the outstanding liabilities by year, including filing dates, assessment dates, filing extensions, penalties and interest owed. A schedule should be prepared showing the amount of taxes owed by year, the penalties and interest added by the IRS, the date each return was due and filed and the dates of each assessment. This schedule will allow the CPA and attorney to determine which outstanding tax liabilities are subject to discharge.
The CPA and attorney should always advise the client of the possibility of an audit adjustment that creates a post-bankruptcy tax, the existence of assessed fraud penalties, or other activities that might constitute an attempt “to evade or defeat … [a] tax,” which may provide the IRS with an argument that the tax should not be discharged (11 USC § 523(a)(1)(C)). In addition, once a future bankruptcy date (the date on which the tax liability meets all the mechanical tests for discharge) is computed, a recheck of the transcript should be made immediately prior to the filing date, to verify that no adverse intervening events have occurred that might extend the mechanical time frames.
Tax planning should include advising the client concerning not only tax liabilities that may currently be discharged, but also those that may soon meet the requirements for discharge. If outstanding tax liabilities do not currently meet the requirements for discharge but soon will, the client may want to consider postponing the filing date of the petition. Time can be gained by negotiating an installment agreement with the IRS. An installment agreement may give the client sufficient relief while allowing time to pass as needed for income taxes to become eligible for discharge.
While an installment agreement does not toll the statute of limitations, other tax resolution methods do extend the time allowed for IRS collection and the mechanical time frames that must be met for discharge of taxes. For example, a CDP hearing request will extend the three-year and 240-day periods, while an OIC filing will extend only the 240-day period.
STRATEGIES FOR ASSISTING WITH THE DISCHARGE OF TAXES IN BANKRUPTCY
If the CPA knows beforehand of an event that will create an income tax liability, such as a sale of low-tax-basis assets, filing a bankruptcy petition before the event can cause the resulting tax liability to be that of the bankruptcy estate, not the taxpayer (IRC § 1398). Usually such events are those that result in accelerated deductions or depreciation recapture, such as from discontinuing a business.
For married couples, always advise married filing separately status when an income tax liability that cannot be paid may be assessed against only one of the spouses. Doing so protects the nondebtor spouse and could significantly limit the ability of the IRS to become secured (and therefore paid as a result of the bankruptcy). It also may reduce the amount of an IRS installment agreement or an OIC. Returns that are separately filed may be refiled as a joint return, with certain exceptions, if amended within three years of the date the separate returns were due (IRC section 6013(b)(2); also see J.V. Millsap, 91 TC 926 (1988)). However, a jointly filed return cannot be subsequently amended into separate returns (Treas. Reg. § 1.6013-1(a)).
When the question of qualifying for a Chapter 7 filing depends on the amount of consumer debt, consider either reducing consumer debt or increasing non-consumer debt to avoid the means testing. For instance, if a taxpayer moves and rents a new lodging while leasing his or her previous residence, the mortgage on the previous residence arguably (see 11 USC § 101(8)) becomes non-consumer debt and might allow the debtor to avoid the means test.
In some cases, filing for bankruptcy should be accelerated, even though some taxes will not be discharged. For example, suppose that an IRS installment agreement requires the payment of $1,500 a month for 12 months remaining before a Chapter 7 bankruptcy will discharge all of the debtor’s $18,000 tax liability (including interest and penalties). However, a bankruptcy filed immediately will leave only $4,500 of the tax liability not discharged. A decision to immediately file a bankruptcy petition would in this instance save the debtor $13,500 plus the interest and penalties that would have continued to accrue during the 12 months of the installment agreement. Sometimes the lack of a notice of federal tax lien’s being filed and the existence of significant exempt assets may also dictate an expedited bankruptcy petition.
There are several ways for a tax debtor to file for bankruptcy on a desired date, while minimizing collections by the IRS. However, some actions can extend certain bankruptcy dates. An installment agreement, which extends none of the mechanical time frames, should always be pursued as a temporary measure when planning for a future bankruptcy filing.
Because an OIC extends the 240-day wait from the assessment date by the time the offer is under consideration plus 30 days (11 USC § 507(a)(8)(A)(ii)(I)), it is beneficial to file an OIC after the 240 days have run, if possible, so that the desired date for filing the bankruptcy petition is not further delayed.
The Internal Revenue Manual specifically provides for a reduction in the amount of an otherwise acceptable OIC due to the taxpayer’s intention to file for liquidation bankruptcy (Internal Revenue Manual Section 22.214.171.124 (5)). Making a good-faith OIC, which discounts the income stream component of the amount the IRS would otherwise compute as an acceptable full-pay offer, is a legitimate negotiating tactic. While the IRS may be reluctant to discount an otherwise acceptable OIC amount based on the potential dischargeability of a portion of the tax liability, such an offer should be pursued and, when necessary, appealed, thereby further delaying IRS collection until bankruptcy. Subsequent submissions of legitimate OICs are an effective tool for running the three-year mechanical time frame for bankruptcy.
In negotiating a resolution with the IRS, the CPA may find a CDP hearing to be a helpful tool. However, a CDP request extends both the 240-day and the three-year time frames and therefore must be carefully considered (11 USC § 507(a)(8)). If the taxpayer is willing to give up his or her Tax Court appeal rights following a CDP hearing, then the use of a CDP equivalent hearing will allow the appeal to go forward without extending the mechanical time frames for a future bankruptcy petition.
An OIC or installment agreement should always be sought as late in the collection process as possible but before a CDP notice is issued. In this manner, the debtor can realize the maximum opportunities to negotiate an installment agreement or OIC while the bankruptcy time frames run.
If filing a bankruptcy petition is delayed by waiting for an audit adjustment to be assessed (because of the 240-day rule), filing amended returns that include all of the taxes possibly owed as a result of the audit can speed up the assessment date and thus the mechanical date required for discharge.
Sometimes accelerating recognition of taxable income is helpful. If, for instance, a reasonable basis exists for amending tax returns to show a greater tax liability in prior years while lessening (or eliminating) the tax liability of the current year, a Chapter 7 bankruptcy filing may be accelerated. Moreover, if a reasonable basis exists for concluding that not all taxable income was properly included in previously filed returns (prior years’ tax liabilities are understated), filing amended returns can increase the client’s non-consumer debt, which in turn could make Chapter 7 protection available. Non-consumer debt might also be increased by maximizing the client’s current-year tax liability, for example, by taking the standard deduction instead of itemizing deductions.
Allocating payments to the IRS can allow the tax debtor to pay down or pay off the most current year’s tax liability or selectively pay nondischargeable taxes (such as trust fund recovery penalty or employment taxes). Carefully planning how tax payments are applied to the debtor’s tax liability can accelerate a Chapter 7 filing or at least limit the amount of taxes that survive the bankruptcy.
Assets that will ultimately be available to the IRS can be liquidated prior to bankruptcy and used to pay off priority/ nondischargeable taxes, reducing the amount of taxes that survive the bankruptcy. However, any pre-bankruptcy liquidation of assets should be done with great care to avoid running afoul of the fraudulent transfer provisions of 11 USC § 548. Practitioners should also consult the rules on preferential transfers in 11 USC § 547 before making any payments to creditors shortly before filing a bankruptcy petition.
A bankruptcy court filing immediately stops the collection efforts of all creditors, including the IRS (11 USC § 362(a)(6)). This legal protection is called the “automatic stay.” At the end of the proceedings, some or all of the petitioner’s debts—including, in some instances, tax liabilities—may be discharged, meaning they are eliminated or no longer legally enforceable. There are two types of bankruptcy:
Liquidation or “straight bankruptcy.” A filing under Chapter 7 liquidates assets that are not exempted under federal or state law and distributes pro rata amounts to unsecured creditors. (Keep in mind that proceeds from the forced sale of nonexempt assets in a liquidation bankruptcy may be significantly less than in an arm’s-length transaction outside of bankruptcy.) Any unsecured debts remaining after such distribution are discharged, including certain tax debts. The court forces all creditors (including the IRS) to accept the proceeds of the liquidation in full settlement of all dischargeable liabilities included in the petition. However, a tax lien recorded before the bankruptcy was filed survives the bankruptcy to the extent it attaches to property owned by the debtor at the time of the bankruptcy. Eligibility for a Chapter 7 bankruptcy is limited to debtors whose income is below a “means tested” amount or whose “non-consumer” debts exceed their “consumer” debts. For details, see tinyurl.com/d2jwdc.
Deferred payment plans. This type of filing (individual Chapter 11 or Chapter 13) forces a payment plan on debtors through a trustee. Creditors (again, including the IRS) must accept an installment schedule that pays at least as much of the dischargeable debt as would have been paid in a Chapter 7 proceeding, and which fully pays all secured and priority creditors within five years (11 USC § 1322). Nondischargeable taxes (see “Not All Tax Debts Dischargeable” in this article) are often priority debts, which must be paid in full over the life of the plan. To qualify for Chapter 13, the debtor must have a steady stream of income: Wages, Social Security, pension payments and receipts of an independent contractor all qualify. Unsecured debts, such as credit cards, doctor bills, student loans and individual income taxes for which a lien has not been recorded cannot exceed $360,475 (adjusted annually for inflation). Secured debts (for example, home mortgages and car loans) cannot exceed $1,081,400 (also adjusted annually). While installment payment plans can be administratively negotiated with the IRS (in lieu of bankruptcy), the periodic payments required under Chapters 11 and 13 are often more favorable to the taxpayer.
The primary tax-related downside to filing for bankruptcy protection is the additional collection time it allows the IRS: The collection statute of limitations is tolled (suspended) while a bankruptcy is in process (IRC § 6503(h)). Chapter 7 proceedings usually take four to six months. However, this is a concern only when the taxpayer emerges from a bankruptcy still owing the IRS. Once taxes are assessed, the IRS normally has a total of 10 years to collect them, along with penalties and interest (section 6502). Therefore, once a bankruptcy case is over, the IRS retains whatever time remained on the original 10 years, plus the time the bankruptcy case was pending, plus an additional six months (section 6503(h)(2)).
CPAs can provide essential services to clients facing bankruptcy by advising them and their bankruptcy attorney on tax debts and their disposition in a bankruptcy estate. CPAs should therefore
be familiar with bankruptcy law and procedure as they relate to tax debts, along with administrative methods of resolving them.
How tax debts may be discharged in bankruptcy depends on the type of proceeding. Chapter 7 (“straight bankruptcy”) liquidates the debtors’ nonexempt assets and apportions the proceeds among unsecured creditors, including the IRS. Chapter 13 and 11 cases establish a payment plan of up to five years, after which certain remaining tax debts can be discharged.
Generally, tax debts that may be discharged in bankruptcy are income tax debts that are not recent—from returns due more than three years before the bankruptcy filing, or, for filed returns, those more than two years old. Assessments from audit adjustments or amended returns must be at least 240 days old. Payroll tax withholding and related trust fund liabilities, along with state sales taxes and certain excise taxes, are not dischargeable.
CPAs should explore strategies for managing tax debts to best advantage when clients are considering bankruptcy. Such strategies can include timing considerations and use of administrative resolution methods such as installment payments, collection due process proceedings and offers in compromise.
Donald L. Ariail (firstname.lastname@example.org) is an associate professor in the Department of Business Administration at Southern Polytechnic State University in Marietta, Ga. Michael M. Smith (email@example.com) is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz PC in Atlanta. Neil Deininger (firstname.lastname@example.org) and Reba M. Wingfield (email@example.com) are founder and partner, respectively, of the Deininger & Wingfield law firm in Little Rock, Ark.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
“Representing Clients With Tax Delinquencies and Deficiencies,” April 2009, page 65
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- IRS Office of Chief Counsel, advice memorandum, CCA 201005029, Feb. 5, 2010 (on dischargeability of taxes in Chapter 13 proceedings)
- “Bankruptcy Basics,” Administrative Office of the U.S. Courts, tinyurl.com/38dq9o5
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