Discharging Tax Debts in Bankruptcy

Most people who owe taxes to the government cannot have those tax debts discharged in bankruptcy.  Although most tax debts are non-dischargeable, some actually can be discharged.  And while those dischargeable tax debts are the exception to the rule, those exceptions are worth knowing about.
Morgan King, an attorney from California, put together this handy little flowchart in 2011 that shows how to determine if a tax debt can be discharged and/or whether it is a priority or non-priority debt.  Whether a tax debt can be discharged generally depends on the type of tax that is owed and the age of the debt, although several other factors also come in to play.  While the chart itself is pretty straightforward, actually finding out the information to answer some of the questions in this chart is often more problematic.

And here’s the relevant statutory text:
11 U.S.C. § 523


(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
(1) for a tax or a customs duty—
(A) of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed;
(B) with respect to which a return, or equivalent report or notice, if required—
(i) was not filed or given; or
(ii) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition; or
(C) 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. § 507


(a) The following expenses and claims have priority in the following order:
(8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for—
(A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition—
(i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
(ii) assessed within 240 days before the date of the filing of the petition, exclusive of—
(I) any time during which an offer in compromise with respect to that tax was pending or in effect during that 240-day period, plus 30 days; and
(II) any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240-day period, plus 90 days; or
(iii) other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case;
(B) a property tax incurred before the commencement of the case and last payable without penalty after one year before the date of the filing of the petition;
(C) a tax required to be collected or withheld and for which the debtor is liable in whatever capacity;
(D) an employment tax on a wage, salary, or commission of a kind specified in paragraph (4) of this subsection earned from the debtor before the date of the filing of the petition, whether or not actually paid before such date, for which a return is last due, under applicable law or under any extension, after three years before the date of the filing of the petition;
(E) an excise tax on—
(i) a transaction occurring before the date of the filing of the petition for which a return, if required, is last due, under applicable law or under any extension, after three years before the date of the filing of the petition; or
(ii) if a return is not required, a transaction occurring during the three years immediately preceding the date of the filing of the petition;
(F) a customs duty arising out of the importation of merchandise—
(i) entered for consumption within one year before the date of the filing of the petition;
(ii) covered by an entry liquidated or reliquidated within one year before the date of the filing of the petition; or
(iii) entered for consumption within four years before the date of the filing of the petition but unliquidated on such date, if the Secretary of the Treasury certifies that failure to liquidate such entry was due to an investigation pending on such date into assessment of antidumping or countervailing duties or fraud, or if information needed for the proper appraisement or classification of such merchandise was not available to the appropriate customs officer before such date; or
(G) a penalty related to a claim of a kind specified in this paragraph and in compensation for actual pecuniary loss.
An otherwise applicable time period specified in this paragraph shall be suspended for any period during which a governmental unit is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior case under this title or during which collection was precluded by the existence of 1 or more confirmed plans under this title, plus 90 days.

Update on Tax Claims in Bankruptcy and the ACA

This from our friend at the IRS:
Just wanted you to be aware that Internal Revenue Service Insolvency has now been tasked with collecting unpaid shared responsibility payments (SRP) in bankruptcy.  These are amounts owed by taxpayers who do not have coverage under the Affordable Care Act.  The Service is treating SRPs as excise taxes, so SRPs will be priority amounts under Bankruptcy Code section 507(a)(8) on our proofs of claim and for discharge purposes.  I don’t yet know how they will be designated (“type of tax”) on the claim.  There are a few differences on how SRPs will be handled compared with our other priority tax claims:

1.        There is no penalty associated with an SRP (interest does accrue at the statutory rate).
2.       We will file motions to lift stay on pre-petition offsets of pre-petition payments (in other words, Bankruptcy Code section 362(b)(26) will not apply) – so we’ll file motions to lift on all offsets of SRPs except post-petition offsets of post-petition payments.  I have not heard how we will inform debtors that we are holding their refund for SRPs, but I assume they can get that information on the “Where’s My Refund” feature of the irs.gov website.
3.       We will file 1305 claims for SRPs.
4.       We will not file estimated claims for SRPs.

Let me know if you have any questions.  I’m sure we’ll be changing things as we go along.

Richard Charles Grosenick
Office of the Chief Counsel – IRS

Can I file bankruptcy against my tax debts?

Many people who are suffering from burdensome debt also count, among their creditors, the Internal Revenue Service and the Wisconsin Department of Revenue.  They wonder what – if anything – can be done about their tax debt.
To answer this question, we look to 11 U.S.C. § 523 – the statute that describes the types of debts that cannot be discharged.  § 523(a)(1) describes certain types of taxes that cannot be discharged in bankruptcy – the most common of which are being income taxes that are further described at 11 U.S.C. § 507(a)(8).  When you boil away the excess verbiage, § 507(a)(8) is basically describing income taxes owed for tax returns that were due within 3 years of filing.
For example – today is July 7, 2014.  Taxes owed for 2011, 2012, and 2013 would generally be considered priority taxes, and therefore non-dischargeable.  Notwithstanding any tax liens that may exist, any remaining tax debt would be considered non-priority, and dischargeable.
Now, there are a handful of ways for older tax debts to still retain priority status (the excess verbiage we boiled away) – such as any new assessments in the past 8 months, if the tax returns were filed late, or if there was a prior stay of collections.
So what does all of this mean?  Well, in Chapter 7 – the result is fairly simple.  Priority tax debts are non-dischargeable and will survive.  Non-priority tax debts are dischargeable (though tax liens will survive) and will go away after bankruptcy.
BUT – just because your tax debts are non-dischargeable doesn’t mean you can’t do anything about them in bankruptcy.  In Chapter 13, priority tax debts can be rolled into the plan.  Generally, they are paid in full with no additional interest (the taxing authority may – in rare cases – stipulate to be paid less than in full of their priority claim, though that stipulation will usually include a provision asserting that the unpaid portion will remain non-dischargeable and survive the bankruptcy).
By the way – what’s true of priority taxes is also true of other priority debts, such as domestic support obligation (child support, alimony, or maintenance) arrears.  Other non-dischargeable debts can also be folded into Chapter 13 bankruptcy, such as student loans.  But since student loans are not a priority debt, they do not have to be paid in full (though the unpaid balance would survive the bankruptcy).
If tax liens have been filed against you, those would also have to be paid in full in a Chapter 13 Bankruptcy (and with nominal interest), but they are secured only to the extent that there is equity in property.  For example, say that a person has a $100k house with an $80k mortgage, a $20k car with a $15k lien, and $10k in personal property – the available security would be ($20k + $5k + $10k) = $35k.  If the amount of tax lien is less than $35k, then the whole amount is treated as secured.  If the amount of the tax lien is more than $35k, then only $35k of it is treated as secured.
It’s a lot to digest, and worthy of a detailed discussion with your bankruptcy attorney.  But the main points to take away are that (1) some tax debts can be discharged in bankruptcy, and (2) tax debts that cannot be discharged can be addressed in Chapter 13.

Tax Season Reminders

As your mailbox fills up with various W2s and 1099s, now is a good time for our annual reminder of certain tax-related issues in bankruptcy.
If you intend to file for bankruptcy (or think you might), do not use your tax refunds to pay unsecured debt until you have consulted with an attorney.  First – you would be wasting money on a debt that could be discharged.  Second – such a payment could be considered a preference and recovered by the Trustee for redistribution.  Third – using tax refunds to pay bankruptcy-related costs can help expedite your case to prevent things like creditor harassment, lawsuits, wage garnishments, bank levies, utility shut-offs, repossessions, and foreclosures.
Tax refunds are generally considered a contingent asset.  Most debtors can exempt their tax refunds and protect them from being seized by the Trustee.  Debtors who do not have sufficient exemptions to protect their refunds can plan their filing strategically to minimize the Trustee’s interest.  (For example, debtors using Wisconsin state exemptions to protect equity in real estate should file shortly after they have received their refund and deposited it, availing themselves to a depository account exemption.  Most other debtors can exempt their tax refunds with federal exemptions.)
All debtors who have filed Chapter 13 bankruptcy are required to submit copies of their tax returns to the Trustee.
Some debtors who have filed Chapter 13 bankruptcy may be required to submit 1/2 of their tax refunds to the Trustee.  Consult your bankruptcy attorney if your are uncertain about this obligation.
Debtors who plan to file under Chapter 13 (but haven’t yet) should plan to file their 2013 tax returns as soon as possible.   Cases filed after December 31, 2013 cannot be confirmed until after the 2013 tax returns are on file (even though they are not due to the IRS and state until 4/15/2014).
Debts discharged in bankruptcy are not income for federal tax purposes.  If you receive a cancellation of debt notice, show it to either your bankruptcy attorney or tax professional.
If you owe tax debt – certain debts more than 3 years old can be discharged in bankruptcy.  Tax debts entitled to priority status (generally, but not limited to taxes 3 years old or younger) can be folded into and paid through a Chapter 13 Plan with no interest.
If you owe tax debt and have already filed Chapter 13 Bankruptcy, notify your attorney immediately.  The IRS can file claims for post-petition taxes that will need to be funded.

Paying a Chapter 13 case off early.

With tax season drawing to a close, one question that frequently pops up with debtors currently in Chapter 13 Bankruptcy (or at least among those who are required to pay in 1/2 of their tax refund) is whether they are close to completing their plan.
I’ll give a real simple case as an example.  John Doe files for Chapter 13 Bankruptcy and has a $4,000 car loan that has to be paid in full.  His income requires him to pay nothing to his unsecured creditors, but he has to pay in 1/2 of this tax refunds.  After a year in the plan, he has paid down the car loan to $2,500.  He gets a $5k tax refund and pays in half – as he is obligated to – to the trustee.  That should be enough to pay off the car loan and end the plan, right?
Not quite.  Although it is true – the trustee will use the tax refund to pay the car loan first (secured and priority creditors get paid in full before any money goes to unsecured creditors) – the tax refund money is earmarked for unsecured creditors.  Therefore, John will have to continue making plan payments pursuant to the terms of his Chapter 13 Plan, and those future payments (which would undoubtedly equal or exceed $2,500) will then go to unsecured creditors.
Why is this?  Well, since secured and priority creditors are required to be paid in full in Chapter 13, most plans are required to fund those creditors in equal monthly payments over 3-5 years.  Tax refunds are the result of over-withholding taxes, which reduces disposable income.  Since plans require that all disposable income come into the plan, tax refunds are intercepted and earmarked for unsecured creditors.
There are, of course, exceptions (and unspoken truths and loopholes) to what I’ve just said.  But that is the main principle of the matter.
So, can you ever get out of a plan early?  Yes.  But with some caveats.
First, you may be eligible to convert to Chapter 7, but the factors that go into such a determination are too numerous for me to list in this article, so you should speak to your attorney if you think conversion is something you want to consider.  If you filed a Chapter 13 because you were ineligible to file Chapter 7 due to a prior bankruptcy, you won’t be able to convert.  Also, generally, there must be a change in financial circumstances such that you can no longer have disposable income.
Second, you can get out of a Chapter 13 Bankruptcy at ANY TIME if you can pay off all claims in full (the caveat here being that the claims deadline must pass, which is about 90 days after the 341 hearing for most creditors, but 180 days after filing for government creditors).  You’re not getting a discharge, but you’re ending the bankruptcy.
After 36 months, below-median debtors (assuming they’re in Chapter 13 for longer than 36 months to begin with) can buy out of a Chapter 13 early by paying off any balance owed on secured and priority debts plus any obligations to pay unsecured debts up to that point.  The plan must also be amended to shorten the length of the plan.
At present, many circuits have held that above-median debtors cannot get out earlier than 60 months (since that is their applicable commitment period)  without paying all debts in full.  It has not yet been established in the Eastern District of Wisconsin whether an above median debtor can buy out between 36-60 months with the benefit of a partial discharge on unsecured debts, but if and when that challenge is made, it is unlikely to go in the debtor’s favor.
On a side note:  Last week, I discussed conduit mortgage payments.  For those who will be making post-petition mortgage payments directly to their lender and have pre-petition arrears, be advised that your first mortgage payment is due with the first contractual due date after your bankruptcy case is filed.  Keep this in mind when planning to file your case.  I get a lot of clients who schedule their appointment toward the end of the month, and their mortgage due date is the first of the month.  They are unprepared to make their first mortgage payment within a few days.  On the other hand, if you file early in the month, you have most of the rest of the month to get ready to resume mortgage payments (just make sure that your reinstatement quote that you provide your attorney includes the current month’s mortgage payment!).

Creditor Superpowers

Not all creditors are created equal.
Some debts are “secured” which means the lender can exercise security rights in collateral you own if you default under the terms of the note.  For example, if you stop making payments on a secured loan, a mortgage lender can foreclose your home, and an auto lender can repossess your car.
Other debts are non-dischargeable in bankruptcy.  A full list of these can be found at 11 U.S.C. § 523(a), but it includes items such as taxes, student loans, debts incurred by misrepresentation and fraud, domestic support, and certain governmental debts, among other things.
Secured debts and non-dischargeable debts are the two most common distinctive classes of debts that people going through bankruptcy are made aware of.  But there are a number of superpowers that certain creditors have over other creditors, and we’re going to go over some of the most pertinent ones here.
Utility Companies – are given special status under 11 U.S.C. § 366, and may discontinue utility services if the debtor does not provide adequate assurance of payment, such as a deposit.  In my experience, requests for deposits have been relatively rare, but they do occur from time to time.
Internal Revenue Service and State Taxing Authorities – in addition to the non-dischargeable and priority status that many tax debts enjoy, taxing authorities are also allowed to file claims in a debtor’s Chapter 13 case for tax debts that arise after the bankruptcy case is filed under 11 U.S.C. § 1305.  For example, John Doe files a Chapter 13 Bankruptcy in 2011 with a 5 year term.  In 2013, John Doe finds that he owes taxes to the IRS for the 2012 tax year.  The IRS can file a claim in John’s existing bankruptcy case and force the debt to be paid in the plan.  On the one hand, this is a good thing, because the tax won’t incur interest while it’s paid in the plan.  On the other hand, it may be difficult for John to fund his plan when it is saddled with the new debt, particularly if John is nearing the end of this plan (no plan can go longer than 60 months, so the later in the plan that this happens, the less time you have to spread the payments out).
Student Loan Creditors – filing bankruptcy can trigger higher default interest rates, which is particularly a problem for Chapter 13 debtors who are not paying off their student loans in full during the Chapter 13 Plan.  Since student loans are currently non-dischargeable (there has been a lot of buzz in Washington lately about possibly amending the bankruptcy code to allow certain types of student loans to be discharged under certain conditions), those post-petition rates continue to be incurred throughout the life of the bankruptcy plan.  Bruning v. United States, 376 U.S. 358 (U.S. 1964).

Taxes On-Time

Oftentimes, when an individual owes income taxes that they cannot afford to pay, they just decide not to file a tax return.  Ordinarily, I don’t give tax advice, because tax law is not my field of expertise.  Outside of bankruptcy, I don’t know if there is any advantage to not filing a return until you can afford to pay the debt.  However, an interesting case passed through my office the other day, and I’d like to share with you this brief cautionary tale.
The individual hadn’t filed taxes since 2006, because she knew she owed a lot of tax debt, but couldn’t afford to pay it.  She is now contemplating a Chapter 13 Bankruptcy to repay the tax debt she owes.  By law, she will need to file her taxes for – at minimum – 2007, 2008, 2009, and 2010 (and 2006 if she expects to deal with that debt).  The thing is, had she filed her taxes on-time, 2006 and 2007 would be treated as non-priority tax debt and potentially paid nothing in her Chapter 13 Plan.  Only her 2008, 2009, and 2010 taxes would have to be treated as priority and paid in full.  However, 11 USC 507(a)(8) – which defines income taxes as priority debts – will necessarily require that we treat 2006 and 2007 as priority as well, because taxes were late filed and not yet assessed.  Depending on how much tax she owes for those two years, that could easily bump up her plan payments hundreds of dollars per month.

How are debts classified?

As a practical matter, I classify debt differently depending on whether I am explaining the effect of Chapter 7 or Chapter 13 to my clients.
Chapter 7
Secured Debts – debts that are secured to property that you own. Examples include mortgages, auto loans, and sometimes loans for furniture, appliances, or jewelry. In Chapter 7, you have the option of keeping the property and reaffirming the debt. Alternatively, you can surrender the property and discharge the debt.
Non-Dischargeable Debts – debts that will not be discharged in bankruptcy. Examples include tax debts, other debts owed to a government unit (including fines, tickets, and criminal restitution), student loans, and domestic support (alimony, maintenance, or child support).
Unsecured Debts – these are debts that are generally presumed to be discharged, and retain no lien against your property. Examples include credit cards, medical bills, personal loans, payday loans, civil judgments, past-due utility bills, and deficiencies resulting from repossessions. An unsecured creditor could object to discharge by alleging and proving fraud, abuse, or bad faith.
Chapter 13
Secured Debts – these debts are as I described them above. In this district, debtors continue to make their regular mortgage payments as they come due, but any arrearage is paid within the Plan with no interest. Auto loans, whether in default or not, are paid in full within the plan with we call “Till Interest”. Till Interest varies from time to time and is calculated based on the current prime rate. If the auto is a lease (or if you rent your home), those lease payments are paid separately as they come due like mortgages, and any arrearage is also paid in the Plan with no interest. Other secured debts (furniture, appliance, or jewelry loans) are like auto loans – paid in full within the Plan at Till Interest. Depending on how old the debt is, your secured loan balances (except for mortgages) could be reduced down to the replacement value of the property securing the loan in a process we refer to as cramdown.
Priority Debts – these are a special class of non-dischargeable debts that must ordinarily be paid in full in the Plan, but with no interest. These debts chiefly consist of tax debts from the past four years and domestic support obligations.
Non-Priority Debts – a grab-bag of other non-dischargeable debts and unsecured debts. These debts will be paid at a percentage, ranging from 0% to 100%, depending primarily on your income and ability to pay. They also share in any “floor amount” (these are amounts that are not based on income, but represent a buy-out of what would be a problem in Chapter 7). At the end of your Chapter 13 Plan, the portion of your non-priority debts that are non-dischargeable (student loans, for example) will survive your bankruptcy. All other unsecured debts will be discharged.