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BANKRUPTCY CASE LAW:
TAXES AND BANKRUPTCY

The following is for the exclusive use of attorneys.  This firm does not make any representations as to the accuracy or current status of any case cited herein. 



 

 


WARNING TO ALL VISITORS: I AM NOT A TAX ATTORNEY, DO NOT RELY ON ANY TAX ADVICE ON THIS PAGE.  GET ADVICE FROM A COMPETENT TAX ATTORNEY WHO UNDERSTANDS BANKRUPTCY LAW.

DISCHARGING PERSONAL FEDERAL INCOME TAXES: article by Dan Furlong, Arizona bankruptcy attorney.

Splitting A Tax Year In Chapters 7 And 11. The general rule is that the chapter 7 trustee cannot pay taxes that become due for the tax year in which the bankruptcy was filed. For example, if you file chapter 7 bankruptcy on July 1 of a year (one half through the tax year) and the following April it is determined that you owe income taxes for that year, the trustee will not pay any of those taxes, not even one half, unless you split the tax year as explained in the next paragraph. There is language in the bankruptcy code, 11 USC §507(a)(8)(A)(iii), that seems to say the trustee can pay such taxes. However, most courts, including In re Allen, Bkrtcy. D. Mass. December 11, 2006, No. 04-1266-JNF have ruled that the trustee cannot pay such taxes unlessthe debtor elected to split the tax year.

The IRS code, 26 USC §1398(d)(2)(A), allows a Chapter 7 or Chapter 11 debtor to split a tax year into two short tax years. One short tax year ends the day before the bankruptcy is filed. The other short tax year starts the day the bankruptcy is filed. If such an election is made by the debtor, then the tax liability for the first short tax year may be paid by the trustee as a priority claim.

The election by the debtor to split the tax year must be made on or before the due date for filing the return for the tax year in which the bankruptcy was filed. The election is irrevocable.

However, the election does not apply if the bankruptcy is dismissed. The election may not be made if the debtor has no nonexempt assets. Daniel F. Furlong

SUMMARY: Most federal income taxes in Chapter 7 are dischargeable only if the debtor meets all of the following conditions:

  • The discharge is for income taxes: Payroll taxes and penalties for fraud are not eligible for discharge.

  • The debtor filed a legitimate tax return: The debtor filed a tax return for the relevant tax years at least two years before filing for bankruptcy.

  • The tax liability is at least three years old: The tax debt is from a tax return that was originally due at least three years before filing for bankruptcy.

  • The debtor is eligible under the 240-day rule: The IRS assessed the tax debt at least 240 days before the debtor filed for bankruptcy.

  • The debtor did not commit willful tax evasion: Possible evasive actions include changing your Social Security number, your name, or the spelling of your name; repeated failure to pay taxes; filing a blank or incomplete tax return; and withdrawing cash from a bank account and hiding it.

  • The debtor did not commit tax fraud: The return contains no information that was intended to defraud the IRS.

In other words, there are a number of subtle requirements that must be met before you can discharge a tax debt in bankruptcy. The best way to make sure you fulfill the requirements is to speak to a local attorney.

1/12/12 - DO YOU ADD 90 DAYS, OR 180 DAYS TO CDP TOLLING PERIOD? IRS says 90, but won't put it in writing! As we know, in order to discharge a personal income tax liability in bankruptcy, five rules must be satisfied.  One of these rules is, the bankruptcy must have been filed at least more than 3 years from the most recent due date for filing the return (typically, from April 15, or October 15). The 3-year period is extended for certain "tolling" events that may, or may not have occurred in the history of the liability.

For example, if, during the running of the 3-year period, the debtor filed either a previous bankruptcy, or a request for a collection due process hearing ("CDP"), the clock stops on the running of the 3-year period, for a period of time as provided in the Bankruptcy Code. But the language of the Bankruptcy Code appears to be at odds with the rule as actually practiced by the IRS, and therein lies a potential disaster for analysis of dischargeability of taxes.

A strict reading of the Bankruptcy Code, and the Tax Code, on the tolling effect of a CDP clearly results in the conclusion that the tolling period is the period from initial request for a CDP, to the date of final determination of the hearing, plus an additional 180 days.

The problem is that bankruptcy practitioners, and the IRS, assume one need only add 90 days. But if in fact one must add 180 days, it's inevitable that some attorneys are going to file cases after only 90 days have been added, thus resulting in non-dischargeability, because the 3-year period will not have been satisfied.

Tolling and Taxes: the 3-year period that ordinarily commences on the most recent date the tax return for the year in question is due, pursuant to 11 U.S.C. § 507(a)(8)(A)(i). The basic rule is, if the tax collection entity (state or federal) is prohibited from tax collection due to the existence of the automatic stay in a bankruptcy case that arose during, or overlapped, the running of the 3-year time, the time is tolled (or "suspended") for the time in which the previous case's automatic stay overlaps the 3-year period, plus an additional 90 days.

That rule is relatively simple to apply. You begin with the due date, extend it out 3 years, then add the time a prior bankruptcy case stay overlapped, then add on an additional 90 days.

THE COURT HELD THAT THE DEBTORS' PRIOR CHAPTER 13 DID NOT TOLL IRS COLLECTION OF THE TAXES - HENCE THE 3-YEAR RULE WAS SATISFIED AND THE TAXES WERE DISCHARGED

KOVE V. INTERNAL REVENUE SERVICE SEPT. 22 2011 (Bkrtcy.W.D.Wisconsin)

The debtors in this case filed a prior chapter 13 prior to the date several previous tax liabilities actually came due. That case was later dismissed prior to plan completion.

The plan contained the boilerplate provision found at 11 U.S.C. § 1327(b) vesting all property into the hands of the debtors. Subsequently, more than 3 years following the filing due date of the previous tax liabilities, the debtors filed a new chapter 13. The IRS argued that the prior chapter 13 had tolled the running of the 3-year period, thus rendering the liabilities non-dischargeable in the new case.

The case raised several questions.
1. If a tax is not due at the time the bankruptcy is filed and the automatic stay arises, can it be said that the filing of the bankruptcy tolled the 3-year period, given that the stay did not prohibit collection (since there were no taxes due for which collection could be "prohibited")?
2. Did the prior chapter 13 toll the 3-year period at all, since the confirmation of the plan re-vested the assets (or a substantial portion of them) into the hands of the debtors (thus rendering them not protected against post-petition tax collection).

In other words, where the IRS was prohibited from collecting only a portion of the debtors' assets (the postpetition income dedicated to the plan), did the case toll the running of the 3-year period?  The court said, no.

The court made several rulings, including, that it is not the bankruptcy per se that can be said to prohibit collection, but rather the automatic stay; that it cannot be said that the IRS was prohibited from collecting a tax that had not yet come due; and that since the Plan did not prohibit all tax collection, it cannot be said that the time period was tolled for discharge purposes.

Excerpted from the opinion:
" ... after confirmation the debtor receives control of at least some of the assets which had formerly been property of the estate. What does this mean for the equitable tolling (or suspension) of the lookback period in this case? After the debtors' extension requests expired, the 2005 and 2006 income taxes were due October 15, 2006, and October 15, 2007, respectively.

"The debtors' chapter 13 plan was confirmed in February of 2006. The plan does not appear to have contained any provision which would prohibit the collection of these tax claims. The confirmation returned control over all pre-confirmation property of the estate to the debtors, and at least some post-confirmation property as well.

"This revesting meant that the automatic stay — which had previously acted to prevent post-petition creditors from pursuing property of the estate — was no longer "in effect" as to those assets. The stay never prohibited the IRS from pursuing a collection action against the debtors, and at the time these tax claims came due, the "stay of proceedings" was in effect (at most) as to only a portion of the debtors' post-confirmation assets.

"Which circles back to the crucial question. Was the IRS actually prohibited from collecting these tax claims at any point after the October 2006 due date of the 2005 taxes or the October 2007 due date of the 2006 taxes?

"This Court agrees with [prior case] Jones that the answer to this question is no. The tolling provision of § 507(a)(8) only applies to situations in which the taxing authority was actually affected by the automatic stay in the prior case.

"The phrase "stay of proceedings" in the statute relates to "an otherwise applicable time period" as to collection of tax claims. The congressional purpose in enacting the statute was to codify the decision in Young, which was premised upon the idea that tolling was justified because the IRS had been "disabled from protecting its claim" during the pendency of the prior case. ... As the IRS did not in fact suffer under any such disability, and could instead have acted to collect the post-confirmation taxes at any time after they came due from those assets which had revested in the debtor upon confirmation under § 1327, there is no basis for tolling, whether pursuant to the statute or in equity." CLICK HERE FOR FULL TEXT OF CASE

Loving v. United States (In re Loving) (Bankr.S.D.Ala., 2011) (8/29/11) DEBTOR FILES CASE BEFORE 3-YEAR RULE SATISFIED

On April 8, 2011 a consumer bankruptcy attorney filed a bankruptcy case to discharge income taxes for tax year 2007. Unfortunately, the 3-year rule would not be satisfied until 7 days later (April 15 2011). The IRS objected to discharge, citing the 3-year rule that the due date for filing the return must be over 3 years prior to filing the bankruptcy. 11 U.S.C. § 507(a)(8)(A)(i).

The Court observed: "In [her] response, Plaintiff asserted that she filed her tax return on February 19, 2008, a date that is more than three years prior to her bankruptcy filing. Also, she alleged that her 2007 taxes were assessed more than three years prior to her bankruptcy filing."

In granting the IRS motion for summary judgment in the case, the court noted that the rule regarding when a tax is assessed had no bearing on the key issue here; to be dischargeable the tax must have been assessed more than 240 days prior to bankruptcy, which occurred in this case. 11 U.S.C. § 507(a)(8)(A)(ii). The court also observed that the date the bankruptcy was filed was within 3 years from the most recent due date for filing the return.

Morgan King - Ed. Note: This case is a textbook example of the attorney getting the rules for discharge all mixed up.

240 day rule: tax must be assessed more than 240 days.

2 year rule: the taxpayer must file his/her return more than 2 years before the bankruptcy. 11 U.S.C. § 523(a)(1)(B).

3 year rule: The due date for filing the return that must be over 3 years prior to the filing of the bankruptcy.  The due date is either April 15th of the year following the tax year, or at the time of all extensions.

Litigating Position Regarding the Dischargeability in Bankruptcy of Tax Liabilities Reported on Late-Filed Returns and Returns Filed After Assessment: http://www.irs.gov/pub/irs-ccdm/cc_2010_016.pdf

Sales taxes or transaction privilege taxes:
4-08:ADOR vs Action Marine, Az Ct Apps 1 CA-TX 06-0006 - in a recent Arizona Supreme Court decision that holds that the "responsible persons" for a business entity may be PERSONALLY liable for the transaction privilege taxes (you probably call these sales taxes) collected by an entity if the entity doesn't pay them over to the ADOR, even if the entity files for bankruptcy relief.  Historically, most people would have thought that the  "responsible person" for the taxes was just the entity itself and not the individuals involved in the entity and that the individuals could not be held liable.  Indeed, that was the very holding in bankruptcy decision called "Inselman" that is cited by the Arizona Supreme Court.

In re: Brenda Marie Jones, No. 10-60000
In a bankruptcy dispute involving the discharge of taxes owed by debtor in a new chapter 7 case to the California Franchise Board, judgment of the bankruptcy court is affirmed where debtor's prior Chapter 13 bankruptcy case had no effect on the look back period such that the period was not suspended and the tax debt discharged. Read more...

Practical Notes: in order to be certain that a tax is discharged - file an adversary in the bankruptcy to discharge the debt.  This gives us an order that the IRS has to follow.  IRS no longer uses the efficient and logical administrative procedure regarding dischargability of income taxes in chapter 7 bankruptcy cases that they used for so many years where we could write to them and they would tell us if they agreed that the tax was dischargeable.  In the adversary, IRS will usually stipulate to the order if the times are correct.  This gives the debtor ironclad proof of the dischargeability. 

Regarding the extension, look at the transcript.  An entry for “Code 460, Extension of time to file” certainly shows an extension.  Also, look for the Code 150: “Tax Return Filed”.  This will show a date.  A date before August 15 usually indicates an April 15 filing; IRS just logs it in late. If the case is still open, you could still file the adversary.  Or, go the the IRS local office now and try and get them to agree that the tax is discharged. 

WARNING: THE FOLLOWING IS OLD LAW AND MAY OR MAY NOT APPLY TO ANY CASES FILED AFTER OCTOBER 17, 2005.

Taxes and BK - nonfiling pre-BK and no assessment by IRS, more than 3 years old + non priority.  Neilsen has decided that such taxes are priority (State agrees) but IRS still does not believe that these are priority.  (11/97)

As of 1997 the information below was the law on how to discharge taxes after a bankruptcy has been filed. It may have dramatically changed since this writing.  This should be included in every client letter of a person who owes back taxes to the Federal Government.  (This info was obtained at http://www.mckenzielaw.com/BANKRUPT.html )

As a result of Bankruptcy Code Sections 523 and 507 the following taxes are dischargeable:

1.     Tax penalties for non-filing, late payment, late deposit, fraud penalties and late estimated payments if the taxes to which they relate are dischargeable.
2.     Income taxes which are:
       a.   Over three years old;
       b.   Have been filed at least two years prior to the petition; and/or
       c.   Have been assessed as an audit deficiency for at least 240 days.
3.     Estate and gift taxes which are over three years old.
** A taxpayer must not have filed a fraudulent return or otherwise tried to willfully evade payment of the tax.

Once a discharge has been entered by the Bankruptcy Court, submit a written request to Special Procedures Branch that the IRS abate the tax. The Service will abate the liability by preparing a Form 3870. The author has found that the IRS is very inefficient in preparing post-bankruptcy abatements. Many clients have had levies made on their wages or bank accounts after a bankruptcy. You must aggressively pursue abatement. If all else fails, the client may request that the Bankruptcy Court hold the IRS in contempt of court. Until the IRS begins protecting the rights of bankrupts, the IRS may take illegal levy action notwithstanding the bankruptcy. If you have taken reasonable steps to notify the IRS of the bankruptcy and discharge, you will have a potential cause of action for reckless violation of the Code [IRC § 7433].

However, the Bankruptcy Court has the authority upon review of a debtor's Chapter 7 bankruptcy to deny discharge and dismiss the matter if it believes the debtor can partially or fully repay some debts. In other words, the Court might try to force a conversion to a Chapter 13 bankruptcy upon a person who originally petitioned for a Chapter 7 bankruptcy. Such a decision is based upon an income and expense statement which all debtors have been required to file since the 1984 amendments to the Bankruptcy Code.

IN RE BUNYAN (01/20/04 - No. 02-56786) (U.S. 9th Circuit Court of Appeals)  Pursuant to 11 U.S.C. section 505(a)(2)(A), the bankruptcy court lacked jurisdiction to consider the validity of income tax assessments filed by the IRS in Chapter 13 proceedings. A 1993 circuit court order granting the Commissioner's motion to dismiss necessarily adjudicated the issue of when the tax court decisions became final.

DUNMORE v. U.S., (9th Cir. 2004)  ONLY BK ESTATE HAD STANDING TO PURSUE TAX REFUND THAT DEBTOR FAILED TO SCHEDULE  Dunmore, as a debtor seeking bankruptcy relief, had a duty to carefully schedule his assets, including his refund claims, on his bankruptcy petition. Cusano v. Klein, 264 F.3d 936, 945-46 (9th Cir. 2001). Dunmore, however, breached this duty when he chose not to schedule his claims against the IRS on his Chapter 7 petition. By operation of statute, assets that Dunmore failed to schedule remained the bankruptcy estate's property, even after the court discharged his debt. 11 U.S.C. § 554(c), (d). Thus, the unscheduled tax refund claims remained the estate's property post-bankruptcy. Accordingly, we conclude that the bankruptcy estate was the real party plaintiff in interest at the time Dunmore filed his action.

IN RE OLSHAN (01/28/04 - No. 02-56792) (U.S. 9th Circuit Court of Appeals)  Bankruptcy court erred in rejecting the IRS' claims for unreported nonbusiness income and overstated business deductions after finding that the IRS' method of computing debtor's unreported business income was flawed. Undisputed evidence in the record will enable the bankruptcy court to determine debtor's liability for taxes, penalties, and interest.

DUNMORE v. US (01/29/04 - No. 02-15789) (U.S. 9th Circuit Court of Appeals) Plaintiff's tax refund claims are "non-core" proceedings under the Bankruptcy Code, despite the offset claim asserted by the IRS; the bankruptcy court therefore could not enter a final judgment without plaintiff's consent. District court abused its discretion when it affirmed the bankruptcy court's final order dismissing the claims.

US INTERNAL REVENUE SERV. v. SNYDER, No. 02-15618 (9th Cir.  September 15, 2003)   An IRS claim for delinquent taxes secured outside of bankruptcy by a lien on a debtor's interest in an ERISA-qualified pension plan is not secured under 11 U.S.C. section 506(a), because a debtor's interest in an ERISA-qualified plan is excluded from the bankruptcy estate pursuant to 11 U.S.C. section 541(c)(2).  http://caselaw.lp.findlaw.com/data2/circs/9th/0215618p.pdf

US INTERNAL REVENUE SERV. v. SNYDER (9th Cir. 09/15/03 - No. 02-15618)  An IRS claim for delinquent taxes secured outside of bankruptcy by a lien on a debtor's interest in an ERISA-qualified pension plan is not secured under 11 U.S.C. section 506(a), because a debtor's interest in an ERISA-qualified plan is excluded from the bankruptcy estate pursuant to 11 U.S.C. section 541(c)(2). http://caselaw.lp.findlaw.com/data2/circs/9th/0215618p.pdf

ERRONEOUS TAX REFUND IS DISCHARGEABLE In re Frontone ___ B.R. ___ (C.D.Ill. 2003)  Held, an overpayment to the taxpayer of a tax refund is a debt owed to the IRS, but is not treated the same as the underlying tax, and therefore is dischargeable in Chapter 7.

In May 2001 the IRS sent debtors a notice saying they had overpaid their tax and refunded them $5,140. Subsequently, the IRS assessed additional taxes owed, and demanded the refund be paid back. In September 2002 the debtors filed Chapter 7 and filed an objection to the IRS claim. The court held that § 507(c) gives an erroneous tax refund the same “priority” as the underlying tax, but not the same nondischargeable status.

“The legislative intent behind the change made in 1984 to the language of Section 507(c) is easy to ascertain. Congress obviously concluded - correctly - that it is inequitable to treat taxpayers who fail or decline to pay their income taxes the same as taxpayers who pay their income taxes but who incur obligations to a governmental unit as a result of that governmental unit's erroneously refunding taxes paid.” 
http://caselaw.lp.findlaw.com/data2/circs/9th/0156992p.pdf

GOLDBERG v. ELLETT (07/16/01 - No. 00-15128) (9th Cir. Ct App)  Bankruptcy court may enjoin a state tax official from collecting state taxes purportedly discharged in a bankruptcy proceeding in which state declined to participate.  http://caselaw.lp.findlaw.com/data2/circs/9th/0015128p.pdf

DEROCHE v. ARIZONA INDUS. COMM'N (11/29/01 - No. 99-16058) (9th Cir. Ct App) In determining whether an employer's failure to provide worker's compensation is an "excise tax" to the Arizona Special Fund for worker's compensation and occurred within three years prior to bankruptcy, the date of the "transaction" is the date employee was injured.  http://caselaw.lp.findlaw.com/data2/circs/9th/9916058p.pdf

N. SLOPE BOROUGH v. BARSTOW (10/21/02 - No. 01-35892/35901)(9th Cir) Under Bankruptcy Code section 724(b), priority unsecured creditors have a right to obtain only that portion of the proceeds equaling the amount of the tax liens. Any remaining proceeds go first to junior lien claimants, then to the holders of the tax liens insofar as their claims were not already satisfied and, finally, to the estate. http://caselaw.lp.findlaw.com/data2/circs/9th/0135892p.pdf

BARSTOW v. US INTERNAL REVENUE SERV. (10/21/02 - No. 01-35819) (9th Cir) The term "tax lien" in Bankruptcy Code section 724(b) means a statutory tax lien, and the term does not embrace a judicial lien securing an underlying tax obligation.  http://caselaw.lp.findlaw.com/data2/circs/9th/0135819p.pdf

US v. GALLETTI, No. 01-55953/4 (9th Cir. August 08, 2002)  The IRS cannot collect a partnership's tax deficiency directly from the partners, without first making individualized assessments or obtaining judgments against the partners, holding them liable for the partnership's tax debts; bankruptcy claims were time-barred.  http://caselaw.lp.findlaw.com/data2/circs/9th/0155953p.pdf

STEIN v. CADLE CO.  (05/10/01 - No. 99-56751)  Under the Federal Priority Statute, 31 USC 3713 gives the federal government priority over other judgment creditors notwithstanding the Federal Tax Lien Act.  http://caselaw.lp.findlaw.com/data2/circs/9th/9956751p.pdf

DEROCHE v. ARIZONA INDUS. COMM'N, No. 99-16058 (9th Cir. April 05, 2002)   When determining the dischargeability in bankruptcy of an excise tax owed on a "transaction," in which an employer reimbursed the state's Special Fund for failure to carry insurance, the date of the "transaction" is the date on which the worker was injured; thus, since transaction occurred over three years prior to filing bankruptcy, the excise tax debt was dischargeable. 

MILLER v. US, No. 02-17073 (9th Cir. April 13, 2004) The interplay of Bankruptcy Code sections 1141(d)(2), 523(a)(1)(A), and 507(a)(8) renders an IRS claim for unpaid withholding taxes nondischargeable by a confirmed Chapter 11 bankruptcy plan, whether or not that claim was secured.  http://caselaw.lp.findlaw.com/data2/circs/9th/0217073p.pdf

OPINION SUMMARIES ARCHIVE FindLaw archives case law summaries of opinion issued since September 2000 by the U.S. Supreme Court, all thirteen Federal Circuit Courts, the California Supreme Court, the California Appellate Courts, and the New York Court of Appeals.  http://caselaw.lp.findlaw.com/casesummary/index.html

goldbreak.JPG    Arizona Exemptions    goldbreak.JPG
 

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