This post is geared more towards attorneys practicing bankruptcy law, but it is useful to anyone trying to resolve income tax debt. I am following up on my last post about how to determine if income tax debt can be discharged in bankruptcy. First, as an attorney, you have to complete and have your client sign a Power of Attorney, Form 2848. Well, actually you have to back up a step further and obtain a CAF number from the IRS. You will need that CAF number in order to get anywhere with them.
Once the 2848 is completed, you send it in to the IRS so that they can either lose it or take weeks to process it. Oh, but do not worry, you can still proceed. You next want to get a Form 4506-T completed. You really should do this at the same time as the 2848 to save time. There are fax numbers of the back of the 4506 to send it to and you only have to try that fax number a dozen or so times. More recent years can be obtained by calling the automated number for the IRS, but the transcripts can only be sent directly to the taxpayer’s address if you go that route.
Once the Account Transcripts come in, you need to look for those “520” codes I mentioned in the last post. If there are any on the transcripts, you will want to spend a leisurely afternoon on the phone listening to the Internal Revenue Services music interrupted by occasional transfers to different departments. Once you get to the right place, you will be grilled about who your are. They will look in the system and fail to find the 2848 that you had dutifully sent in per the instructions. Just go ahead and have a copy of the 2848 at hand because the person helping you will ask you to fax it directly to them.
Once that 2848 is in front of them, they will ask you to repeat information that is clearly spelled out on the form itself to “verify” things. It seems this only verifies that you faxed them the very same document they are looking at, but no matter. Now you are cooking with GAS – well, perhaps kerosene. It will just take a few seconds to get the closing code. If you want to forgo this whole experience, then look for a code “971” and see it there is one whose dates corresponds to the “520”. If so, you are safest to assume that the closing code is 77.
PS: By the by, attorneys, this is a time intensive and liability laden analysis, so be sure to charge separately from the bankruptcy for this procedure.
PPS: Be sure to get your client’s dates of birth – the IRS sometimes asks for this to verify that you are whom you say you are.
I just finished an analysis of whether over $90,000.00 in income tax debt from 2003 to 2005 could be discharged for a client through bankruptcy. The surprise answer for them was that it would be discharged completely in a Chapter 7 or a Chapter 13. Many have the mistaken belief that income tax debt never goes away; even many attorneys assume you must pay it no matter how far behind you find yourself. The truth is, there is a series of time-based limits set on income tax debts and once those limits are reached, the tax is treated like any other unsecured debt in bankruptcy.
To know whether a tax debt can be discharged in bankruptcy, one must obtain an “Account Transcript” for each year in which tax debts are owed. This transcript has a series of three digit codes along with dates for those codes and sometimes dollar amounts listed. Certain codes matter more than other. For example, one must make sure there are no “320’s” because that indicates an assertion that there was fraud involved in the tax return filed. Then, one needs to ascertain the dates of any penalties assessed by scrutinizing codes 290, 294, 298, 300 and 304. These penalties are also subject to the time limits but have to be addressed separately due to different stating dates.
Another code that makes a huge difference is the “520” code. A 520 event is one that may or may not cause a stand still (a “tolling”) of those time limits from running. Just finding the 520 code is not enough because one must CALL the Internal Revenue Service to find out what the “closing code” is. The closing code will be a “77” or a “90”. The 77 closing code means the time between the 520 date and the following 521 or 522 closing date did toll the time making it take longer to be able to discharge the debt. There is also code “480” that happens when there is an “offer in compromise” proposed. A 480 event also tolls the time until the tax debt can be discharged.
If you have done your best to pay your income tax debt and it is just too big a burden, go a an attorney who can analyze a Tax Account Transcript. Find out if you can get a fresh start even from income tax debt.
I write about this every year because it is a recurring issue for people facing bankruptcy. Taxes have a bearing on bankruptcy whether you are owed a refund or whether you owe the IRS. Therefore, they must always be taken into account, but it is especially important during this first handful of months each year.
The first thing to remember is that if you are owed a refund at the time of filing, that refund is an asset of the estate and must be reported in Schedule B and hopefully exempted in Schedule C. If you owe taxes, they are reported on either Schedule F or E depending on whether they are priority debts or not. Your attorney can help sort that out. Tax debt and tax refunds arise on December 31st each year. So, if you file a bankruptcy on January 1st, then you must account for the tax situation that arose from just the day before. So, even if you do not file your tax return until April 15th (or October if you file an extension) you either owe taxes for the year that just ended or you are getting a refund (rare indeed is the person who lands right at zero, but I suppose it happens).
If you owe taxes for the preceding year, they will be considered a “priority” debt and a debt that cannot be discharged. In a Chapter 7, the IRS and any state agency you owe taxes to will begin collection activity after your Chapter 7 is closed. In a Chapter 13, you will have to make sure you pay enough into the plan for those taxes to be paid in full over the life of the Chapter 13 along with 4% interest for federal income taxes and 5% interest on Kentucky income taxes.
If you are owed a refund, you need to report the refund as accurately as possible in your schedules of assets. This means you will likely have to run at least a rough draft of your tax return to get a good faith estimate of what is due back to you. Then, you will attempt to cover the entire amount in “wild card” exemptions. If you cannot exempt the entire amount, you will need to make a determination with help from your attorney as to whether you should wait until you receive the refund or press on.
If you decide to wait until you receive the refund, then the smart thing to do would be to pay for the bankruptcy and spend the money on necessities, such as food or needed repairs to you car. Do NOT use it to pay unsecured debt, especially not to relatives. Your attorney can help you know how much you can hold onto and exempt.
Your attorney can also help you determine if older income tax debts, such as those that arose a few years prior to the bankruptcy, will be discharged in your Chapter 7 or 13. All of this is acceptable pre-petition planning to make the most of the fresh start bankruptcy allows.
I have often written about Chapter 13 and how it is a great mechanism for resolving tax debt. And it is! When looking at income tax debt, there are basically two kinds: that which can be discharged and that which cannot be discharged. Simple enough.
The basic rules of figuring out which tax debts can be discharged are also simple, but the various times and ways the time-frames of these rules get “tolled” gets tricky:
- The most recent date (remember extensions) the filing was due is over three years ago.
- The tax was assessed at least 240 days ago.
- The tax return was actually filed more than two years ago.
- The tax return was not fraudulent.
- The taxpayer was not willfully trying to evade the taxes.
So, in a Chapter 7 or 13, the income tax debts that meet these rules get discharged. If there are tax debts that are not discharged, then in a Chapter 7 they keep on accruing interest and penalties and must get paid. In a Chapter 13, these non-dischargeable tax debts must be paid in full. So, if you have enough disposable income to accomplish it, then in three to five years the tax debt PRINCIPAL is paid in full on tax debt that cannot be discharged.
Ahhh, the rainbow is at hand! Oh, but wait, Federal tax debt can still accumulate 4% interest while in bankruptcy and Kentucky income tax can accumulate 5% interest. You see, 11 USC Sect. 1322(b)(10) has a little catch. A debtor in Chapter 13 can ONLY pay the accruing interest on these income tax debts IF AND ONLY IF all the claims filed by creditors are paid at 100%.
There is nothing for it other than to give plenty of advance notice to Chapter 13 debtors. There is no way to change the fact that the interest can accumulate and there is no way to make it get discharged. So, unless you have a 100% Chapter 13 plan, be prepared to have to pay the accumulated interest on your income tax debt EVEN after the Chapter 13 is closed out. Don’t fret too much though. When you have gotten that far, you are going to be much more freed up financially to take care of that last issue.
If you consult with a bankruptcy lawyer about a possible Chapter 13, then you will likely hear them tossing around phrases such as, “100% plan” or “7% plan”. This sounds foreign, but I want to give you a quick explanation. When one files a Chapter 13, they propose a plan. This is very much like the reorganization of debt plans that businesses (and sometimes individuals) use to restructure in a Chapter 11. On a miniature scale, the individual debtor in a Chapter 13 is restructuring their debt via their plan.
One aspect of a plan that can be confirmed (approved by the court) is that it divides debts and creditors into different classes. The common classes are priority debts, such as recent income tax debt; secured debt, such as a car loan or mortgaged loan on your house; and unsecured debts, such as most credit cards. There are different rules for each class. For example, priority debts get paid in full in a plan. The rule for unsecured creditors is that each gets treated the same and will receive a pro-rata share of the payments made over an above what is required to pay priority and secured debts.
So, unsecured creditors are the last on the list of who gets paid and they only receive the leftovers. They must get as much in leftovers as they would have gotten in a Chapter 7, but this bottom number is usually zero. That is, most individual Chapter 7 bankruptcies have no non-exempt assets to be liquidated, divided and distributed. But, if your assets in the Chapter 13 are not entirely exempt, then you may have a higher dollar amount that must go to unsecured creditors. For example, if you can exempt all but $10,000.00 of the equity in the home you are keeping, then your unsecured creditors will have to collectively receive $10,000.00 over the course of your Chapter 13.
Now, the percentages I referred to above speaks to the pro-rata share each unsecured creditor will receive through the plan. Ordinarily, trustees will give higher scrutiny to expenses listed in your budget (Schedule J) when your plan only pays a very low percentage. Despite this, there are plans that get approved for debtors who are barely getting by where unsecured creditors get zero percent payment. From my experience, though, the average Chapter 13 debtor is going to repay 3 to 7% of their unsecured debts.
I have seen a number of 100% plans for debtors with relatively high income who fell behind because of a temporary job loss or some snowball effect of debt. In these plans, the trustees are typically less concerned about relatively high expenses and lifestyles.
My last post hit some highlights on tax debt from a presentation by Professor Williams at the 16th Biennial Judge Joe Lee Bankruptcy Institute. This post delves a bit deeper into a specific tax law I touched on in that last post. The tax code provision is 26 USC Sect 1398 and it applies specifically to Chapter 7 and Chapter 11 bankruptcy cases. It does not address Chapter 13 cases.
The main thrust of Sect. 1398 is to allow for a Debtor to make an election to treat their ordinary tax year as two separate, shorter tax years. The first tax year would go up to and include the day before a Chapter 7 or Chapter 11 is filed. The second tax year includes the filing date of the bankruptcy and runs through the remainder of the normal tax year. This does NOT happen automatically, so the Debtor must take affirmative action.
If a married couple file jointly, the Joint-Debtor may also make this same election, but again it has to be an affirmative step taken by the Joint-Debtor; the Debtor’s election does not automatically apply to the Joint-Debtor. The election of the Debtor and election of the Joint-Debtor must be made no later than the due date for filing the return for the first short year and it cannot be undone once made.
By making the election, income that is part of the bankruptcy estate is taxable to the estate instead of to the Debtor. An example of how this might matter for a consumer debtor is if the Debtor becomes entitled to an inheritance or lottery winnings during the 180 days after filing. These monies get pulled back into the estate and might not be exempt or only partially exempt. Without this election, the Debtor may be hit with taxes on monies they were not able to keep.
This tax code provision would most usually come into play for business related bankruptcy debtors. Even if the Debtor is an individual, they own a business entity that may not be exempt or only partially exempt. The revenue that business generates would be income to the estate to the extent that business entity is not exempt. This can occur through ongoing revenues of the business or liquidation. The Debtor, again, would not want to be liable for taxes on funds they cannot enjoy.
The 1398 provision does not, however, have any impact on tax debt arising prior to the filing of the bankruptcy and the vast majority of consumer debtors will never need to avail themselves of this election to split tax years. Business related debtors need to be mindful of this option when there are non-exempt assets. Businesses entering bankruptcy as an entity, rather than the individual owner, must remember this election.
Here are a few more insights gleaned from the 16th Bicentennial Judge Joe Lee Bankruptcy Institute I attended last week. Professor Jack Williams gave an informative talk on the intersection between tax law and the bankruptcy code. Here are a few bullet points pulled from that talk:
- The tax law, contained in Title 26 of the United States Code contains a key provision related directly to bankruptcy. 26 USC Sect 1398 is a must see when a debtor comes into bankruptcy with significant tax liabilities. One thing this law does is allow a debtor to bifurcate (split) their tax year into two short tax years. One reason this matters is that it would make it clear that tax liability arising from assets of the estate post-bankruptcy remain the liability of the estate rather than the debtor. Another way it may come into play is to insure that priority tax debt derived from pre-filing income will get pulled into and paid in full through the plan in a Chapter 13.
- When looking at tax liability, look at the nature of the taxes. For example, trust fund tax liability that an employer debtor should have paid on behalf of their employees will be imputed as the debtor’s personal liability if the employer owned a pass through single member LLC. This debt never becomes stale – that is, it will never become non-collectable or get discharged. However, personal income tax liability will become non-collectable or get discharged at some point.
- With tax debt, time is usually the debtor’s friend. If a tax return was filed, the IRS has only three years in which to challenge it. And, once a tax is assessed, the IRS only has ten years to collect it unless a bankruptcy, installment agreement, or offer in compromise tolls that time. So, if a debtor can wait it out, they may be better off.
- If, though, a bankruptcy is necessary, the timing of filing still matters greatly. The overly simplified timeline is that when three years have passed from when a tax became due, unless it has been tolled for some reason, then those taxes will be discharged in a bankruptcy. If it has been more than 240 days from when the IRS assesses a tax, then that tax may be discharged in a bankruptcy. So, one must look carefully at these and try to time the filing of a bankruptcy to discharge most or all of the tax obligation.
- It is ALWAYS better to file a tax return even if the debtor cannot pay the tax. Failure to file a return does not stop the obligation from arising. But, filing the return starts the time limitations running on the IRS and stops the IRS from assessing their own version of tax liability, absent deductions, against the debtor.
- The worst tax scenario is the tax debt is non-priority debt but it is not discharged because of some kind of bad act such as fraud. This is because if it is priority tax, then it would get paid first and in full in a Chapter 13 or at least paid first in an asset Chapter 7. But, if it is not priority, then it only gets the same pro-rata share as general unsecured creditors and still hangs around after discharge.
The ringing wisdom of this presentation confirmed the approach I adopt when tax debt is at issue and that is to be patient, thorough, and wait when possible.
This is the next installment in a series that began looking at the timing between subsequent Chapter 7s. There really is not a prohibition against filing; the prohibition is on receiving a discharge if filing within certain time frames.
If the preceding bankruptcy was a Chapter 13 (or Chapter 12), then you cannot receive a discharge in a subsequent Chapter 7 if the Chapter 7 was filed six (6) years or less of when the preceding bankruptcy was filed. See 11 USC Sect. 727(a)(9). There are two exceptions: if there was 100% payment to unsecured claims in the Chapter 13 or if there was 70% repayment AND it was the Debtors’ best effort.
I am doing a series on timing between filings of bankruptcies and began looking at the time between two Chapter 7 filings. Today is looking at the time between Chapter 13s. As I stated previously, the issue is not when one can file, but when one can receive a discharge in the subsequent case. The time issue for a 13 to a 13, unlike other scenarios, is open to litigation.
If the preceding bankruptcy was a Chapter 13, then you cannot receive a discharge in a subsequent Chapter 13 if it is filed two (2) years or less from the prior Chapter 13. However, it remains unclear in the Sixth Circuit (including Kentucky) if this means two years from the discharge of the prior Chapter 13 or the date the first Chapter 13 was filed. See 11 USC Sect. 1328(f)(2). I believe the most likely reading is from filing date to filing date due to the similarity in language of the statute. However, one should be aware that this has not been squarely decided in the Sixth Circuit and there are arguments on the other side. The main argument on the other side is that it really makes no sense to have a two-year period when Chapter 13s run three to five years, but that really only makes this statute cover a rare situation, not an impossible one.
4) If the preceding bankruptcy was a Chapter 13 (or Chapter 12), then you cannot receive a discharge in a subsequent Chapter 7 if the Chapter 7 was filed within six (6) years of when the preceding bankruptcy was filed. See 11 USC Sect. 727(a)(9). There are two exceptions: if there was 100% payment to unsecured claims in the Chapter 13 or if there was 70% repayment AND it was the Debtors’ best effort.
5) If there was no discharge in a preceding Chapter 7 or Chapter 13, then there is no time limit on filing with regard to receiving a discharge. However, there is an impact on the automatic stay which is not covered here.
When I say “within” I advise to wait that period of years and then one can file the day after that period has run.
I began looking a the time between Chapter 7s if one wishes to receive a discharge. The time frame is different when the subsequent case is a Chapter 13 showing the favored status of Chapter 13 bankruptcy. If the preceding bankruptcy was a Chapter 7 (or Chapter 11 or 12), then you cannot receive a discharge in a subsequent Chapter 13 if is filed four (4) years or less of when the Chapter 7 was filed. See 11 USC Sect. 1328(f)(1).
If one gets a discharge of unsecured debt in a Chapter 7 but still has some non-dischargeable priority debt in income taxes, they may want to turn right around and file a Chapter 13 without waiting the four years because they will be paying the debt in full over the length of the plan. So, there is no need for the discharge. This is a strategy discussion to have with your attorney.
- What your bank CAN and CANNOT do when you file bankruptcy
- Tax Time!
- Interest Rates on Secured Claims in Chapter 13 Cases in the EDKY
- CAUTION: Tax Refund
- When Business Owners Should File Bankruptcy
- To File or Not to File: Attorney decision making
- Deadlines for Filing Prepetition Tax Returns in Chapter 13 Cases
- Delinquent Property Tax Claims in Chapter 13 Cases
- Lessons Learned the Hard Way
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