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Bankruptcy Code Sections 523(a) and 507(a)(8) specify taxes that are not dischargeable in bankruptcy. The following describes the general rules under which a debtor may or may not be allowed relief from certain tax debts.
This article discusses income, excise, trust fund, property and sales taxes, as well as tax penalties and tax liens.
Generally, Federal and State “income” taxes are not discharged (forgiven) in a Chapter 7 or Chapter 13 bankruptcy. But they can be discharged if certain tests or conditions [per Bankruptcy Code 11 U.S.C. § 523(a)(1)] are met:
Income Tax Discharge Tests - all of which must be met to discharge the tax:
1. Three Year “Tax Due” Test: The tax must be owed at least 3 years after the tax return was due. Normally, the tax return was due on April 15.
Example: 2007 taxes are due on April 15, 2008*. To pass this test, the bankruptcy must be filed after April 15, 2011.
Note: If an extension to file to October 15 was made, the three year
time clock starts on October 15.
2. Two Year “Tax Return” Test: The tax return must have been filed more than 2 years before filing bankruptcy. This rule applies to all filers but especially to late filers.
Example: 2005 taxes, but the tax return was not filed until August 23, 2010. To pass this test, the bankruptcy must be filed after August 23, 2012.
3. 240 Day “Assessment” Test: The tax must have been assessed more than 240 days before filing bankruptcy.
Example: The year 2006 tax return did not accurately reflect all the tax that was due; therefore on July 14, 2009, the IRS finished assessing additional taxes after discovering the mistake. To pass this test, the bankruptcy must be filed after 240 days, i.e., approximately March 10, 2010.
Warning – Taxes “Assessable” but Not Yet Assessed are not dischargeable: The Bankruptcy Code [11 USC §507 (a)(8)(A)(iii)] defines as nondischargeable [per 11 USC §523(a)(1)] taxes not yet assessed but assessable by applicable law or agreement.
Assessable by Law:
Federal IRS Assessability Time Limit: Generally three years. See Part “H” below near the end of this article.
Assessable by Agreement: Additionally, priority (nondischargeable) tax definition also includes taxes that continue to be assessable “by agreement”. It is reported that tax officials discussing tax matters frequently pressure a taxpayer to sign an agreement (with a clause or provision that extends the time limit that taxes can be assessed).
taxes “assessed?” The Internal
Revenue Code makes assessments
through the Secretary of the
assessment, the secretary must to send a notice
of deficiency to the taxpayer. Unless the taxpayer
deficiency, the secretary may assess a deficiency after a certain
federal income taxes, the date of the assessment is the
date the summary record is signed by the assessment officer.
Other factors: The 3-year and/or 240-day wait periods may be, in certain cases, tolled or extended by a prior bankruptcy, request for collection due process hearing, an offer-in-compromise, contesting of a proposed assessment, and other potential factors.
4. “Fraud” or “Motive” Test: The bankruptcy filer must not have made a fraudulent return or willfully attempted to evade or defeat payment of the tax [See Bankruptcy Code - 11 USC §523(a)(1)(C)].
Example: Generally, evidence of simple non-payment, without anything more, does not provide sufficient proof that a person tried to evade or defeat payment of the tax. But nonpayment combined with efforts to hinder, frustrate and/or prevent collection may render a debt nondischargeable.
Trust fund tax liability is not dischargeable (forgiven, wiped out, erased) in bankruptcy. Even if the debt is old, trust fund taxes are not discharged.
Common example of trust fund tax: Employee wage withholding (that is, wages that an employer withholds from the employee's paycheck).
Potentially responsible (liable) persons: Employer or a "responsible person" for a corporation, LLC or partnership that did not pay withheld funds to the taxing authority.
In some states, sales
taxes are also trust fund
taxes. In other states, such as
C. EXCISE TAX
An excise tax is dischargeable if the bankruptcy petition is filed no earlier than three years from the date a return is due, or if no return is due, three years from the date the transaction occurred.
D. PROPERTY TAX
Note: In some states (California included), property taxes “run with the land” meaning that, after, for example, a foreclosure sale, the new owner now owes the delinquent property tax.
Unsecured tax penalties are dischargeable in bankruptcy if the underlying tax debt is dischargeable. But if the underlying tax debt is NOT dischargeable in bankruptcy, then the tax penalty is NOT dischargeable.
1. What is a tax lien? A tax lien is a lien (a type of legal claim) upon assets or property imposed by law arising after certain events occur to secure the payment of delinquent taxes.
What Property and Assets? A federal tax lien attaches to virtually all property. Courts have interpreted Internal Revenue Code (IRC) §6321 to include all real, personal and intangible property of the taxpayer, including after-acquired future property (that is, acquired by the taxpayer after the lien has come into existence), .
But see discussion on bankruptcy's effect on after-acquired property below.
individual States cannot enact laws that exempt (protect the taxpayer)
reach of the federal tax lien. See
issued by the California Franchise Tax Board attaches to all property
rights to property located in
Levy / Seizure: The Internal Revenue Code (IRC) authorizes levies to collect delinquent tax. See IRC §6331. Any property or right to assets and property can (after proper due process notices and opportunity to contest), be levied / seized unless it is a type of property that is exempt (that is, protected from levy or seizure). See IRC §6334.
Federal Tax Lien Statute of Limitations: The statute of limitations under which a federal tax lien may become "unenforceable by reason of lapse or passage of time" (generally 10 years after the date of assessment) is found at 26 U.S.C. § 6502. Various exceptions may extend the time periods (for examples waiver signed by the taxpayer, bankruptcy proceedings, etc.)
A bankruptcy filing tolls or extends the 10 year limitation tax lien by 101 days [CA Code of Civil Procedure (CCP) §356. See also RTC §2963, 3007].
Existing property: If a tax has obtained lien status on property of the debtor before the bankruptcy is filed, it will continue to attach to that property even though the tax liability may have been discharged in bankruptcy. Therefore, the property will remain subject to the tax lien.
Thus, if the tax debt liability is dischargeable, then your “personal liability” to the government entity (federal or state) is discharged. But the government entity still has a claim against your real or personal property [“in rem”, “against the thing”] that is subject to the lien.
After-acquired property: In contrast to a non-bankruptcy debtor, a tax debt that is discharged in bankruptcy does not attach to the property acquired by the debtor after the date that the bankruptcy papers were filed with the court.
Some assets (like household goods) lose value over time. Discharged debtors sometimes ignore the lien with the expectation that the asset will eventually become worthless causing the tax authorities to not likely enforce the lien against the personal property. Further, IRS statutes exempt certain types of personal property so that the IRS cannot levy on it (See IRC §6334).
Regarding tax liens, state exemptions that protect certain property generally do not apply to the IRS.
G. BANKRUPTCY BENEFITS REGARDING CERTAIN TAX DEBTS
1. Chapter 7 Bankruptcy filings may benefit tax debtors.
Chapter 7 bankruptcies completely 100% wipe out, discharge, and forgive taxes debt personal liability but only to the extent that the tax debt is dischargeable.
Thus, if 100% of your tax debt is dischargeable, then a Chapter 7 wipes out and discharges 100% of the tax debt.
But, if, for whatever reason, only 40% of your tax debt is dischargeable, then a Chapter 7 wipes out and discharges only 40% of the tax, and for the other 60% you continue to remain personally liable for.
2. Chapter 13 Bankruptcy filings may benefit tax debtors.
First, Chapter 13 bankruptcy provides relief from collection efforts by taxing authorities.
Second, it may stop further penalties and interest to a tax debt.
Third, the taxpayer may repay the tax debt over time (up to 60 months) through a Chapter 13 plan.
Fourth, unlike Chapter 7 debtors, Chapter 13 debtors may discharge a loan that they obtained in order to pay nondischargeable taxes.
Fifth, dischargeable (non-priority) type of taxes and all tax penalties may often be discharged by paying less than full payment owed. Why? Because such non-priority tax debts are relegated to the same “low man on the totem pole” status as other unsecured debts like credit cards; thus such nonpriority tax debts are paid with the leftover money (sometimes, pennies on the dollar) after higher priority obligations and debts are paid. But nondischargeable priority taxes must ultimately be paid in full.
H. STATUTE OF LIMITATIONS REGARDING TAX DEBTS
But be aware there is a time limit (statute of limitations) on the collection of IRS taxes, including trust fund taxes. The time limit is generally 10 years from the date of assessment.
How long do tax entities has to assess?
IRS Assessability Time Limit: The IRS has three years to assess an additional tax due [IRC section 6501(a)]. For example, for a taxpayer who filed a 2004 tax return on April 15, 2005, the IRS has until April 15, 2008, to assess an additional tax. (Two major exceptions: First, IRS has six years to assess where the taxpayer omitted more than 25% of gross income [see IRC section 6501(e)(1)(A)]. Second, no statute of limitation in cases where no return has been filed, or where the taxpayer has filed a fraudulent return [see IRC sections 6501(c)(1), 6501(c)(2), and 6501(c)(3)].
Notice: The purpose of the statute of limitations is to specify the time within which FTB must initiate its assessment procedure. There are no limitations requiring that the assessment process be completed or finalized within any specific time period. (Appeal of Jenkel-Davidson Optical Company, 81-SBE-101, May 19, 1981; Appeal of Peter I. and Inga M. Kune, 84-SBE-106, June 27, 1984.)
The information provided in this article is informational, only. The subject matter and applicable law is evolving and/or constant state of change. No legal advice is given and no attorney/client or other relationship is established or intended. The information provided is from general sources, and I cannot and do not represent, guarantee or warrant that the information contained in this website is accurate, current, or is appropriate for the usage of any reader. It is strongly recommended that readers of this information consult with their own legal and/or professional counsel rather than relying on any information in this article.
This article contains only a summary of the treatment of taxes in bankruptcy. The effect of certain activities which affect tax debts and other details of covered material herein have been omitted for simplicity.
To determine whether or not and how the above bankruptcy tax laws apply to your particular situation, you are urged to seek counsel from an experienced and knowledgeable bankruptcy attorney or, alternatively, a tax attorney with specialized knowledge in bankruptcy discharge laws.
Tax laws are complicated and changing. This article is not tax advice. To determine whether or not and how the above tax laws apply to your particular situation, you are urged to seek counsel from an experienced and knowledgeable tax attorney, accountant and/or other tax professional.
Article's Author: Bankruptcy lawyer Matthew B. Tozer.
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