[Tax Counsellor]

Karrie L. Bercik, JD, LLM

Discharging the Nondischargeable: Tax Claims in Bankruptcy, Barristers Club of San Francisco (March 1998)

 

I. Basic Discharge Provisions

    A. Income Taxes
      1. Secured Taxes
        a. Make sure lien is properly perfected.

        b. Is there value supporting the lien?

        If so, the tax is secured and is nondischargeable. A secured tax must be paid in full. In a Chapter 11, the tax may be paid over any period of time permitted under the plan. In a Chapter 13, the tax must be paid in 3-5 years. In a Chapter 7, the tax is not discharged and survives the bankruptcy. After the Chapter 7 is completed, the IRS will attempt to collect out of the exempt assets (house, pension plans, cars, etc.). Generally, you can negotiate a release of the lien by calling IRS Special Procedures.

      2. Priority Unsecured

        a. Priority taxes are not dischargeable in a Chapter 7.

        After the bankruptcy, they must be either paid under an installment agreement or disposed of in an offer - in - compromise. In a Chapter 13, the taxes must be paid in full over 3-5 years. In a Chapter 11, the priority tax must be paid in full in six years. As the debtor determines when to file the bankruptcy petition, the debtor should be able to plan to avoid the priority status. If the debtor miscalculates and files too soon, the debtor may not voluntarily dismiss the petition and refile after the period has expired. See, In re Leach, 130 BR 855 (BAP 9, 1991).

        b. Three-year Rule

        Generally, a tax is a priority tax if the return was due within three years of the date the bankruptcy petition is filed. See, Bankruptcy Code §507(a)(8)(a)(i). For example, 1997 taxes are due on April 15, 1998. Thus, any liability for 1997 taxes (assuming no extension) would become dischargeable on April 16, 2001. Additionally, if April 15 falls on a weekend, the return would actually be due on April 16 or 17, 1998. In such case, the tax would not be dischargeable until April 17 or 18, 2001. To be safe, wait several days after the due date to avoid this problem. To calculate the date a return is due, include extensions. The important date is the due date, not the date the return was actually filed.

        c. 240-day Rule

        Generally, a tax is a priority tax if it is assessed within 240 days of the filing of the bankruptcy petition. Additionally, the 240-day period is tolled while an offer-in-compromise is outstanding plus 30 days. See, Bankruptcy Code §507(a)(8)(a)(ii). The 240-day period is not tolled for installment agreements. If there are multiple assessments, each assessment starts a new 240-day period. Assessment dates are determined for federal taxes under the assessment provisions of the Internal Revenue Code. To accurately determine the assessment date, you must obtain a record of account for the debtor. For state taxes, state tax law determines the assessment date. In California, a tax is assessed 60 days after the issuance of Notice of Proposed Additional Tax. See, In re King, 122 BR 383 (BAP 9, 1991), aff'd, 961 F2d 1423 (CA 9 1992). An offer-in-compromise must be made during the 240-day period to toll the period. Thus, offers made prior to the assessment or after the 240-day period do not toll the period. See, In re Aberl, 78 F3d 241 (CA 6 1996).

        d. Not assessed, but assessable

        Any tax that has not been assessed at the time the bankruptcy petition was filed but was assessable is a priority tax. This rule does not include nonfiled returns, late filed returns, or fraudulent returns. Generally, this rule would apply where an assessment could be made under an extended statute of limitations such as based upon a substantial understatement of tax .

      3. Non-priority Unsecured

        Taxes that are not secured and that are not priority are dischargeable in a Chapter 7,11, and 13.

      4. Non-filers

        Bankruptcy Code §523(a)(1)(B)(i) provides that tax debts for which no tax return was filed are not dischargeable in a Chapter 7 or 11. Note that these taxes may be discharged under the superdischarge provisions of Chapter 13. This rule is one of the most difficult as there is no definition of what constitutes a "return". Most of the difficult revolve around the IRS filing a substitute return for the debtor. In such cases, the courts have generally found that the debtor failed to file a return. On some occasions, if the taxpayer cooperated with the IRS and signed Form 870, the debtor has been treated as filing the return. See, In re Carapella, 84 BR 779 (MD FLA 1988). It is not clear whether a subsequent amended return will be treated as a return. See, In re Arenson, 145 BR 310 (D. Neb 1992).

      5. Late Filers

        A tax is not dischargeable in a Chapter 7 or 11 if it is filed late and within two years of the date the bankruptcy petition is filed. See Bankruptcy Code §523(a)(1)(B)(ii). Note that these taxes may be discharged under the superdischarge provisions of Chapter 13.

      6. Fraud

        A tax is not dischargeable in a Chapter 7 or 11 if it where it is related to a fraudulent return or where the debtor willfully attempted to evade or defeat the tax. See Bankruptcy Code §523(a)(1)(C). Note that these taxes may be discharged under the superdischarge provisions of Chapter 13.

      7. Piggyback State Tax Assessments

        Currently being debated in California and many other states. Where debtor is required to file a state return after a federal audit and fails to file the return, tax may not be dischargeable under Bankruptcy Code §523(a)(1)(B)(i). Note that these taxes may be discharged under the superdischarge provisions of Chapter 13.

      8. Amended Return

        Cases are all over the board! Generally, most cases go against the debtor.

    B. Employment Taxes

      1. General Rule

      Employment taxes imposed on the employer are dischargeable if the return was due (including extensions) more than three years before the bankruptcy petition is filed. See, Bankruptcy Code §507(a)(8)(D).

    2. 940 FUTA Liabilities

      Dischargeable if meet the three year rule.

    3. 941 FICA and Income Tax Withholding

      Portion of 941 FICA that is imposed upon employer is dischargeable under the three year rule. Portion that is imposed on employee and withheld by employer is a trust fund tax that is not dischargeable. Income tax withheld is a trust fund obligation that is not dischargeable.

    4. Entity Issues.

      a. Corporations

      The corporation is the employer. Thus, the shareholders, directors and officers are not liable for these taxes unless personally assessed as responsible person. Can only be assessed for trust fund portion.

      b. Partnership

      The partnership is the employer, not the partners. Employment taxes are merely a general obligation of the partner that may be discharged in the partner's bankruptcy (unless the partner is a responsible person).

    C. State Taxes

      1. Income
        There are no differences in federal and state income taxes. See general rules above.

      2. Sales

        In California, the sales tax is imposed upon the seller, not the purchaser. Thus, it is not a trust fund tax. Several cases have held that it is a gross receipts tax that is dischargeable under the same rules as the income tax.

      3. Property

        Property taxes that are assessed and payable without a penalty more than one year before the date of the filing of the bankruptcy petition are dischargeable under Bankruptcy Code § 507(a)(8)(B)
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