Last updated 01 Oct 2014
This topic discusses strategies for dealing with potentially non-dischargeable taxes. ( This topic does not yet include strategies relating to Chapter 11 or Chapter 12 bankruptcies.) To determine which taxes are non-dischargeable, see Taxes Not Discharged in Bankruptcy.
Table of contents for this topic:
- Preliminary matters
- Challenge the liability for or amount of tax
- Postpone or forgo filing
- File Chapter 12
- Discharge of capital gains taxes
- File Chapter 13
- Obtain benefit of broader discharge
- Obtain benefit of priority status
- File a claim for the taxing authority
- Elect a short tax year (Chapter 7)
- Practice pointers
- See also
- Footnotes
Confirm dates. The dischargeability of taxes often depends on whether and when (a) a return has been filed (and by whom), (b) an assessment made, or (c) an intervening event – including an extension – has extended an applicable time period. Clients are often poor sources for such information. Accordingly, counsel should obtain a tax transcript (from the IRS) or other documentary evidence (from state taxing authorities) to determine the taxing authority’s position on these matters.
Also keep in mind that due dates that fall on weekends and holidays are often extended to the next business day.
Consider other taxes. Similarly, if your client has one tax problem then your client may well have others. Explore with your client the possibility of taxes from other jurisdictions (state and federal), other tax periods, and other types (withholding and unemployment, for example).
While cancellation of your client’s debt in bankruptcy may be relatively painless, if your client has an interest in a failed or failing pass-through entity ( e.g., an LLC electing pass through treatment or a partnership) then your client – made solvent by the bankruptcy discharge – may face substantial future tax liability for the entity’s cancellation of debt income.
Check interest. If the claim is substantial then you may want to double check the taxing authority’s calculation of interest due. There is software available to assist in this process(1) or you may want to consult with a local accountant or enrolled agent.
Challenge the liability for or amount of tax
The debtor can ask the bankruptcy court to exercise its discretion to determine “the amount or legality of any tax” that has not been previously adjudicated.(2) This provision provides a nifty alternative to the non-bankruptcy requirement that, to contest a tax that has reached final assessment, the taxpayer must first pay the disputed tax and then request a refund.
Practice pointer: Aware of this provision, most taxing authorities will voluntarily review a tax amount upon a request by the debtor. So you should try an informal approach before resorting to litigation. Similarly, if the taxpayer previously neglected to file “final” returns for a business enterprise, resulting in continued assessments of estimated taxes, filing the belated final return will often result in the taxing authority voluntarily adjusting the amount due to the proper amount.
Postpone. If a tax is non-dischargeable on account of an event or deadline falling within a certain time of the bankruptcy filing then a simple strategy is to file only after the time has run. When you calculate the waiting period you should take great care to determine any factors that would extend the time.
Sometimes the taxpayer can start a time running by taking an affirmative action, such as filing an income tax return to trigger an assessment (and then waiting out the 240 day period before filing a bankruptcy).
Forgo. A tax approaching a statute of limitations may be resolved by the passage of time without a bankruptcy filing. Again, properly computing the limitations period is crucial. Factors extending the federal limitations periods(3) include:
- the time assets are in the custody or control of a court plus 6 months(4)
- the time the taxpayer is in bankruptcy plus 60 days (assessment) or 6 months (collection) (5)
If your client qualifies for Chapter12 (11 USC 109) then the following options may be available.
Discharge of capital gains taxes
11 USC 1222(a)(2)(A) allows chapter 12 debtors to treat taxes incurred by selling farm assets before the filing of a bankruptcy petition as payable in less than full and dischargeable. The Supreme Court tells us that such taxes incurred after the filing are entitled to similar treatment only if the debtor is an entity.(6)
If your client qualifies for Chapter13 then the following options may be available.
Obtain benefit of broader discharge
No pay. The following tax related claims are dischargeable in Chapter 13 and need not be paid during the plan period:(7)
- True penalties – 11 USC 523(a)(7)
- Debt incurred to pay tax – 11 USC 523(a)(14)&(14A)
Pay without interest or penalties. The following priority tax claims are dischargeable in Chapter 13; however, the amount due at the time of the bankruptcy filing – but not post-petition interest or penalties – must be paid in full during the plan period:(8)
- Income – 11 USC 507(a)(8)(A)
- Property – 11 USC 507(a)(8)(B).
- Employment – 11 USC 507(a)(8)(D)
- Excise – 11 USC 507(a)(8)(E)
- Customs – 11 USC 507(a)(8)(F)
- Pecuniary loss penalty – 11 USC 507(a)(8)(G)
Keep in mind that when a secured tax claim ( e.g., a lien is filed) cannot be a priority unsecured claim. Holders of secured claims are entitled to receive interest on their claims.(9) That said, if the claim amount is in excess of the debtor’s equity in assets then the claim may be bifurcated into partially secured (entitled to interest) and partially priority unsecured (not entitled to interest) portions, with each portion being treated separately in the Chapter 13 plan.(10)
Once in a rare while a debtor will hit the tax jackpot and a taxing authority will neglect to timely file a claim for a dischargeable, full pay claim.
Obtain benefit of priority status
If your client has non-dischargeable tax debt and needs to file a Chapter 13 for other reasons then consider this:
Certain non-dischargeable taxes are not accorded priority status in Chapter 13, the result being that the taxing authority shares in the dividend to the general unsecureds. However, transforming that tax to a priority status will allow it to be paid ahead of general unsecured claims. For example, an income tax for which an filed return was due more than than three years before the bankruptcy that is a non-dischargeable, non-priority tax (under 11 USC 523(a)(1)(B)) can be converted into a non-dischargeable, priority tax (under 11 USC 523(a)(1)(A)(incorporating 11 USC 507(a)(8)(A)) if the debtor files the tardy return and seeks bankruptcy relief within 240 days thereafter.
File a claim for the taxing authority
Under Bankruptcy Rule 3004 a debtor has 30 days after the claim bar date to file a claim on behalf of a creditor. Under 11 USC 726(a)(1) the deadline for filing a priority claim in an asset Chapter 7 is effectively extended to the earlier of (a) 10 days after the summary of the trustee’s final report is mailed to creditors or (b) the date on which the trustee commences final distribution.
The debtor should file a claim on behalf of taxing authorities for non-dischargeable taxes in Chapter 13 cases and in asset Chapter 7 cases. The debtor should not file a claim on behalf of taxing authorities for dischargeable tax claims in Chapter 13 cases. Although there is no deadline for creditors to file secured claims, the debtor should also file claims for secured tax claims in Chapter 13 cases if the taxing authority does not do so on a seasonable basis.
Elect a short tax year (Chapter 7)
Under 26 USC 1398(a)(2)(A) an individual Chapter 7 debtor may elect to split the tax year and file two returns, one for the pre-bankruptcy part of the year and one for the post-bankruptcy part of the year. This election would make any income tax arising from the pre-bankruptcy portion of the year a claim payable on a priority basis in an asset Chapter 7. However, any portion of the tax not paid out of the bankruptcy estate and any post-petition interest and penalties would remain the obligation of the debtor.
Give proper notice. Whether or not there is a known tax liability it is wise to give notice to all state and federal taxing authorities when filing a petition for bankruptcy relief. Whether objecting to claims or prosecuting an adversary proceeding notice, or simply giving notice of a case filing, if a federal tax is involved the bankruptcy rules(11) require that you give notice to the following parties: Attorney General(12), United States Attorney for your district, and (c) the taxing agency(13)
Take action if dischargeability is in doubt. Taxing authorities are not required to seek a determination that their claims are not dischargeable. Accordingly, if there is a dispute then the debtor should file an adversary proceeding requesting the bankruptcy court resolve the issue.(14)
- Bankruptcy Discharge Taxes – list of non-dischargeable taxes
- 26 USC 6325 – Relating to release of federal tax liens
1 : Examples include TaxInterest and Instant Interest.
3 : 26 USC 6501(assessment) & 26 USC 6502(collection)
4 : 26 USC 6503(b)]]
5 : 26 USC 6503(h)
6 : See discussion at 11 USC 1222#Commentary.
7 : See 11 USC 1328(a)(2) (not among exceptions to Chapter 13 discharge); 11 USC 1322(a)(2) (not among taxes that must be paid in full).
8 : See 11 USC 1328(a)(2) (not among exceptions to Chapter 13 discharge);11 USC 1322(a)(2) (must be paid in full).
9 : 11 USC 1325(a)(5).
10 : See 11 USC 506 regarding valuation of secured claims.
11 : Bankruptcy Rule 7004(b)(4)&(5) & Bankruptcy Rule 9014(c)
12 : The Attorney General’s mailing address is: 10th and Constitution Streets, NW, Washington, D.C. 20530
13 : The IRS mailing address is: P.O. Box 7346, Philadelphia, PA 19101-7346. For overnight mail use: Internal Revenue Service, 2970 Market Street, Mail Stop 5-Q30.133, Philadelphia, PA 19104-5016. If you are objecting to a claim then you may want to also send a courtesy copy to the individual who filed the claim. (It is difficult to get into trouble by giving too much notice.) Note: At least one court has faulted a debtor for naming “Internal Revenue Service,” rather than “United States of America,” as the party against which relief was sought. In re Scott, 437 B.R. 376, 380 (9th Cir. BAP 2010). To be safe you may want to name “United States of America Internal Revenue Service.”
14: See, e.g., In re Cassidy, 892 F.2d 637, 640 & 641 (7th Cir 1990) (tax court cannot determine dischargeability).