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Considering “Bankruptcy” to eliminate individual federal income liabilities? It ain’t easy, it’s complicated!

Note to filer: Better be ready to pay up front for any tax work needed to determine the tax liability to be included in the bankruptcy filing.  “Ah...no your credit ain’t good!”

Court Jurisdiction Over Tax Matters

Bankruptcy Court

Determination of tax liability. Generally, the bankruptcy court has the authority to determine the amount or legality of any tax imposed on a debtor under its jurisdiction and the bankruptcy estate, including any fine, penalty, or addition to tax, whether or not the tax was previously assessed or paid.

The bankruptcy court does not have authority:

  1. To determine the amount or legality of a tax, fine, penalty, or addition to tax that was contested before and adjudicated by a court or administrative tribunal of competent jurisdiction before the date of the bankruptcy petition filing, or
  2. To decide the right of a tax refund for the bankruptcy estate before the earlier of:
    • A determination for refund by the IRS or other governmental unit, or
    • 120 days since the trustee properly requested the refund.

Federal Tax Claims

Proof of claim. Upon filing a bankruptcy petition, as a result of the automatic stay, the debtor's assets in the bankruptcy estate under the jurisdiction of the bankruptcy court are not subject to levy. However, creditors may file a "proof of claim" with the bankruptcy court to protect their rights. The IRS may file a proof of claim with the bankruptcy court in the same manner as other creditors. This claim may be filed with the bankruptcy court even though taxes have not been assessed or are subject to a Tax Court proceeding. 

Secured tax claims. If the IRS filed a Notice of Federal Tax Lien (NFTL) before the bankruptcy petition was filed, the IRS will have a secured claim in the bankruptcy case to the extent the lien attached to equity in the debtor's assets. In chapter 7 cases, in certain circumstances, the trustee may be able to subordinate the tax lien in order to pay certain non-tax priority claims. In chapter 11 cases, if the secured claim would otherwise have been entitled to treatment as a priority claim, the chapter 11 plan must provide for the secured tax claim in the same manner, over the same period, as an unsecured eighth priority tax claim. 

Unsecured Tax Claims

Eighth priority taxes. In general, certain unsecured debts are given priority for payment purposes. Certain tax debts arising before the bankruptcy case was filed are classified as eighth priority claims.

The following federal taxes, if unsecured, are eighth priority taxes of the government:

  1. Income taxes on or measured by income or gross receipts for a tax year ending on or before the date of the filing of the petition for which a return, if required, is last due, including extensions, after 3 years before the date of the filing of the bankruptcy petition.
  2. Income taxes on or measured by income or gross receipts assessed within 240 days before the date of the filing of the petition. The 240-day period is exclusive of any time during which an offer in compromise for that tax was pending or in effect during that 240-day period plus 30 days, and exclusive of any time during which a stay of proceedings against collections was in effect in a prior case during the 240-day period plus 90 days.
  3. Income taxes that were not assessed before the bankruptcy petition date, but were assessable as of the petition date, unless these taxes were still assessable solely because no return was filed, a late return was filed within 2 years of the filing of the bankruptcy petition, a fraudulent return was filed, or because the debtor willfully attempted to evade or defeat the tax.
  4. Withholding taxes that were incurred in any capacity.
  5. Employer's share of employment taxes on wages, salaries, or commissions (including vacation, severance, and sick leave pay) paid as priority claims under title 11 U.S.C. section 507(a)(4), or for which a return was last due within 3 years of the filing of the bankruptcy petition, including a return for which an extension of the filing date was obtained.
  6. Excise taxes on transactions occurring before the date of filing the bankruptcy petition, for which a return, if required, is last due (including extensions) within 3 years of the filing of the bankruptcy petition. If a return is not required, these excise taxes include only those on transactions occurring during the 3 years immediately before the date of filing the petition.

Payment of Tax Claims

Chapter 7 cases. In a chapter 7 case, eighth priority taxes may be paid out of the assets of the bankruptcy estate to the extent assets remain after paying the claims of secured creditors and other creditors with higher priority claims. 

Chapter 11, 12, and 13 cases. Different rules apply to payment of eighth priority pre-petition taxes under chapters 11, 12, and 13:

  1. A chapter 11 plan can provide for payment of these taxes, with post-confirmation interest, over a period of 5 years from the date of the order for relief issued by the bankruptcy court (this is the bankruptcy petition date in voluntary cases), in a manner not less favorable than the most favored non-priority claims (except for convenience claims under section 1122(b) of the Bankruptcy Code).
  2. In a chapter 12 case, the debtor can pay such tax claims in deferred cash payments over time. However, certain priority taxes may be paid as general unsecured claims if they result from the disposition of a farm asset, but only in cases where the debtor receives discharge, and
  3. In a chapter 13 case, the debtor can pay such taxes over 3 years (or over 5 years with court approval).

For more information check out this publication: https://www.irs.gov/publications/p908

steve@stevesimsea.com