How federal income taxes are handled in bankruptcy is unclear to most practitioners, including tax specialists, who do not practice in the bankruptcy area. Numerous tax issues can arise in a bankruptcy proceeding. This article will consider the automatic stay, resolving tax disputes in bankruptcy, the priority of tax claims, and the discharge of taxes.
The Automatic Stay
A fundamental aspect of the Bankruptcy Code ("BC") is the automatic stay. On the filing of a voluntary or involuntary petition, the automatic stay arises (BC §362). It applies to all entities, including governmental units. It continues until it is terminated by the bankruptcy court (BC §362(d)) or the Bankruptcy Code (BC §362(c)). The automatic stay enables the trustee to preserve the estate and marshal the assets of the estate; allows the trustee time to identify, investigate, and satisfy the claims of creditors; affords the debtor time to confirm a plan of reorganization in a Chapter 11 proceeding; and protects creditors from each other by abating the race to the courthouse.
The automatic stay is self-enforcing. It arises by operation of law and requires no person to seek its issuance. Violations of the stay are strict liability acts; knowledge is irrelevant to a determination that a violation exists. Any act in violation of the stay is void.
The automatic stay operates as a stay of:
1. The commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the bankruptcy case, or to recover a claim against the debtor that arose before the commencement of the case (BC §362(a)(1)).
2. The enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the bankruptcy case (BC §362(a)(2)).
3. Any act to obtain possession of property of the estate or property from the estate or to exercise control over the property of the estate (BC §362(a)(3)).
4. Any act to create, perfect, or enforce any lien against property of the estate (BC §362(a)(4)).
5. Any act to create, perfect, or enforce against the property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the bankruptcy case (BC §362(a)(5)).
6. Any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the bankruptcy case (BC §362(a)(6)).
7. The set off of any debt owing to the debtor that arose before the commencement of the bankruptcy case against any claim against the debtor (BC §362(a)(7)).
8. The commencement or continuation of a proceeding before the United States Tax Court concerning the debtor (BC §362(a)(8)).
The automatic stay, however, does not operate as a stay of, among other actions, an audit by a governmental unit to determine tax liability (BC §362(b)(9)(A)), the issuance of a notice of tax deficiency to the debtor (BC §362(b)(9)(B)), a demand for tax returns (BC §362(b)(9)(C)), or the assessment of any tax and issuance of a notice and demand for payment of such an assessment. However, any tax lien that would otherwise attach to property of the estate by reason of such assessment does not take effect unless such tax is a debt of the debtor that will not be discharged in the case and such property or its proceeds are transferred out of the estate to, or otherwise revested in, the debtor (BC §362(b)(9)(D)). Further the stay does not prevent the debtor from appealing an adverse Tax Court decision issued before the commencement of the bankruptcy case, but it does bar an appeal by the IRS.
Any party in interest can request relief from the automatic stay. Relief will be granted for cause, including lack of adequate protection of an interest in property, or with respect to property if the debtor does not have an equity in such property and such property is not necessary to an effective reorganization. When a request for relief from the stay is made, the stay will be terminated 30 days after the request unless the bankruptcy court, after notice and a hearing, orders such stay continued in effect pending the conclusion of, or as a result of, a final hearing and determination.
The running of the statute of limitations on the assessment of tax is suspended until 60 days after the bankruptcy case has ended (IRC §6503(h)). The running of the statute of limitations on the collection of tax is suspended until 6 months after the bankruptcy case has ended (IRC §6503(h)). The statute of limitations for filing a Tax Court petition is suspended for the period the taxpayer is prohibited from filing such petition, plus 60 days thereafter (IRC §6213(f)(1)). If the automatic stay is lifted, allowing a petition to be filed in the Tax Court, the trustee may join the Tax Court proceeding (IRC §7464).
Determination of Federal Income Tax Liabilities in Bankruptcy
The IRS must file a proof of claim for any taxes it claims the debtor owes (BC §501(a)). Generally, the bankruptcy court will set a bar date by which time all claims must be filed. Tax claims are usually filed in a bankruptcy case if the debtor would otherwise be discharged by the bankruptcy case, or the plan of reorganization in a Chapter 11 case has provisions affecting the debtor’s tax liabilities. The IRS may not file a proof of claim if the debtor has no assets or the taxes cannot be discharged. If the IRS does not file a claim, the debtor may file one on behalf of the IRS if she wishes to have the dischargeability of the tax liability determined by the court, or to have the court determine the amount or legality of a tax liability.
In general, the bankruptcy court has the power to determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction (BC §505(a)(1)). However, the bankruptcy court cannot determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the bankruptcy case (BC §505(a)(2)(A)), or any right of the estate to a tax refund before the earlier of (1) 120 days after the trustee requests such refund from the appropriate governmental unit, or (2) a determination by such governmental unit of such request (BC §505(a)(2)(B)).
Thus, there are two routes available for determining a debtor’s federal income tax liability. First, the bankruptcy court can make the determination. Second, the bankruptcy court can lift the automatic stay and allow a petition to be filed with the Tax Court, or a stayed Tax Court case to proceed.
Unsecured Federal Income Tax Claims in Bankruptcy
The nature of the claim generally dictates how the claim is treated. The IRS can have claims for taxes. If the tax has been assessed or is assessable, the bankruptcy court determines the amount of the IRS’s claim. The IRS can also have a claim for interest. Prepetition interest on tax claims is allowed as a claim and entitled to the same priority as the tax claim itself (U.S. v. HGD & J Mining Co., 74 Bankr 122 (SDWV 1986)). If the interest is "unmatured," it is specifically disallowed (BC §502(b)(2)). Unmatured interest is interest that had not accrued as of the filing of the bankruptcy petition. Postpetition interest will be paid if the assets of the estate are sufficient after all administrative expenses and unsecured claims are paid in full; interest is then paid pro rata at the legal rate on all allowed claims (BC §726(a)(5)). Note that for a secured tax claim, postpetition interest is paid to the extent the value of the collateral exceeds the tax liability (BC §506(b)).
There are two types of penalties for which the IRS may have a claim. Pecuniary loss penalties, which are really taxes owed under the label of a penalty, are treated the same as an unsecured tax claim (BC §507(a)(8)(G)). Nonpecuniary loss penalties, which are true penalties which punish the debtor, are specifically subordinated to the prior payment of all unsecured creditors (BC §726(a)(4)).
Claims secured by assets, including the federal tax lien, must generally be satisfied first out of such assets (BC §725). Payout is limited to the value of the collateral. If the value is less, the unpaid portion of the secured claim becomes an unsecured claim.
Payment of unsecured claims are subject to a statutory priority system. The first priority is administration expenses. They include any tax liability incurred by the estate. These include income taxes, if any, and all employment taxes (FICA and FUTA).
The eighth priority is unsecured tax claims. Income taxes for taxable years ending on or before the date the petition is filed and for which a return was required to be filed within 3 years of the filing of the petition are entitled to an eighth priority (BC §507(a)(8)(A)(i)). This includes a tax year ending on or before the petition is filed even if the return is due after the petition is filed. For the tax year that ends after the petition is filed, the tax liability is an administrative expense entitled to a first priority (BC §§503(b)(1)(B)(ii) & 507(a)(1)). The due date is the due date including extensions (BC §507(a)(8)(A)(i)).
Taxes assessed within 240 days before the petition is filed are also entitled to an eighth priority (BC §507(a)(8)(A)(ii)). If an offer in compromise was submitted within 240 days after the assessment, the 240 day period is extended for the period during which the offer was under consideration plus 30 days. The year for which the assessment was made is not relevant. Taxes that are not assessed before the petition is filed, but that are otherwise permitted to be assessed under applicable law, are also entitled to an eighth priority (BC §507(a)(8)(A)(iii)).
Taxes the debtor was required to withhold from others is entitled to an eighth priority (BC §507(a)(8)(C)). This includes the liability of a responsible officer of a debtor in bankruptcy. There is no time limit with respect to these taxes.
Employment taxes for wages earned and paid before the petition was filed are entitled to an eighth priority (BC §507(a)(8)(D)). The return for the employment taxes must have been due within 3 years, including extensions, of the date the petition was filed.
Tax liabilities classified as penalties are entitled to the same priority as the underlying tax on which the penalties are based. If the penalty is punitive, it is paid only after all unsecured claims are paid (BC §726(a)(4)). A claim arising from an erroneous refund or credit is entitled to the same priority as the tax to which the refund or credit related (BC §507(c)). If the debtor had entered into a deferred payment agreement with the IRS, it receives no special priority; the underlying tax liabilities are entitled to priority under the rules described above.
Federal Tax Liens in Bankruptcy
The Bankruptcy Code radically alters the treatment of secured tax claims in bankruptcy. Secured claims for true penalties are subordinated to all claims, secured and unsecured, of all creditors (BC §726(a)(4)). Then, property secured by a tax lien is distributed as follows (BC §724(b)):
1. First, to the holders of an allowed claim secured by a lien on such property that is not avoidable and is senior to the tax lien.
2. Second, to any holder of an allowed claim qualified for a first through seventh priority, to the extent of the allowed tax claim that is secured by the tax lien.
3. Third, to the holder of the tax lien, to the extent that such holder’s allowed tax claim secured by the tax lien exceeds the distribution under (2).
4. Fourth, to any holder of an allowed claim secured by a lien on such property that is junior to the tax lien.
5. Fifth, to the holder of the tax lien, to the extent that such holder’s allowed claim secured by the tax lien not paid under (3).
6. Sixth, to the estate.
Example 1: Debtor’s debts are a first mortgage debt of $1,000, a tax claim secured by a tax lien of $15,000, $3,000 of which is for a true penalty, a second mortgage debt of $2,000, and unsecured claims of $25,000, $5,000 of which qualify for first through seventh priorities. The secured tax claim is first reduced to $12,000 to eliminate the $3,000 penalty. The payout order is then:
a. First, $1,000 is paid to the first mortgage holder.
b. Second, $5,000 is paid on the unsecured claims qualifying for first through seventh priorities.
c. Third, $7,000 is paid on the secured tax claim, which is the $12,000 reduced claim less the amount paid on first through seventh priorities.
d. Fourth, $2,000 is paid to the junior mortgage holder.
e. Fifth, the remaining secured tax claim of $5,000 is paid.
f. Sixth, the unsecured creditors are paid.
g. Seventh, if funds remain, the $3,000 penalty is paid.
Discharge of Federal Income Taxes
The primary advantage of filing a petition in bankruptcy is the fresh start obtained by a discharge of the debtor’s prepetition debts. What taxes can be discharged depends on whether the case is under Chapter 7, 11 or 13, and the nature of the taxes.
Tax claims qualifying for an eighth priority are not dischargeable, whether or not a claim is filed or allowed. BC §523(a)(1)(A). These include:
1. Income taxes for taxable years ending on or before the filing of the petition for which a return was due within 3 years, including extensions, of the date the petition was filed.
2. Income taxes assessed within 240 days of the filing of the petition.
3. Income taxes for prepetition periods that were not assessed but are assessable after the petition is filed.
4. So-called trust fund taxes: all taxes required to be collected or withheld and for which the debtor is liable in whatever capacity.
5. Employment taxes for wages earned during a period for which a return was due within 3 years of filing the petition.
Discharge is also not available for a tax with respect to which a return, if required, either was not filed or was filed late and within 2 years of filing the petition (BC §523(a)(1)(C)), or with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax (BC §523(a)(1)(B)).
Example 2. Taxpayer filed her 1993 individual tax return on April 15, 1994, but could not pay the tax shown as due on the return. The IRS made a summary assessment of the unpaid tax. On April 15, 1998, taxpayer files a petition in a Chapter 7 bankruptcy. The IRS’s claim for the unpaid tax is not an eighth priority and, therefore, is dischargeable because the return was due more than 3 years prior to April 15, 1998, the tax was assessed more than 240 days before April 15, 1998, and the tax was assessed before April 15, 1998.
Example 3. Assume the same facts as in Example 2 except that the taxpayer did not file a return. Because no return was filed, the tax is not dischargeable. (BC §523(a)(1)(B)).
Example 4. Assume the same facts as in Example 2 except that the taxpayer filed her tax return on June 1, 1996 and the IRS summarily assessed the tax on July 1, 1996. Although the IRS’s claim for the unpaid tax is not an eighth priority (the return was due more than 3 years prior to April 15, 1998, and the tax was assessed more than 240 days before April 15, 1998), because the return was filed late and within 2 years of filing the petition, the tax is not dischargeable.
In Chapter 7 cases a discharge of prepetition debts is available only for individual debtors. Because debtors have control over when the bankruptcy petition is filed, they can use the priority rules to their advantage. The debtor can, if possible, delay filing the petition more than 3 years from the due date of the tax returns, more than 2 years from the date the returns were filed, and more than 240 days from the date of assessment. The debtor should refrain from submitting an offer in compromise during the 240 days following an assessment to avoid extending the 240-day period. Although there are no cases on pont, it is logical to assume that if a return is filed late, any extensions are void and the due date of the return is the original due date, not including extensions.
In Chapter 11 cases discharge is available for corporations and partnerships, as well as individuals. The confirmation of a plan discharges the debtor from any debt that arose before the date of confirmation, whether or not a proof of claim was filed or deemed filed, the claim was allowed, or the holder of the claim accepted the plan (BC §1141(d)(1)(A)). However, the confirmation of the plan does not discharge an individual debtor from any debt excepted from discharge under BC §523 (BC §1141(d)(2)). The confirmation of the plan also does not discharge a debtor if the plan provides for the liquidation of all or substantially all of the property of the estate, the debtor does not engage in business after consummation of the plan, and the debtor would be denied a discharge under BC §727(a) if the case were a Chapter 7 case (BC §1141(d)(3)).
To be confirmed, a plan must:
1. Provide for the payment in full in cash of all claims qualifying for first and second priorities (BC §1129(a)(9)(A)).
2. Provide for the payment in full of priority tax claims in deferred cash payments over a period not to exceed 6 years after the date of the underlying assessment (BC §1129(a)(9)(C)).
3. Include interest so that the payments have a present value, as of the effective date of the plan, equal to the amount of the claim.
4. Provide that general unsecured creditors must receive an amount equal to that which they would have received in a Chapter 7 liquidation (BC §1129(a)(7)).
Under a Chapter 13 plan, a debtor’s future income must be paid on existing debts. Priority claims, including tax claims qualifying as administrative expenses or for an eighth priority, must be paid in full over a period of 3 years, unless the court approves a longer period not to exceed 5 years (BC §1322(a)(2)). Unsecured claims must be paid only to the extent of available assets dedicated to that purpose, which cannot be less than the amount, valued as of the effective date of the plan, they would have received if the debtor liquidated under Chapter 7 (BC §1325(a)(4)). All debts provided for by the Chapter 13 plan or disallowed under BC §502 are discharged after completion of all payments under the plan (BC §1328(a)). However, discharge is not available for any debt (BC §1328(a)):
1. Provided for under BC §1322(b)(5) - defaults in payments due under the plan.
2. Specified in:
a. BC §523(a)(5) - alimony, child support, etc.
b. BC §523(a)(8) - certain educational loans.
c. BC §523(a)(9) - death or personal injury damages caused by debtor’s operation of a motor vehicle.
3. For restitution, or a criminal fine, included in a sentence on debtor’s conviction of a crime.
Under this "super-discharge" rule, both dischargeable and nondischargable taxes are discharged.
A bankruptcy discharge operates only to prohibit any action "to collect, recover or offset any ... debt as a personal liability of the debtor...." (BC §524(a)(2)). Therefore, a discharge has no effect on a valid lien; the lien remains enforceable against the property to which it has attached, including exempt property. A valid federal tax lien is treated the same. If the underlying tax claim is not dischargeable, the IRS can continue to look to the debtor personally, in addition to the property to which the lien has attached, for satisfaction of the unpaid taxes. If the underlying tax claim is dischargeable, the IRS cannot proceed against the debtor personally; however, it can foreclose against the property to which the lien has attached for payment of the unpaid taxes.
A myriad of tax issues can arise in a bankruptcy proceeding. This article has considered those which relate to the fundamentals of bankruptcy.
John B. Truskowski is a Principal of Lord, Bissell & Brook, Chicago. His practice is concentrated in Business Taxation. He received his Undergraduate Degree in 1967 from the University of Illinois and his Law Degree in 1970 from the University of Chicago. He may be reached at email@example.com.