Regular readers of this irregular series on dealing with the IRS Collection Division will know that bankruptcy can be very useful in resolving overwhelming tax debts.  However, this window of opportunity is closing, and it will slam violently shut on October 17, 2005, about four months from the scheduled publi­ca­tion date of this article.  If you have clients who are drown­ing in tax debt, you need to consider the bankruptcy option now, because time is quickly running out.

            The problem is caused by the "Bankruptcy Abuse Preven­tion and Consumer Protection Act of 2005" (BAPCPA).  This is an entirely misleading name for legislation long sought by the big banks and credit card companies.  It does nothing to protect consumers, but instead will make it exceed­ingly diffi­cult for an individual to get a fresh start after a financial crisis brought on by loss of employ­ment, unexpected and uninsured medical bills . . . or by unmanage­able income tax liabilities.

            The BAPCPA represents the most significant restruc­turing of the Bankruptcy Code since 1978, and the changes are too numerous and complex to cover comprehensively in an article of this length.[2]  But here's the "take away message" for this little sermon:  bankruptcy cases can be filed under the existing law for the next few months, and you should give careful consideration to this option before it is too late.  This opportu­nity is available because the BAPCPA includes a provision delaying the effective date of most of the statutory changes until 180 days after the date of enactment.  The President signed the BAPCPA on April 20th, so this means that most provisions of the new law will not become effective until October 17th.  Thereafter, the bankruptcy world will be a different and much less debtor friendly place.

            A previous article in this series explained in detail how tax debts are treated in bankrupt­cy.  It was published in the February - March 1999 issue of the Freestate Accountant.[3]  Please see that article for a comprehensive discussion of the existing rules and how they can be used to deal with insurmountable tax problems.  However, so we can highlight some of the more significant changes made by the BAPCPA, the following discussion starts with a quick review:[4]

            Types of bankruptcies

            Two forms of bankruptcy are typically used by individuals:  Chapter 7 and Chapter 13. 

            In a Chapter 7, a trustee is appointed for the purpose of protect­ing the unse­cured creditors.  (Secured creditors have already protected them­selves by acquiring a security interest in some or all of the debtor's assets, and so have less need for the trustee's protection.)  Under the super­vision of the trustee, the debtor's nonexempt assets, if any, are mar­shalled and sold.[5]  Fully encum­bered assets are usually abandoned back to the debtor, subject to those liens, since they are of no economic benefit to the un­secured credi­tors.  No payments out of the debtor's post-petition earnings are required.  In many cases, after October 17th this kind of simple Chapter 7 will be unavail­able, especially to debtors who have income in excess of the median level of income for the state in which the case is filed.

            Chapter 13 is for small debtors with regular income who can make monthly payments against their debts.  To use Chapter 13, a debtor must have unsecured debts of less than $307,675, and secured debts of less than $922,975.[6]   The debtor makes monthly payments measured by his or her ability to pay.  The payments are made to a trust­ee, who distributes the money to the credi­tors.  For a Chapter 13 plan to be confirmed by the Court, the monthly payments must be at least enough to pay all nondischargeable debts in full.  At the conclusion of the series of monthly payments, all other debts that remain unpaid are dis­charged.  Under present law, these payments typically run for three years.  But under bankruptcy "reform," five years of payments will be required if the debtor's income is above the median income for the state in which the case is filed.  Further­more, under the BAPCPA the amount of the required monthly payments will be based on the IRS's miserly standards for "allow­able" living expenses, a process that will probably result in higher monthly payments than under current law.

            Secured v. unsecured

            In bankruptcy the IRS can be a secured creditor if a lien has been filed, or an unsecured creditor if no lien has been filed.  It can also be partially secured and partially unsecured if a lien has been filed but the amount owed exceeds the taxpay­er's equity in the property reached by the lien.  Liens for debts that are not paid during the bankruptcy survive the dis­charge.  So while the debtor's personal or in personam liability for a discharge­able tax debt is eliminated, the IRS's in rem claim against property encumbered by a valid pre-petition lien remains and, at least in theory, can be enforced later.

            Priority v. nonpriority

            Apart from the question of whether tax claims are secured or unsecured, federal and state tax debts (like all other debts) must be categorized as to their "priority," or order of distribu­tion in bankruptcy.  BC §507(a)(8)(A) under current law gives an eighth priority status to income taxes under certain circumstances described below, effec­tively making them nondis­chargeable in the typical Chapter 7 or Chapter 13:

            BC §507(a)(8)(A)(i) -- Taxes are nondischargeable if the return was last due (with extensions) less than three years prior to the filing of the bankruptcy petition.[7]

            BC §507(a)(8)(A)(ii) -- Taxes are nondischargeable if assessed less than 240 days prior to the filing of the bankruptcy petition (with this 240 days being extended for the period of time an offer in compromise is pend­ing, plus 30 days).

            The computation of both of these BC §507(a)(8)(A) timing rules will be made much more compli­cated by the BAPCPA.  First, it restates the present rule expanding the BC §507(a)(8)(A)(ii) 240-day period for the time an offer in compro­mise is pending plus 30 days.  However, the relevant language now reads "pending or in effect. . ."  An offer in compromise is pending from the time it is filed until the date it is accepted and the offered amount is paid.  But what does ". . . in effect" mean for this purpose?  One contractual element of an accepted offer in compro­mise is that the taxpayer must stay in full compliance for a period of five tax years after the offer is accepted.  Failure to do so results in the revival of the compro­mised taxes, interest and penalties.  Is the offer in compromise "in effect" for this entire five year post-acceptance compliance obligation period?

            Second, the BAPCPA extends both of the BC §507(a)(8)(A) time periods for the time the tax authorities are "prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days. . ."  Thus, both the 3-year and 240-day time periods are extended by a request for a collec­tion due process hearing.  Similar suspen­sions would no doubt result from other kinds of administrative appeals during the pendency of which the IRS is legally barred from taking collection action.  These would include an appeal from the rejection of an offer in compro­mise, or from an IRS decision to deny or terminate an installment agreement, or during an appeal from the denial of a request for innocent spouse relief. 

            Third, the BAPCPA extends both BC §507(a)(8)(A) periods for the time IRS collection action was barred by a prior bankruptcy case, plus 90 days.  A suspension of the BC §507(a)(8)(A)(i) 3-year from due date period was already required by Young v. U.S., 535 U.S. 43 (2002), but the BAPCPA codifies this decision and adds an extra 90 days.

            In short, computing the date on which any given tax liability lost or will lose its BC §507(a)(8)(A) priority status and thus become potentially dischargeable will require a great deal more informa­tion about the history of the case than in the past, and this complexity will lead to greater uncertainty, more litigation, and inevitably more mistakes in pre-petition planning.

            A third important timing rule, applicable in Chapter 7 but currently not in Chapter 13, is found in BC §523(a)(1)(B):

            523(a)(1)(B) -- Taxes are nondischargeable if the tax return was not filed, or was filed less than two years prior to the filing of the bankruptcy peti­tion.[8]

As part of the elimination of the "superdischarge" features of Chapter 13 under the BAPCPA, BC §523(a)(1)(B) will apply both in Chapter 7 and Chapter 13.  Thus, after October 17th a debtor will no longer be able to use Chapter 13 to discharge income taxes for years for which the returns were filed less than two years prior to the petition date, or not filed at all.  Under current law this rule often makes relief from tax debts available under Chapter 13 even though the same taxes would not be dischargeable in Chapter 7.  This has been particularly useful with nonfilers, or those who had filed but filed late.

            BC §507(a)(8)(C) bars the discharge of "a tax required to be col­lected or withheld and for which the debtor is liable in any capacity."  This covers the withheld portion of employment taxes and the related IRC §6672 trust fund recovery penalty.  This same language also prevents the discharge of a liability for sales taxes which were collected, or which should have been collected, by the debtor.  Such debts remain nondischargeable under the BAPCPA.

            Finally, BC §523(a)(C) bars the discharge of debts, includ­ing tax debts, arising due to fraud.  Under present law, this rule applies in Chapter 7 but not in Chapter 13, making it possible to use Chapter 13 to discharge even income taxes result­ing from fraud.  This, however, is another one of the "superdischarge" aspects of Chapter 13 that will fall victim to the BAPCPA after October 17th.

            As bad as these changes to the bankruptcy dischargeability rules will be, further pain and suffering is inflicted on debtors by other parts of the new BAPCPA  .  .  .  provisions which have the effect of making bankrupt­cy less attractive or in many cases entirely unwork­able.

            Means-tested bankruptcy

            Under present law, a Chapter 7 is a one-time, snapshot event.  It looks at the debtor's assets and liabilities, and wipes out the debtor's liability for all dischargeable debts that exceed what can be collected from the nonexempt assets.  Antici­pated future income has little bearing on the matter, and no future monthly payments are required.  This often makes Chapter 7 a much better way to deal with large income tax debts than an offer in compro­mise, since in an offer one's future income is an important factor in determining how much must be paid.

            Sadly, the BAPCPA imposes a new "means-tested" bankruptcy system, under which a debtor's income can disquali­fy him from Chapter 7.  Specifically, effective for cases filed on or after October 17th, a Chapter 7 involving primarily consumer debt will be dismissed or converted to Chapter 11 or Chapter 13 upon a finding of "abuse."  Abuse can be found in either of two ways:  (1) through the operation of a presump­tion applica­ble under certain circum­stances, or (2) on general grounds including bad faith determined on the totality of the facts.  If the debtor's income is above the median income for the state in which the case is filed, either the presumption or the general grounds standard for finding abuse can be raised by the Court, by the trustee, or by a creditor.  The abuse presumption is inappli­cable if the debtor's income is below the median income for the state.  The applicable median income is that for a family unit of similar size, determined by the Bureau of the Census, and adjusted for changes in the Consumer Price Index.

            The presumption of abuse arising under new BC §707(b)(2) turns on the new means test, which has three elements:  (1) the debtor's monthly income, (2) the allowable deductions from that monthly income, and (3) trigger points at which the net income after allowable deductions would give rise to a presumption of abuse.   A schedule showing the calculations under the means test must be filed with the Court by the debtor.

            Income for this purpose is the debtor's average income over the six month period prior to the petition date.  And even if only one spouse files bankruptcy, means test income includes that of the debtor's spouse unless they are separated.

            The "allowable" means test deductions start with those used by the IRS in determining how much a taxpayer could afford to pay under an installment agreement, or in evaluating whether to accept an offer in compro­mise.[9]  These often unrealistic living expense standards are quite familiar to those of us in the tax world who routinely represent clients before the IRS Collection Division.  But they will be entirely novel to bankruptcy judges and practitio­ners, who are already complaining bitterly about being dragged into the mist-shrouded, malarial swamp of the Internal Revenue Code and IRS administrative practice.  The allowable expenses for the new means test include the IRS's so-called "national standard amount" covering food, clothing, etc.[10]; the local standard allowance for transpor­tation; the county-specific standard amount for housing and utilities[11] ; and those additional expenses that would be allowed by the IRS as "other necessary expenses."  The BAPCPA provides that for purposes of the means test calculations, these other necessary expenses can include health insurance and health care costs; disability insurance; expenses for the care and support of an elderly, chronically ill or disabled family member; up to $1,500 per year per dependent child for private elementary or private school; and continuing contribu­tions to charity of up to 15% of gross in­come.[12]   Required alimony and child support payments will also be allowed, and indeed such debts are given a much higher distribu­tion priority than under current law.

            Next, because the purpose of the means test is to determine what the debtor could afford to pay to the nonpriority unsecured creditors, the computation deducts contractually scheduled payments to secured and priority creditors.  This includes the scheduled monthly payments for the five-year period after the petition date.

            After determining the debtor's income and the allowable expenses, the "excess" income is compared to certain standards to determine whether the presumption of abuse arises.  These are the so-called "trigger points."  Abuse is presumed if the debtor's excess monthly income, multiplied by 60, exceeds the lesser of:

            (1) $10,000; or

            (2) the greater of

                        (a) $6,000, or

                        (b) 25% of the debtor's non­priority unse­cured debt.

If the debtor's income is below the median income for the state the means test does not apply at all, although the Court or the trustee (but not a creditor) can still raise the issue of abuse based on the facts and circum­stances.  But consider the following examples for a debtor with income above the median:

            (1) Assume $40,000 of unse­cured nonpriority debts (such as income tax debts old enough to have lost their priority status).  Abuse would be presumed if the debtor has "excess" monthly income of $166.67 or more.

            (2)  Assume $30,000 of unsecured nonpriority debt.  Abuse would be presumed if the debtor has "excess" monthly income of $125 or more (25% x $30,000 / 60 = $125/mo.).

            (3)  Assume $10,000 of unsecured nonpriority debt.  Abuse would be presumed if the debtor has "excess" monthly income of $100 or more.

            If the presumption of abuse arises, the debtor can try to rebut it by showing special circumstances.  (Remember, the issue is whether the debtor will be allowed to use Chapter 7, or will instead have his case dismissed or converted to Chapter 11 or Chapter 13.)  Special circum­stances warranting deviation from the otherwise applicable limits on allowable expenses, so as to bring the excess income below the presumption of abuse threshold, can include things like a serious medical condition or a call to active duty in the armed forces.

            Consequences of dismissal or conversion

            The taxpayer's objective in filing under Chapter 7 is to discharge his tax debts without having to make payments against those debts out of future income.  The dismissal of the case for abuse will obviously frustrate that objective.  The conversion of the case to Chapter 11 or Chapter 13 will at least in theory permit the discharge, but only at the price of making monthly payments.  Under current law, the typical Chapter 13 plan in­volves monthly payments for three years.  But the BAPCPA will soon require such payments for five years, a clear disadvan­tage.

            Not only will the payments required under Chapter 13 plans in the future extend over two extra years, but they will probably be higher in amount.  Again, the reason is the legislative trans­planting of the IRS's less than generous collection standards into the Bankruptcy Code.  In the past, the Court and the typical trustee have been more liberal in evaluating a debtor's budget than the IRS would have been under the same circumstances.  Further­more, during the extended five-year life of a Chapter 13 plan, the debtor will be required to provide financial information to the trustee each year, and if the debtor's income goes up or if the value of the debtor's property has increased, the trustee might decide to seek a modification of a previously confirmed plan.

            Finally, many debtors simply won't fit the statutory limita­tions of Chapter 13.  As noted above, in Chapter 13 a debtor can have unsecured debts of no more than $307,675, and secured debts of no more than $922,975.  If the debtor is tossed out of Chapter 7 but has debts exceeding one or both of the Chapter 13 limits, the only remaining option is Chapter 11.  Chapter 11 in the past has been used almost exclusive­ly by businesses rather than individuals.  Chapter 11 is much more complicated, cumbersome and expensive than the typical Chapter 7 or Chapter 13.  This will be a disincentive to seeking a fresh start through bankruptcy if Chapter 7 and Chapter 13 are unavailable.

            Other "reforms" restricting access to bankruptcy

            Increased time between bankruptcies

            Under present law, a debtor can file a new Chapter 7 case six years after the date of the petition in a previous Chapter 7 case.  The BAPCPA will extend this period between cases to eight years. 

            Similarly, under present law a debtor can file a Chapter 13 case immediately after receiving a discharge in Chapter 7.  The BAPCPA will impose restrictions on this, effectively killing the heretofore useful "Chapter 20" technique (i.e. filing a Chapter 7 immediately followed by a Chapter 13).  After October 17th, a Chapter 13 will be prohib­ited for four years from the petition date in a prior Chapter 7 in which a discharge was obtained, or two years from the petition date in a prior completed Chapter 13.

            Nondischargeability of debts due to fraud

            Next, the ability to use Chapter 13 to discharge debts arising due to fraud will be eliminated by the BAPCPA.  This has an obvious impact when there has been a convic­tion for tax evasion or willful failure to file, or when the tax debts include the civil fraud penalty. 

            The presumptions for when certain non-tax debts are deemed nondis­chargeable due to fraud have also been expanded.  Thus, the threshold for a presumption of fraud for a credit card debt incurred within 90 days of the petition date for the purchase of luxury goods is reduced from $1,225 to $500, and for cash advances within 70 days of the petition date from $1,225 to $750.

            Mandatory debtor "education"

            Another "inconvenience" is that debtors under the BAPCPA will now be required to take "an instructional course concerning personal financial management," and will be denied a discharge if the course is not completed.  This will apply to both Chapter 7 and Chapter 13 cases.  Also, no discharge will be permitted unless within 180 days prior to the petition date the debtor has received "an individual or group briefing from a nonprofit budget and credit counseling agency approved by the U.S. Trustee's Office."  (Remem­ber, the whole point of this odious legislation is to make it more dif­ficult to wipe out debts owed to the big credit card companies, which one wag observed must have been starving their sharehold­ers and barely able to make payroll to hear them tell it.)

            Providing copies of tax returns

            The new BAPCPA includes several provisions requiring the filing of copies of tax returns with the Court at various stages of the case.  Perhaps constituting the only silver lining in this very dark legislative cloud, this may bring new clients to your office to get delinquent returns prepared, since the failure to provide these returns will result in the dismissal of the case.  The requirements include providing a copy of the most recently filed return prior to the first meeting of creditors, and if requested by the Court or by a party in interest, copies of all tax returns due during the four year period prior to the filing of the case.

            Reduced homestead exemptions

            Finally, the ability to protect the equity in a debtor's primary residence with the generous homestead exemptions avail­able in a few states (such as the unlimited exemption applicable in the District of Columbia) is drama­tically curtailed.  Among other things, the homestead exemption otherwise available will be reduced to the extent of the equity acquired within 1,215 days (about forty months) of the filing of the petition.  Unlike other provisions of the new BAPCPA, this little gem was effective immediately upon enactment.  The object is to keep those contemplating bankruptcy from stashing their assets in newly acquired residences in a few states that have high or unlimited homestead exemptions, like Texas, Florida, and more recently the District of Columbia.

            Conclusion

            The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 is wrongly named.  It would be more accurate to call it the "Bank­ruptcy Prevention, Consumer Abuse and Bank Protection Act" (in my humble opinion). 

            But regardless of your political views or your position on the merits of this particular legisla­tion, it is quite clear that the opportunity to help your clients seek relief from unmanageable tax debts in bankruptcy is about to go the way of the Edsel.  The sky is indeed falling, and the Congress has officially decreed that it will land on our respective heads on the morning of October 17, 2005.  If you have clients who have been strug­gling with income tax debts and who might benefit from discharging at least some portion of those debts in bankruptcy, it's now or never.