Getting a fresh start

Installment Agreements and Offers in Compromise are useful. But there are situations in which these devices are unavailable, inappropriate or inadequate. And in these cases, relief can often be obtained through bankruptcy. Contrary to popular opinion, a properly timed and structured bankruptcy can discharge many federal and state income tax liabilities, thus providing a much needed "fresh start." Furthermore, bankruptcy can be useful in contesting the amount or validity of a tax when other judicial forum cannot be used.

Types of bankruptcy

Two forms of bankruptcy are typically used by individuals: Chapter 7 and Chapter 13. (While an individual can file for reorganization under Chapter 11, this is a more complicated and expensive procedure usually appropriate only for businesses.)

A Chapter 7 is a traditional "liquidating" bankruptcy. A trustee is appointed to protect the unsecured creditors. (Secured creditors have already protected themselves by becoming secured creditors in the first place.) In theory, under the supervision of the trustee, and subject to certain statutory exemptions, the debtor's assets are marshaled and sold. However, often the statutory exemptions are sufficient to protect most or even all of a debtor's assets. Thus, the vast majority of Chapter 7 filings are so-called "no asset" cases, in which no assets at all are sold. And where there are sales of assets, often the assets are "sold" right back to the debtor himself for a price negotiated between the debtor and the trustee. Assets which are fully encumbered by liens are usually abandoned back to the debtor by the trustee, subject to those liens, since such assets are of no benefit to the unsecured creditors.

A Chapter 13 is for people with regular income who can make monthly payments against their debts. To "qualify" to use Chapter 13, a debtor must have unsecured debts of less than $336,900, and secured debts of less than $1,010,650. Under a Chapter 13 "plan," the debtor makes monthly payments to a trustee, who distributes the money to the creditors. To be "confirmable," a Chapter 13 plan must provide for the full payment of all priority debts. At the conclusion of the required series of monthly payments, all dischargeable debts which remain unpaid are discharged.

Effect on IRS

As to the IRS, filing a bankruptcy petition is like holding a crucifix in front of a vampire. Immediately upon filing, an "automatic stay" arises, and all IRS enforced collection action must cease. If assets are seized by the IRS before the filing of the petition but haven't been sold, the trustee can demand that they be surrendered to the estate for the benefit of the creditors. This "turnover" power can be extremely useful if the IRS has seized assets necessary for the operation of the taxpayer's business. As soon as it learns of the filing of a bankruptcy petition, the IRS posts its computer with a "bankruptcy hold" code to avoid inadvertent violation of the automatic stay.

Secured vs. unsecured

In bankruptcy, the IRS, despite its Draconian collection powers, is just another creditor. It can be a secured creditor if a tax lien has been filed. Or it can be an unsecured creditor if no lien is filed. Finally, the IRS can be partially secured and partially unsecured if a lien has been filed but the amount owed exceeds the equity in the property covered by the lien.

Priority vs. nonpriority

Taxes (like other debts) are categorized as to priority. Certain taxes are given a higher priority than most other debts, effectively making them nondischargeable:

• Taxes are nondischargeable if the return was due less than three years prior to the filing of the bankruptcy petition.
• Taxes are nondischargeable if assessed less than 240 days prior to the filing of the bankruptcy petition.
• Taxes are nondischargeable if the return was not filed, or was filed less than two years prior to the filing of the bankruptcy petition.

Thus, as with so many things in life, timing is everything. Tax debts  that are nondischargeable today may be dischargeable tomorrow, so careful planning with an advisor thoroughly familiar with these complex rules is absolutely essential. This is an area in which it pays to be very, very careful.

WANT MORE INFORMATION?

See Dealing with Tax Debts in Bankruptcy After the BAPCPA, written by Mr. Haynes and published in the Maryland Bar Journal.