Will Bankruptcy Stop the IRS From Collecting Tax Debts?
Whenever a person files for bankruptcy, a court order or an injunction wipes out any older qualifying income tax debt. It is called an automatic stay that stops creditors, including the IRS from initiating or continuing their tax collection activity. This includes sending letters, garnishing your wages or your bank account or
even filing liens against your property. It also lets you pay back recently assessed taxes at a lower amount than the IRS offers. The automatic stay is effective only the first time you file for bankruptcy. It's not always valid in subsequent bankruptcy filings. This stay lasts as long as the bankruptcy case lasts and only the bankruptcy court has the authority of lifting it upon receiving a good reason and by the creditor. The IRS can, however, resume their collection activity once the bankruptcy
case is over if the tax debt hasn't been paid or wiped out or discharged yet.
Dischargeable taxes
While filing for bankruptcy does wipe out some old income tax debt, the Bankruptcy Code believes that except for some exceptions, only death and
taxes are certain in life. This is why you can't beat the IRS so easily and why the Bankruptcy Code has a limit to the amount of dischargeable taxes for a debtor
in bankruptcy. It's unfortunately not difficult for the IRS to retain your tax debt. They have to first prove that the tax isn't dischargeable by disclosing important information
like the type of tax, its date of assessment, its due date and if it's a tax or penalty. The IRS can secondly prove that the case is preponderance in nature, or in
layman's language, ‘maybe I'm right and maybe I'm wrong'. The IRS also has to prove if the claim is for tax, or for the tax penalty because the Bankruptcy Code
doesn't clearly define a tax. Bankruptcy attorneys and lawyers should be well versed with the Bankruptcy Code to know which taxes can, and cannot, be forgiven to beat the IRS. This is why you and your bankruptcy attorney should know which taxes are dischargeable and which aren't.
Read on to find out more about this.
1. Priority and Gap Period Taxes
There are some taxes called priority taxes given priority status for distribution
by the Bankruptcy Code. They are non-dischargeable, like the taxes in an
involuntary bankruptcy case between the petition date and either a trustee's
appointment or an order for relief. Priority taxes are taxes not commonly discharged, and knowing the differences
between priority and which are not, helps beat the IRS. There are altogether 7
types of priority taxes, and none of them are dischargeable. So while there are times you won't beat the IRS, if the discharge is time-limited, you can wait for the stipulated time frame. However, in cases where there are no time limits, you have to come up with a way to pay it.
These 7 categories of priority taxes are:
a) Income taxes
These are cases where more than three years have passed since returns were
filed, or where it's more than 240 days since tax assessment. This means you
have to wait for three years after filing returns, or 240 days after tax
assessment whichever is later, to discharge the tax liability and beat the IRS on
income taxes.
b) Property taxes
These are cases of property taxes due more than a year ago. As property taxes
are usually liens on the property while you may personally discharge property
taxes more than a year old; you have to pay off its liens to keep the property.
c) Trust fund or withholding taxes
You have to pay them. There's no other way out. Full stop. PAYROLL OR SALES TAX
d) Employment taxes
It's applicable to employment taxes with returns due more than three years
ago. It means you have to wait for three years to file for bankruptcy to beat the
IRS. However non-dischargeable employment taxes are the employment taxes
on the debtor's earned compensation. In a case, a pair of debtors owned a company owing to unemployment
insurance taxes. While the taxes were the company's responsibility, being responsible people, they were also liable for the taxes. But as the Bankruptcy Code provision restricts the priority and non-dischargeability on taxes for compensation earned from the debtor, and as the company's employees earned their pay from the company and not the
debtors, the debtors discharged the unemployment taxes.
e) Excise taxes
Applicable to excise taxes where returns were due more than three years ago
or when events occurred more than three years ago. This means you need to
wait three years before filing for bankruptcy.
For example, a trucker was a debtor who incurred motor carrier taxes under
the Oregon state law. The taxes were non-dischargeable because the court
considered these taxes to be excise taxes because they were exacted for the
public, and not the payer's individual benefit.
g) Penalties related to priority taxes
You will have to pay penalties for not paying other types of priority taxes when
you were supposed to pay if you hadn't avoided them.
2. Late or unfiled returns
You can't discharge taxes if you hadn't filed returns or if you had filed them
late, less than two years before filing bankruptcy. However, if it's been more
than two years since you had filed returns, although it's late, and the tax isn't a
priority tax, then you can beat the IRS and discharge the tax.
For example, a debtor hadn't filed tax returns for three consecutive years.
While the IRS had prepared substitutes for returns for those years (as
permitted), and the debtor hadn't agreed to nor signed on them, the taxes
weren't discharged after filing for bankruptcy. The court highlighted that the taxpayer had to have signed the prepared return substitutes to have been accepted as the taxpayer's filed return.
It's only upon receiving tax returns that the IRS deems it filed, which is usually
the date the IRS receives it. In another case, a debtor opted to file by private
courier service on a Monday. He had then filed for bankruptcy two years minus two days later. He argued
that as the date two years before filing for bankruptcy was a Saturday, the
Saturday deadline had to be adjusted to the next Monday so that he could
stipulate that his return was filed two years before bankruptcy, and discharge
taxes. However, the court didn't agree to this, and wouldn't make the adjustment.
The debtor could have beaten the IRS if he had waited two more days before
filing or at least used the post instead of the quicker courier option.
Neither the IRS nor the debtor can change the two year period. This means the
IRS or any other taxing authority cannot convert dischargeable taxes into non-
dischargeable tax claims by asking for successive amended returns for the
same information. This means that once a debtor files a return at the right time while disclosing
all income, it's deemed that the return has been filed for the Bankruptcy Code
purposes.
A debtor cannot use two successive bankruptcy filings to convert a
nondischargeable tax into a dischargeable tax. The two year period can be extended by the time in which the automatic stay was implemented in any bankruptcy case filed by, or against the terminated debtor.
A husband and wife who were debtors had filed a Chapter 7 petition 29
months after filing tax returns. They argued that the taxes were discharged
because this was more than two years later. The debtors had earlier filed for an earlier Chapter 13 petition a month after
filing tax returns. While the Chapter 13 petition was dismissed four months later, the two year period was tolled for the time the automatic stay was in effect and the Internal Revenue Code's mandatory six months.
3. Fraudulent returns and attempts to evade taxes
The bankruptcy Code considers a tax to be non-dischargeable if the debtor files
a fraudulent return, or willfully tries to avoid paying taxes, no matter how old
the tax may be. Returns are considered fraudulent if the debtor knows the
returns are false, tries to evade taxes or if he or she doesn't pay taxes.
A debtor, an insurance agent was once charged by the IRS for substantially
understating his income. He could, however, discharge his taxes because the IRS couldn't provide substantial proof.
The IRS had to establish through evidence, the debtor's actual intentional wrongdoing. But as they had inadvertently destroyed most relevant proof, and as the court considered the remaining evidence to be inconclusive, the court
could not prove that the debtor had intentionally taken illegal deductions or
made false returns. Most of the debtor's liabilities were discharged, and the
debtor managed to beat the IRS.
a) Fraudulent returns
In the case of fraudulent returns, the court uses a civil fraud test in federal tax
cases to ascertain if the return is fraudulent or not, without any evil or sinister
motive.
Fraudulent returns are called badges of fraud which the courts ascertain by
checking if:
There were large income understatements made regularly over time
No relevant records were maintained
Tax returns weren't filed
There's inconsistent behavior
There are any concealed assets
There's no cooperation with authorities
There's illegal income generation.
There was a debtor who had underestimated his income by $365,237.29 in
1980 and by $209,606.00 in 1981. His income by selling an illegal substance
called phenylacetone, known as speed, and used in manufacturing
methamphetamine. The court had found out that the debtor had reported large income
discrepancies and had an illegal source of income. He had even reported
$9,000 in illegal income, proving he knew he had to declare his income.
The debtor then fled the country after the indictment of drug charges, which
the court construed as an unwillingness to cooperate with authorities. He had
also admitted to having overseas bank accounts, which the court construed as
concealed assets.
All this evidence proved to the court that the debtor was intentionally filing
fraudulent returns.
b) Willful tax evasion
A tax is considered nondischargeable if the debtor tries to evade the collection,
payment or assessment of tax. There are various conditions the court
considers as willful tax evasion like:
Willfully concealing assets
Fraudulent transfers
Doing business so that it's difficult tracking or levying on income
Significant income understatements
Repeatedly not filing returns or filing it late despite past compliance and
governmental demands
Not cooperating with taxing authorities
Filing false forms
Statements showing intent at evading taxes
Criminal convictions for tax evasions
Failure at explaining income deductions and calculations
Involvement in tax protester activities
Not paying taxes despite being able to and living lavishly
Inconsistent behavior
Factors proving that failure to pay tax was not intentional include timely filing
accurate returns and cooperating with the taxing authority. Non-payment on
its own isn't proof of willful tax evasion.
A debtor who hadn't filed tax returns or pay taxes because of poverty is a good
defense. While his excuse was that he didn't have the money to pay taxes,
penalties, and interest, he had also argued that he hadn't done anything wrong
to evade taxes.
The court, however, concluded that willful was synonymous to voluntary,
conscious and intentional and included both acts of omission and commission.
As the court noted that the debtor could file returns and pay taxes, his taxes
were considered nondischargeable.
The court considers all relevant facts to determine if a debtor had admitted to
evading tax. In this case, it was irrelevant that the debtor had no money
because they could have at least filed returns if not paid taxes.
Another debtor hadn't filed tax returns till late, although he knew he was
obligated to file. He had also admitted to understating his income and
depositing his paychecks in his girlfriend's bank account. The court thus had
enough evidence to prove stupidity and willfully evading payment of taxes,
which is why the debtor lost to IRS.
The courts consider willful evasion of discharge cases similar to federal civil tax
fraud cases and perform the same test. Proving that the non-payment or
underpayment of tax was voluntary, intentional and conscious was necessary
to prove willful tax evasion.
A debtor had always filed tax returns and paid taxes on time till one year
where his salary rise led to lifestyle changes. He thought he could beat the IRS that year and hadn't filed returns or paid taxes. He had even asked his
employer to make him an independent contractor to avoid withholding taxes
from the paycheck.
The court thus decided that the debtor had intentionally failed to file returns
and pay taxes when he could. The court had also found out that he knew he
had to file returns and pay taxes when he had the money, which was enough
to prove that the debtor had intentionally and voluntarily evaded tax payment.
The government just had to prove that the debtor had voluntarily and willfully
evaded tax payment to prove willfulness, and didn't have to show any
affirmative action.
There was another debtor who had managed to beat the IRS and discharge tax
liabilities despite intentionally not paying taxes. While he properly filed
returns, he used his income to pay off personal and business debts instead of
taxes. While he had money to pay taxes, it wasn't enough to pay off his debts.
The court considered that dishonesty wasn't the reason for his failure at paying
taxes. It was because he didn't have enough money. The court ruled that the
debtor knowing he failed to pay taxes wasn't a willful attempt at evading taxes.
The court believed that always trusting the IRS's arguments would lead to no
debtor in bankruptcy being able to discharge taxes because they had all
anyway willfully failed to pay tax. This is why the debtor was discharged from
the tax.
Another pair of debtors who had repeatedly avoided taxes ultimately couldn't
beat the IRS. They had given all their money and land to their children and had
created corporations in their children's names but still controlled them. They
had paid off creditors without paying taxes and had reduced their salaries to
make less money available to the IRS.
Considering all of the debtors' actions the court decided that the debtors were
clearly trying to avoid paying taxes through voluntary, conscious and
intentional attempts.
Another couple had a long history with the IRS before filing bankruptcy and
hadn't tricked the IRS after bankruptcy too. They had underreported their
income from 1974 to 1979 and hadn't filed returns from 1980 to 1983. They
had also moved all their property to a trust and had tried transferring all their
income to the trust.
The court, however, ruled that the income was taxable as individuals, and had
then checked the debtor's company distributions and social security payments
for properties the trust owned. The debtors had never voluntarily paid taxes
and the court stated that just non-payment wasn't enough to deny discharge.
The court had also considered failure to pay to determine if the debtor had
willfully tried to avoid or defeat taxes. Their non-payment would include
failure to file tax returns, trying to conceal assets or non-dischargeable income
for tax. The court concluded that the debtors had done much more than not
pay their taxes.
Another debtor tried to prove that attempting to conceal assets were not
attempts to evade or defeat taxes, which made taxes non-dischargeable. But
he eventually lost to the IRS because the court interpreted the Bankruptcy
Code to include concealment of assets.
The court had found out that the debtor had willingly tried to conceal his
ownership interest in his condo, and a corporation he had organized in his
wife's name.
He had paid at least $60,000 for the condo's $106,000 purchase price and had
testified that it wasn't a gift to his wife. He also hadn't conveyed the property
to his wife till two years later, around the same time tax assessments were
made.
The said corporation was involved in oil reclamation, which was the debtor's
expertise and not his wife's, who was supposed to be the company owner. The
wife tried testifying that no expertise was required to run the business but the
court didn't believe her.
The debtor was instrumental in starting the company and doing most work but
didn't have any stock and wasn't paid for his services. The court thus found out
that he had willfully tried to conceal assets to evade or defeat taxes.
Another pair, a surgeon and his wife had repeatedly failed to file tax returns,
pay taxes and had also tried to hide income and assets. This was all considered
to be a willful attempt at evading or defeating taxes. They hadn't filed tax
returns, or paid any taxes, for 8 years.
The IRS, however, found out that they had in that period, spent lots of money
and deposited more money to their personal and charity bank accounts. It
proved that they were earning money, but were not filing tax returns. The
courts found out in the bankruptcy case that the debtors had willfully tried to
evade and escape their tax liabilities which is how the IRS beat them.
There was another debtor who had filed false W-4 withholding statements so
that his employers wouldn't withhold any money from his paychecks. It wasn't
enough to beat the IRS because he hadn't filed tax returns or paid taxes on
time.
The court decided that evading tax liability wasn't like evading a tax payment.
Evading tax payment was dischargeable because the debtor had acknowledged
the ability, but couldn't pay, which is the type of honest debtor the Bankruptcy
Code helps. However, evading tax liability wasn't dischargeable because of the
level of dishonesty involved.
The bankruptcy system doesn't appreciate such conduct so the court decided
that the debtor's combined conduct proved a willful evasion of tax liability
which was nondischargeable under Bankruptcy Code.
Another debtor claimed to be a tax protestor, who never beats the IRS. He had
an income but hadn't filed any returns or paid any taxes. He had attended the
meetings of a group of tax protestors to find out how to avoid paying taxes.
The protestors had given him document forms to use to avoid taxes, which he
did use. The court found out that he knew he had to pay taxes, and file tax
returns, and decided that the debtor had voluntarily and willfully violated his
duties and declared the tax liability to be non-dischargeable.
4. Tax penalties
You can beat the IRS and discharge tax penalties if the penalties are for
dischargeable taxes, or if the events creating the penalties occurred more than
3 years before the bankruptcy.
Most courts maintain that tax penalties connected with events that had
occurred three years before bankruptcy is dischargeable even if it's connected
to a nondischargeable tax.
A pair of debtors couldn't beat the IRS this way. They had non-dischargeable
tax liabilities, with related interests and penalties, which the court ruled were
non-dischargeable.
Another pair of debtors hadn't filed income tax returns, nor the IRS assessed
taxes, interest, and penalties, and had filed a Chapter 7 bankruptcy 5 years
later.
The court ruled that since the penalties were for a transaction or event that
had occurred more than 3 years before the petition, the penalties were
dischargeable, and that's how the pair beat the IRS on penalties.
The IRS had in another case established that the underlying taxes were non-
dischargeable because of the debtor's fraud. The tax-related penalties were
however analyzed separately and as they met the criteria, they were
dischargeable and the IRS lost again.
Another debtor had filed for bankruptcy in 1992 because of taxes from 1982 to
1987. The taxes were found to be non-dischargeable and the penalties,
dischargeable. This anomaly of discharging penalties and not discharging taxes
and interest was because of how the Bankruptcy Code provisions were drafted.
5. Debts incurred for paying Federal Taxes
The Bankruptcy Code doesn't permit you to discharge debts incurred for
paying a federal tax which would have been non-dischargeable if you still owed
it after filing bankruptcy. This provision is to encourage people to lend money
to debtors to pay off their taxes, even if the payment is through a loan or a
credit card.
However as a commenter mentioned, it's rather difficult to prove trace loan
proceeds as tax payments. As it's difficult to beat the IRS outright, you should
pay the IRS and try to discharge unpaid debts because you had paid the IRS.
6. Interest on nondischargeable tax claims
The interest can't be discharged if the related taxes are nondischargeable. A
debtor had nondischargeable tax liabilities but contested if its interest was
dischargeable. The court agreed with most other courts that had ruled on this
matter and had decided that the interest was non-dischargeable.
Interest accrued on a nondischargeable tax before filing bankruptcy is also
nondischargeable. A Chapter 13 debtor had provided for priority payment of
pre-petition tax liabilities, but not for pre-petition interest on the tax liabilities.
According to the Bankruptcy Code, interest is an important part of an allowed
claim and had the same priority as actual tax, and is not dischargeable.
Another court used the same reasoning for a Chapter 7 case.
7. Limited applications of Section 523(a) in Chapter 13 Cases
According to Chapter 13 of Bankruptcy Code, as long as the debtor clears
payment of Chapter 13 case and plan, only certain discharge exceptions are
applicable to a Chapter 13 case. This leads to a greater discharge for the
debtor.
None of the noted applicable exceptions are related to taxes, and all taxes are
discharged upon completing payments under the plan. Chapter 13 also
requires that all priority claims in the plan be paid in full.
All priority taxes have to be paid in full under a Chapter 13 plan before granting
a discharge. Except for priority taxes, all other discharge exceptions discussed
earlier don't have to be paid in full to get a discharge. Taxes in Chapter 13
cases are dischargeable even if it's not paid in full till the taxes fit one of the
priorities.
A debtor was found in a Chapter 7 filing to have willfully tried to evade his tax
obligations to get nondischargeable tax liability. He had then filed a Chapter 13
case where only a few specified debt types were non-dischargeable, and taxes
wasn't one of them. The debtors were thus entitled to a discharge upon
completing all payments under the Chapter 13 plan and could beat the IRS.
8. Limited applicability of Chapter 11 case discharge exceptions
Discharge exceptions have limited applicability in Chapter 11 cases. Though
Chapter 11 usually discharges all debts upon confirming a plan of
reorganization, it applies discharge exceptions to individual Chapter 11 case
debtors with confirmed plans.
An individual Chapter 11 debtor was assessed tax deficiencies upon
commencing the bankruptcy case. According to the court, an individual
Chapter 11 debtor can't be discharged of debts enumerated in the Bankruptcy
Code, including taxes given priority status.
As mentioned earlier, priority taxes include taxes not assessed but are still
assessable at the petition date. So the debtor was not discharged of the tax
liability, and could not beat the IRS.
These exceptions to discharge do not apply to corporate or partnership
debtors. Chapter 11 debtor has to pay priority claims and priority tax claims
within six years to confirm a Chapter 11 plan.
Although the parties may practically agree to varied treatments for claims,
they don't have to pay non-priority taxes, or other claims, to meet the bare
minimum legal requirements for confirmation.
Chapter 11 corporate and partnership debtors can discharge similar claims a
debtor under Chapter 13 can discharge, without making full payment. This
includes all discharge exceptions mentioned earlier, except for priority taxes.
What happens with nondischargeable tax debt?
Income tax debts are treated differently based on whether you file Chapter 7
or a Chapter 13 bankruptcy case.
1. In the case of chapter 7 bankruptcy, there's not much effect on
nondischargeable tax debts except for automatic stay. The court clerk
closes the bankruptcy case when the discharge is issued by the
bankruptcy court.
The case may remain open if the court-appointed trustee gathers and
sells the debtor's non-exempt property. The IRS is free to resume
collection actions if the bankruptcy case doesn't discharge the IRS tax
debt.
2. Chapter 13 bankruptcy is best used to manage nondischargeable IRS
debt. You propose a plan for paying your IRS and other debts over a 3-5
year period.
While your nondischargeable debt gets paid in full, you get the benefit
of discharging your older and unsecured IRS debt.
IRS tax liens are a game changer
Your case gets more complicated if the IRS files a tax lien because it turns the
tax debt into a secured obligation that has to be repaid no matter which
Chapter you file. It doesn't matter even if the tax is old and would have
otherwise been dischargeable.
