Bankruptcy and Tax Laws

The interrelationship between taxes and bankruptcy can be complicated and confusing. While there are not many examples of direct conflict between the Bankruptcy Code and the Internal Revenue Code, these are waters that should be navigated with care.

In certain circumstances, individual income taxes may be discharged in bankruptcy. Income taxes arising from a tax year for which the tax return was last due at least three years prior to the date of the filing of the petition are potentially dischargeable. The operative words here are “last due” and “potentially dischargeable.”

Taxes that otherwise seem dischargeable under the three-year rule might not be, due to a number of other factors which are discussed below.

Recent assessments. Income tax liability for the year or years in question must not have been assessed within 240 days of the date of the bankruptcy filing. In other words, even if the three-year rule has been met, the tax liability itself must have been assessed more than 240 days ago. It sometimes takes the IRS a long time to assess delinquent taxes. It cannot be assumed that just because the unpaid taxes arose many years ago, they were also assessed many years ago.

Offers in compromise. A further reading of Bankruptcy Code indicates that there cannot be a discharge where there is an outstanding offer in compromise, or that less than 30 days had elapsed since it was withdrawn or rejected.

Tax Court litigation; extension of limitations period. Taxes that otherwise would be eligible for discharge are excluded from dischargeability if the taxpayer is currently engaged in litigation in the Tax Court with respect to such liability or if the taxpayer, in the context of a settlement or workout arrangement, has agreed to extend the limitations period on the assessment or collection of such taxes.

Late-filed returns. What if the debtor meets all of the standards for dischargeability, but either filed the returns for the years in question late, or not at all?

If the return was never filed, the tax may not be discharged. Occasionally, debtors have argued that “substitute returns” prepared by the IRS entitled them to discharge as if they had filed the tax return themselves. The courts have consistently rejected this. To be eligible, the return must be signed by the debtor. Courts have also rejected “protest” returns as not satisfying the standard for having filed a return.

A debtor can be discharged for taxes, even if the return is late filed, if at least two years has passed since the filing, and all other conditions for discharge have been met.

Willful evasion or fraudulent returns. Most litigation regarding the dischargeability of individual taxes relates to the issue of whether the debtor filed a fraudulent return or whether the taxpayer attempted in any manner to evade or defeat the payment of taxes. Under Bankruptcy Code, the evasion must be willful. What constitutes “willful evasion” has been the subject of much court interpretation and the threshold for a finding of willfulness is a high one.

Litigating the tax discharge. Assuming the debtor has satisfied all of the criteria for dischargeability under Bankruptcy Code, and the court issues its standard blanket discharge order, is it safe to assume that he or she need no longer be concerned with enforcement or collection by the IRS? For careful practitioners, the answer is a resounding “no.” The better practice is to file an adversary proceeding under Bankruptcy Rule 7001 seeking declaratory relief. The specific relief requested is a declaratory determination that the specific taxes at issue are discharged by operation of law.

Under Code Sec. 7491(a), the IRS has the absolute burden of proof on all matters in such proceedings. Obtaining a specific court order as to dischargeabilty is the best safeguard from future collection action and prevents the client from having to move to reopen the bankruptcy case years down the road.

Nondischargeable taxes. Certain types of taxes are not dischargeable. The “trust fund” portion of payroll or withholding taxes that are imposed on a “responsible person” are not dischargeable.

The IRS may impose a penalty (commonly referred to as the 100% penalty) against responsible persons who fail to meet their duty to preserve and secure withholding taxes. This, as well as certain other types of tax penalties, are not dischargeable under Bankruptcy Code.

Any tax penalty arising from otherwise nondischargeable taxes is equally nondischargeable. If the underlying tax is dischargeable, so is the penalty.

If the IRS has attempted to impose the 100% penalty, but the statutory period during which the taxpayer can object to this assertion has not passed at the time that the debtor files his or her petition, the debtor can use the jurisdiction of the bankruptcy court to make the determination as to whether he was in fact the responsible person. If the IRS fails to prove that the debtor was a responsible person for purposes of the 100% penalty imposed by Section 6672, the trust fund taxes will be given seventh priority in bankruptcy and will be therefore dischargeable.

Bankruptcy Court’s tax jurisdiction. The Bankruptcy Code invests in the Bankruptcy Court the power to rule on most tax issues relating to debtors. (Bankruptcy Code section 505(a)) This statute also permits the Bankruptcy Court to determine the amount of any penalty, and whether it is pecuniary or punitive.

It is important to note, however, that the Bankruptcy Court lacks jurisdiction to rule on the merits of a tax claim that has already been adjudicated before a court of competent jurisdiction in a contested proceeding. Nevertheless, even if the merits of the tax claim have previously been decided in another court, the Bankruptcy Court is not deprived of jurisdiction to determine the dischargeability of the tax.

Tax liens. The dischargeability of tax obligations does not affect valid tax liens. In other words, tax liens will survive a discharge determination to the extent they attached to assets of the debtor at the time of the bankruptcy filing.

If you have any questions regarding the impact of your tax

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