Individual taxes, penalties and interest forgiven in a Chapter 7 versus a Chapter 13 bankruptcy.

• Author: Hansen, Kenneth A.

Taxpayers may have tax-related government claims (i.e., individual taxes, penalties and interest) forgiven (discharged) in bankruptcy by filing a bankruptcy petition at the proper time. However, haphazard results will occur unless the tax practitioner knows whether a Chapter 13 or a Chapter 7 bankruptcy is suitable for his client. Also, reducing taxes for a client who consults his adviser just before filing time is difficult. It is as hard, after the fact, to position the taxpayer (debtor) for a useful bankruptcy filing to discharge taxes. Practitioners with a working knowledge of how a Chapter 7 or a Chapter 13 bankruptcy affects delinquent individual taxes, penalties and interest will be able to avoid leaving the results of bankruptcy to chance.

The statute of limitations allows the IRS 10 years to collect taxes,(1) starting after the date of formal recording by the Service of a taxpayer's liability (date of assessment). The collection period has been extended from six to 10 years for taxes not expiring under the previous six-year collection period as of Nov. 5,1990.(2) With the longer tax collection period and the recent recession, tax practitioners may have clients with accumulating tax debts and limited resources.

The categories that prevent the discharge of individual taxes, penalties and interest in bankruptcy are (1) government priority claims, (2) government exceptions to discharge and (3) government tax liens. Unless paid, government priority claims survive a Chapter 7 or a Chapter 13 bankruptcy.(3) Certain government claims for taxes, interest and penalties survive a Chapter 7 bankruptcy but are discharged in a Chapter 13 bankruptcy.(4) Finally, government tax liens attaching before the bankruptcy filing date generally survive any Chapter 7 or Chapter 13 bankruptcy discharge of taxes, penalties and interest.(5)

Government Priority Tax Claims

Certain government priority tax claims survive either a Chapter 7 bankruptcy or a Chapter 13 bankruptcy.(6) The nondischargeable government priority tax claims identified in the Bankruptcy Code are:

* Taxes that are due, including extensions, within three years of the bankruptcy petition filing.(7) The three-year period begins from the final due date of the return, including extensions.(8) For example, a debtor who owes 1989 Federal income taxes due Apr. 15, 1990 should not file a bankruptcy petition until after Apr. 15, 1993 to avoid paying 1989 taxes as a priority claim. If the bankruptcy petition is filed on or before Apr. 15, 1993, it is filed too early to prevent the discharge of 1989 taxes. The court may deny a debtor's motion to dismiss a bankruptcy petition filed too early to discharge the 1989 taxes if the purpose is to refile the bankruptcy petition at a later date. The United States is prejudiced by losing potential tax collections if the bankruptcy petition is dismissed and subsequently refiled.(9)

* Any taxes assessed within 240 days before the bankruptcy petition filing date.(10) A tax assessment is required before the IRS can demand payment and collect the tax through administrative powers.(11) For example, assume the 1988 taxes due on Apr. 15, 1989 are assessed on Mar. 30, 1992. Any bankruptcy petition filed within the next 240 days from Mar. 30, 1992 gives the 1988 taxes a nondischargeable priority status. To avoid such status, the taxpayer should wait 240 days after Mar. 30, 1992 before filing the bankruptcy petition.

The 240-day period increases if the taxpayer files an "offer in compromise" with the IRS. An offer in compromise is a contract agreement with the IRS (statutory contract agreement) in which the taxpayer agrees with the Service to pay less than the full amount of taxes, penalties and interest due.(12) The 240-day period is suspended temporarily (tolled) while the offer of negotiation is before the IRS. An additional 30 days is added to the original 240-day period once the offer is withdrawn or otherwise terminated. However, if an assessment of tax liability is made but the tax is not collected within 240 days, filing an offer in compromise thereafter will not revive the IRS's priority. In this circumstance, the offer in compromise will not prevent the discharge of tax.(13)

* Employment and FICA taxes collected. Employees' payroll withholdings (trust fund taxes) held for the exclusive use of the government have no time limits restricting their priority status.(14) This type of assessment, commonly termed the 100% penalty, for failing to withhold trust fund taxes is considered a tax rather than a penalty. The 100% penalty cannot be discharged in any bankruptcy.(15)

* The employer's one-half share of employment tax. For an employment return due within three years of the bankruptcy petition filing date, the employer's share of employment tax is a nondischargeable priority tax claim.(16) The employer's share of employment tax includes the employer's one-half share of FICA tax.

* A penalty that compensates for an actual monetary loss, such as prebankruptcy petition interest on taxes.(17) Prebankruptcy filing date (prepetition) interest does not punish (is not punitive), but rather compensates the government for delays in using money owed.(18) Any priority tax claim will attach with it the prepetition interest as a priority claim.(19) Prepetition interest survives bankruptcy if the underlying tax obligation survives bankruptcy.

* Taxes not assessed before, but assessable under law. Taxes not assessed before, but assessable under law, are elevated to a priority status.(20) For example, adjustments available during a normal tax audit or pending Tax Court case are elevated to a priority status. Thus, if a tax was never assessed and the general three-year statute of limitations for assessment has expired, the tax is not entitled to priority. Conversely, if the statute of limitations is open for a previously unassessed tax, it is entitled to priority status.

However, any unassessed tax not due within three years of bankruptcy that is assessable because of fraud, failure to file or delinquent filing is not elevated to a priority government tax claim. Even though the circumstances listed are not elevated to government priority claims, they do survive a Chapter 7 bankruptcy. The bankruptcy policy for this treatment of tax fraud, failure to file or delinquent filing avoids reducing the estate share available to the private general creditors due to the debtor's deliberate misconduct. Not giving priority to a tax claim means that the IRS can still collect part or all of the debt from the...