Timing considerations of discharging taxes in a Chapter 7 bankruptcy.

• Author: Salzman, Martha L.

The economic turmoil that has enveloped the United States and much of the rest of the world over the past several years has led to a dramatic increase in the number of bankruptcies. For example, in the 12-month period ending March 31, 2008, bankruptcy filings under all chapters of the U.S. Bankruptcy Code (1) totaled 901,927. They grew to 1,202,503 filings for the 12 months ending March 31, 2009, and to 1,571,183 for the 12 months ending March 31, 2011. The passage of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) (2) in 2005 placed new limitations on Chapter 7 filings under the Bankruptcy Code. (3) Even so, the increase in Chapter 7 cases has been breathtaking. The number filed for the 12 months ending March 31, 2011 (1,118,481), is nearly double that of the 12 months ending March 31, 2008. (4)

Besides illustrating the depth of the economic crisis, the increase in bankruptcy filings underscores the importance for businesspersons and professionals of understanding bankruptcy law. Tax accountants, although immersed in the intricacies of the Internal Revenue Code, are not immune from this observation. A failure to anticipate a likely bankruptcy filing, or providing tax advice to a financially troubled client that docs not consider the implications of a pending bankruptcy case, could have unintended and costly consequences, including nondischarge of tax debt. Now more than ever, CPAs involved in tax practice must be aware of bankruptcy law and the treatment of tax liabilities in bankruptcy.

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This article discusses liquidations under Chapter 7 and focuses on individuals who are attempting to have their debts discharged, or wiped out, in bankruptcy. Corporations are not discussed, as they arc not eligible for a Chapter 7 discharge. (5) The article begins with an overview of Title 11 of the United States Code, which contains the bankruptcy provisions, and then describes some of the rules that determine whether an individual debtor can jettison income tax liabilities through a liquidation filing. It also discusses the consequences of certain taxpayer misconduct, including tax fraud. The article concludes with suggestions for tax accountants to follow when working with clients who may be involved in bankruptcy filings, to maximize discharge of income taxes. CPAs must be mindful of other tax issues raised by a bankruptcy petition, however, and should anticipate working closely with a client's bankruptcy attorney to successfully manage the complex issues raised by the interaction of the bankruptcy and tax codes. (6)

Bankruptcy in General

The goals of the bankruptcy law are twofold: to provide a fresh start to debtors and equitable treatment among creditors. Chapters 1, 3, and 5 of the Bankruptcy Code address administrative issues in bankruptcy, such as the automatic stay, which at least temporarily prohibits certain collection actions once a bankruptcy petition is filed. (7) Chapter 7 contains the liquidation rules and is used by businesses and individuals seeking an orderly resolution of debt. (8) Reorganization provisions are found in Chapter 11, which is typically used by corporations, and Chapters 12 (family farm) and 13 (individual plan for the adjustment of debts or a repayment plan). The aim of these proceedings is to restructure debt and, in the case of a corporation filing under Chapter 11, preserve the business as a going concern. A trustee is appointed in Chapter 7 cases and is responsible for collecting and in most cases liquidating or selling the debtor's nonexempt assets and distributing the proceeds to the creditors. By contrast, a Chapter 11 debtor typically manages the assets of the bankruptcy estate as a "debtor in possession." (9)

A debtor may voluntarily file a bankruptcy petition, or creditors may file an involuntary petition. The filing creates a separate bankruptcy estate that succeeds to all of the debtor's nonexempt assets as of the commencement of the case. (10) In Chapter 11 reorganization filings, a plan must be developed, classifying the claims against the debtor and describing the treatment of each class. (11) The bankruptcy court must confirm the plan. In liquidation cases, secured creditors are entitled to be paid first with respect to the collateral securing the debtor's obligations to them. To the extent a secured creditor's claim actually is secured (meaning that the claim does not exceed the value of the collateral), a secured creditor is entitled to receive either payment of its claim or the collateral. (12) However, the Chapter 7 trustee, whose duty is to maximize the return to a debtor's unsecured creditors, may sell a secured creditor's collateral if the asset is worth more than the security interest, to capture the excess for the estate. (13)

Thereafter, unsecured creditors entitled to priority under the bankruptcy rules are paid in the order provided by statute. The highest priority is given to domestic support obligations, but administrative expenses, wages, employee benefit plan contributions, and certain other debts are also priority claims. (14) Any assets remaining after all priority claims are paid in full are distributed to the debtor's general unsecured creditors, who typically receive at most only a fraction of the amount owed to them. Debts that the estate does not pay but that are discharged in a Chapter 7 filing arc uncollectible, and creditors are prohibited from taking action against the debtor to recover them. (15) Debts that are not paid and that are excepted from discharge remain liabilities of the debtor following the Chapter 7 bankruptcy. (16)

Dischargeability of Federal Income Tax Claims in Chapter 7

Many debtors considering a liquidation bankruptcy do so at least partly hoping to shed tax obligations owed to the federal government. However, the discharge of these debts is subject to precise timing rules that in many cases restrict the ability of debtors to eliminate these obligations. Further, other provisions of Title 11, such as the treatment of perfected federal tax liens and rules regarding property abandoned by the bankruptcy estate, may limit the effectiveness of bankruptcy as a tax relief tool. Therefore, it is important for tax advisers with clients considering a bankruptcy petition to render careful advice about what a filing can and cannot accomplish.

General Limitations on Discharge

Notice of Federal Tax Lien

Even if a debtor is an individual and therefore potentially eligible for the discharge of certain federal income tax debt, a Chapter 7 proceeding will not eliminate exposure on a tax debt for which a notice of federal tax lien (NFTL) has been properly filed before the debtor's bankruptcy petition is filed. (17) The effect of this notice is to convert the IRS to a secured creditor, allowing it to enforce the lien against the debtor's preposition assets even if the tax debt itself is discharged. (18) As a result, "exempt assets," which a debtor otherwise would be allowed to keep in bankruptcy, could be lost to the payment of taxes. Generally speaking, which assets are exempt depends upon the debtor's domicile before the filing of the bankruptcy petition, but IRAs and residences are examples of assets that might be claimed as wholly or partially exempt. (19) The possibility of an NFTL can create difficult issues for the timing of a Chapter 7 petition. A debtor seeking to avoid a loss of assets that the exemption rules otherwise would allow the debtor to keep would want to enter bankruptcy before the IRS files an NFTL. (20) Unfortunately, under timing provisions to be discussed later, filing a bankruptcy petition too soon may limit which tax obligations can be discharged.

Postpetition Taxes

Postpetition taxes incurred by a debtor also survive a Chapter 7 bankruptcy. This is because a bankruptcy discharge applies only to debts arising before the date of the order for relief. (21) As a result, a calendaryear taxpayer who petitions for Chapter 7 relief on November 30, 2010, for example, will be fully liable for his or her 2010 taxes, since the amount of taxes due cannot be calculated until year end, and the obligation to pay does not arise until April 18, 2011. (22) A planning opportunity exists here, however. Under Sec. 1398 of the Internal Revenue Code, a debtor may elect to close his or her tax year the day before the bankruptcy case commences.

A debtor who makes the Sec. 1398 election files two returns for the year in which he or she enters bankruptcy. The taxes owed for the period ending before the bankruptcy represent a priority claim against the bankruptcy estate and will be paid if there are sufficient assets. Depending upon the circumstances, this payment may be at the expense of the debtor's general unsecured creditors, whose unpaid claims will be discharged by the Chapter 7 filing. This is because the assets available to satisfy those debts will be reduced by the amount paid to the IRS. If the bankruptcy estate does not have the resources to pay, the priority tax obligation is not dischargeable and remains an obligation of the debtor. (23)

Whether the Sec. 1398 election should be made depends on various factors, including the likelihood the bankruptcy estate will be able to pay the short-year prepetition tax and the debtor's tax situation in the year of filing. For example, a debtor who realizes a significant capital loss in the portion of the tax year occurring before the petition date may not want to make the Sec. 1398 election, to retain the loss for use in later years. Note that a debtor who has no assets other than exempt assets cannot make the Sec. 1398 election. (24)

Abandoned Property

A trustee's power to abandon property (25) can also complicate the prospective tax relief offered by a discharge because of the potential tax liability if the property returned to the debtor is subject to debt that exceeds its basis. (26) The courts arc split on whether abandonment is...