All posts tagged Taxes

Chapter 11 Debtors Are Prohibited From Paying Taxes… Without a Notice and Hearing!

Before people worry too much, this is not as bad as it sounds but it is still pretty awful.

Under Bankruptcy Code section 102, “notice and hearing” is a due process safeguard: “after such notice as is appropriate in the particular circumstances, and such opportunity for a hearing as is appropriate in the particular circumstances.” In other words, there are circumstances where notice and hearing means just notice or notice and an opportunity to object. Hopefully local bankruptcy rules are modified to make these notice only requests.

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Discharging tax debts when the debtor has evaded collection

Section 523(a)(1) of the bankruptcy code distinguishes the nondischargeable taxes from those that may be discharged in bankruptcy.

In most cases, the analysis is pretty simple. Generally, nondischargeable taxes are those where the return was due less than three years ago, where the return was actually filed less than two years ago, or where the tax was actually assessed less than 240 days ago (assuming the debtor is filing a bankruptcy petition today). This is, in the end, numerical.

If the debtor made a “fraudulent return,” the taxes are not dischargeable. This is also very easy to determine: did the IRS assert the fraud penalty and win? It’s a rare case when a debtor files a bankruptcy petition and the first allegation of fraud comes when the debtor wants to discharge taxes.

But there is one phrase that invites interpretation, and that can trip up the most conscientious practitioner: 523(a)(1)(C) says that “A discharge . . . does not discharge an individual debtor from any debt for a tax with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

There are two main functions to the IRS: audit and collection. Audit determines how much tax you owe; collection ensures that you actually pay it. This subsection implicates both functions, and they have very different standards of bad behavior.

Because the subsection starts with the “fraudulent return” element, it’s a reasonable assumption to believe that fraudulent intent extends to the element of “willful attempt to evade or defeat tax.” Not so.

“Willful evasion” includes both a conduct element (an attempt “in any manner”) and a mental state element (“willful” means “voluntary, conscious, and intentional”). The conduct may be an affirmative act, such as transferring property to another family member for no consideration while tax debts hang over the owner’s head, or an omission, such as failure by a law partner’s failure to tell the accounting gal to withhold taxes.

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The Silent Tax Lien and the Bankruptcy Trustee

A colleague writes:
PC has $150k of equity in her home. Taxes owed are dischargeable. I know if the IRS filed a Notice of Lien, the lien remains but what if no Notice of Lien was filed – is the unrecorded lien still attached to the equity?

Gentle lawyer:
The IRS does indeed have a silent lien against the equity in the house, but it disappears in bankruptcy. Because the bankruptcy trustee takes over the property with the powers of a judgment creditor, and because there was no Notice of Federal Tax Lien on file, the trustee’s interest trumps the IRS’s interest. The debtor gets to keep the equity in the house. After the discharge is entered, the taxes are discharged, and the IRS can no longer attach the house.

Why can the IRS use a refund to pay off dischargeable taxes?

The client owes $15,000 in taxes for the 2004 tax year, and you’ve done the analysis and determined that this is a dischargeable debt.  He also owes $10,000 for the 2009 tax year, and this isn’t dischargeable.  For some reason, no notices of federal tax lien are on file, so there is no question of a secured debt (or so you think).  After filing his 2011 tax return, he gets a $12,000 refund.  You’re filing his chapter 7 petition tomorrow.  What happens to the refund?

Answer: it pays off $12,000 of the dischargeable tax from 2004, and none of the 2009 liability.
Why, you ask?  And then, depending on your temperament, you may even add the phrase “that ain’t fair” after your question.  After all, the IRS didn’t have a Notice of Federal Tax Lien, so why does it get to pay itself on a tax debt that is going to be discharged?

The reason is that the 2004 tax debt, while dischargeable, is also secured. IRC Section 6321 puts a silent lien on all property of a tax debtor to secure the payment of tax. When the taxpayer gives the IRS money in the form of excess withholding of tax, the IRS has a lien on that money to pay the delinquent tax.  Because this is not a voluntary payment, the IRS, not the taxpayer, gets to determine where the tax refund will be applied.

So, as of December 31, 2011, the taxpayer-debtor had a credit of $12,000 on his 2011 tax account (even if this computation did not take place until a few months later). He also owed $15,000 on the 2004 tax year, which we assume is the oldest collectible tax delinquency. When he files his bankruptcy petition on February 15, 2012, the IRS is in possession of his tax refund, and it may use it as an offset against the 2004 debt – prepetition asset against prepetition liability. So what if the 2004 liability was going to be wiped out in the bankruptcy? At the end of the 2011 tax year, when the IRS had full possession of the tax refund, the liability existed.

The good news for your debtor: the IRS won’t apply his 2012 refund against the 2004 liability, because the 2004 liability will have been discharged.