WHEN TAXES MAY BE DISCHARGED IN BANKRUPTCY
This article discusses the treatment of taxes due to the Internal Revenue Service (IRS). Income taxes due to the IRS may be dischargeable if such taxes meet five (5) criteria. 11 USC 507 and 523 hold that taxes are dischargeable in bankruptcy if:
- The tax return was due more than three (3) years before the filing of the bankruptcy petition.
If the debtor, received an extension of time to file the tax return, the period of the extension is added to the three (3) year requirement;
- The tax was assessed more than 240 days before the date the bankruptcy petition was filed;
- If the debtor requested an offer in compromise from the IRS, the time in which the IRS considered such offer is not counted towards the 240 day assessment requirement. Furthermore, an additional 30 days is added to the period it takes the IRS to reach a decision.
For example, if the debtor requests an offer in compromise and the IRS rejects such offer four months later, the debtor must wait 240 days, and an additional four (4) months and 30 days, in order to obtain a discharge of such debt in a bankruptcy;
- The tax return was filed more than two (2) years before the filing of the bankruptcy petition;
- The tax return was not deemed fraudulent or there was no willful attempt to evade the tax.
Simple negligence, which may be treated as a misdemeanor, does not automatically disqualify a filer. Tax fraud occurs when a tax filer does any of the following: Intentionally fails to file a
Income tax return; Willfully fails to pay taxes due; Intentionally fails to report all income received; Makes fraudulent or false claims; or prepares and files a false return. Under
11 USC 1129(d), the governmental unit has the burden of proving that the principal purpose of the plan is tax avoidance. Most courts apply a “totality of the circumstances” approach, meaning the bankruptcy court must evaluate each case on a case by case basis, examining all relevant factors.”
If the tax debt meets all of the above term, the tax debt qualifies for discharge in bankruptcy. However, if the IRS has placed a tax lien on your property, the tax lien may not be discharged in bankruptcy. The debtor may receive a discharge of his or her personal liability as it related to the tax debt, but the property subject to the tax lien will carry liability subsequent to the bankruptcy. However, the debtor has a number of options to address such tax lien, through the mechanism of a Chapter 7 bankruptcy or Chapter 13 bankruptcy.
TAXES NOT DISCHARGED IN BANKRUPTCY
Certain federal taxes are not eligible for discharge in bankruptcy. These taxes may not be discharged in bankruptcy, irrespective of any criteria, such as the age of the tax, or date of assessment. For example, trust fund taxes are not subject to discharge in bankruptcy. Trust fund taxes are taxes that are withheld from an employees paycheck for social security and medicare. The amount withheld represents both the employee’s portion of social security and medicare taxes, and the employer’s share.
The employee’s share of such employment tax may not be discharged in bankruptcy. However, the employer’s share of the employment tax is eligible for discharge if the tax meets the five (5) requirements enumerated above.
Excise taxes, such as sales tax, estate and gift taxes, and fuel taxes are not subject to discharge in bankruptcy.
TAX LIENS GENERALLY
A lien is a security interest or claim against the property or assets of a debtor. A mortgage is a lien against a home or real property. A federal tax lien secures an obligation to the IRS, as a mortgage secures an interest against a home.
A federal tax lien attaches to “all property and rights to property, whether real or personal, belonging to the taxpayer (26 USCA 6321). This provision is broadly defined to include “every species of right or interest protected by the law and having an exchangeable value.” The IRS is able to levy on all funds in a joint bank account, despite the fact a private creditor under State law may not, because the debtor has an unqualified right to withdraw such funds.” The tax lien also extends to IRAs, pension plans, disability income and beneficiary interests in a spendthrift trust, even though such assets are generally protected from levy by a private creditor.
Federal tax liens are imposed by action of the IRS. The IRS first files a notice in order to implement the tax lien. The notice must be filed in the county where the property is located or where the debtor resides. Subsequent to the filing of the notice, the IRS possesses a tax lien against all property owned by the debtor, including both personal and real property (real estate). The tax lien is imposed against all property owned by the debtor, prior to and subsequent to the imposition of the tax lien.
Under 26 USC 6321, “If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, amount additional to tax, or assessable penalty, together with any costs that may accrue in addition, shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.” This may include, but is not limited to bank accounts, pensions, liquor licenses, homestead property, or even wages and salaries.
For a federal tax lien to be effective against real property, such lien must be filed in the county in which the real property is located. However, the tax lien is additionally effective against all other forms of property of the debtor, wherever located.
If the debtor is an individual, the tax lien must be recorded in the county in which the debtor resides. If the tax lien is recorded in the county in which the taxpayer resides and the taxpayer moves to another county, the federal tax lien will still remain effective and enforceable, despite the difficulty presented to creditors who may seek to discover the existence of such lien.
Federal tax liens are effective for ten (10) years after the imposition of the lien. After ten years the tax lien is no longer effective against the debtor.
PERFECTION OF TAX LIENS
A federal tax lien attaches upon assessment of the tax, but is not enforceable against other creditors, or a trustee in bankruptcy until the lien is perfected. Against real property, the tax lien is perfected through recording the lien in the county recorder’s office for the county in which the real property is located. If the taxpayer is an individual, the tax lien is perfected against personal property by recordation in the office of the county recorder for the county in which the person resides.
If the taxpayer is a corporation, the federal tax lien is perfected through recordation with the Secretary of State, usually in the manner of a UCC-1 filing. The tax lien must be filed in the State where the principal executive office of the business is located.”
A perfected federal tax lien takes priority over existing but unperfected security interests and subsequently perfected security interests and judgment liens. The federal tax lien takes priority over existing liens in all property acquired after the tax lien is filed.
FEDERAL TAX LIENS AND 45 DAY SAFE HARBOR RULE
The Statute addressing federal tax liens contains two provisions which defer the effect of the tax lien on other creditors for the first 45 days after its recordation. First is a provision that protects transactions when the tax lien is filed, and which are funded and close within the 45 day period, and second, a provision which protects the priority of existing floating liens for the first 45 days following the recordation of the tax lien.
A security interest that is perfected shortly after the filing of the federal tax lien is protected and takes priority over the federal tax lien if the following requirements are met. The security interest must have attached before the filing of the tax lien. The security interest could not be defeated by a judgment lien on the date of the filing of the tax lien. Finally, the creditor’s disbursement or financing was made without notice of the federal tax lien and before the 46 day after the federal tax lien filing.
TAX LIENS AND BANKRUPTCY
Where the creditor asserts an allowed claim that is secured by a lien on property in which the Estate has an interest, Bankruptcy Code Section 506(a) defines the extent to which that claim shall be considered a secured claim. If the value of the property which secures the debt is less than the allowed claim, Bankruptcy Code Section 506(a) provides, “The creditor holds a secured claim to the extent of the value of such creditor’s interest in the Estate’s interest in such property and….an unsecured claim to the extent that the value of such creditor’s interest….is less than the amount of such allowed claim.”
If the tax lien is applicable to a tax that is otherwise discharged in bankruptcy, the lien only attaches to property possessed by the debtor prior to the filing of the bankruptcy. The tax lien does not attach to assets obtained by the debtor after the filing or commencement of the bankruptcy.
If the tax is not eligible for discharge in bankruptcy, such as certain employment taxes or priority tax debt, such as recent income taxes, the lien also applies or attaches to property the debtor acquires after the commencement of the bankruptcy.
According to IRS Statutes, some personal property is exempt, meaning the IRS is prohibited from levy on such property.
TAX LIEN ON REAL PROPERTY
A federal tax lien only operates against the real property or real estate located in the county or counties where the IRS files the tax lien.
If the debtor owns real property or real estate, the IRS may place a tax lien upon such property. If the tax debt is otherwise dischargeable in bankruptcy (meaning it meets the five criteria listed above) the debtor may receive a discharge of his or her personal liability. However, the tax lien against the real property will survive the bankruptcy.
The tax lien may only released by its satisfaction. The tax lien will remain recorded against the real property until the tax lien is released through a number of measures. The debtor may sell the real property and pay the tax lien through the sale. The tax lien may expire. The debtor may surrender the home in bankruptcy.
TAX LIENS ON PERSONAL PROPERTY
A federal tax lien on personal property applies to all of the personal property, wherever located.
If the debtor does not own real property or real estate, the tax lien may only be enforced against the debtor’s personal property. Again, the tax debt may be discharged in bankruptcy against the debtor personally if the debt meets the five requirements for discharge. However, the tax lien against the personal property will survive the bankruptcy.
The tax lien will only be effective against assets that the debtor owned before the bankruptcy filing. Any assets that the debtor acquires after the bankruptcy filing are not subject to the tax lien.
TAX LIENS AND BANKRUPTCY EXEMPTIONS
In United States v Craft, the United States Supreme Court held “exempt status under state law does not bind the federal collector.” Even if a person’s residence is designated as homestead property, or if the residence was held in tenancy by the entirety, the IRS may still attach a lien upon such property.
Likewise, the state exemptions or bankruptcy exemptions do not apply to personal property or other assets that are protected from seizure by either a creditor outside of bankruptcy or a bankruptcy trustee within a bankruptcy.
For example, in the state of Florida, the debtor may use the state exemption for personal property in the amount of $1,000 (additional exemptions for personal property apply if the debtor does not own a homestead). If the debtor owns personal property possessing a value of $3,000, the IRS may apply a tax lien against this property for the full amount of the value of the personal property, meaning $3,000. In a bankruptcy, the debtor may not reduce the tax lien against the personal property by use of the bankruptcy exemption.
TAX LIENS AND RETIREMENT PLANS
ERISA qualified retirement plans are subject to any tax lien placed by the IRS. However, the IRS cannot seize the retirement plan until the debtor retires and is eligible to receive monies pursuant to the retirement plan. At such time, the tax lien may expire and no longer enforceable against the debtor.
CLASSIFICATION OF TAX DEBTS IN BANKRUPTCY
The reader may surmise that tax debt is treated differently in bankruptcy, based upon how such debt is classified. Tax debt may be determined to either (1) secured, (2) unsecured priority, or (3) unsecured and dischargeable.
A debtor who files bankruptcy may have tax debt that meets each of the three classifications of tax debt. If the IRS has enacted a tax lien against the debtor’s real property and personal property, the tax debt is secured to the value of such assets. Any tax debt that does not meet the five criteria for discharge in bankruptcy, but is not subject to a tax lien is classified as unsecured priority tax debt. Any tax debt that meets the five requirements for discharge in bankruptcy and not subject to a tax lien is classified as unsecured and dischargeable.
PROPERTY TAX LIENS AND BANKRUPTCY
Most cities or counties in the United States will levy a tax on its inhabitants’ real property, based upon the value of such property. Such tax on real property is a lien that attaches to the property.
In most jurisdictions, the city or county tax lien is placed in first position, and has priority over even the first mortgage on the property.
If the debtor files Chapter 7 bankruptcy, and surrenders his home, the taxes will continue to be assessed against the debtor as long as he is the legal owner of the property. The debtor remains the legal owner of the property until the property is conveyed to a new owner through foreclosure, purchase, deed in lieu, or quit claim deed. It is generally not necessary for such debtor to pay the tax or tax lien because the tax is a lien on the property and not the individual, and is paid when the home is conveyed to the new owner.
CHAPTER 13 BANKRUPTCY TREATMENT OF TAX DEBT
Chapter 13 bankruptcy, in comparison to Chapter 7 bankruptcy, possesses certain advantages to a debtor in relation to tax debt. In a Chapter 13 bankruptcy a debtor may obtain the discharge of taxes for which returns were filed late and within two years before the commencement of the bankruptcy, provided no tax assessment was made less than 240 days before the filing of the bankruptcy, or the debtor filed fraudulent returns or willfully evaded such tax. Penalties on priority tax claims are dischargeable in a Chapter 13 bankruptcy.
If the debtor files Chapter 13 bankruptcy, the tax debt subject to the tax lien must be paid pursuant to the Chapter 13 plan, up to the value of the debtor’s assets. If a debtor owns $10,000 in personal property, including automobiles, bank accounts, furnishings and other varieties of personal property, the debtor must pay the IRS $10,000 pursuant to the Chapter 13 bankruptcy.
In the Chapter 13 bankruptcy, any tax debt that is classified as unsecured and priority must be paid in full through the Chapter 13 bankruptcy plan. Any debt that is classified as priority must always be paid in full through the Chapter 13 bankruptcy. This includes taxes that are so classified, but also other priority creditors, such as persons due child support arrears.
The priority tax debt includes any penalties and interest accrued up to the filing of the Chapter 13 bankruptcy. However, interest and penalties cease upon the filing or commencement of the Chapter 13 bankruptcy.
Bankruptcy Code Section 1325(a)(5) provides that secured claims are to be paid the value of the claim over the life of the plan at a rate of interest that is equal to a market rate plus a risk factor, Tax claim under Bankruptcy Code Section 507(a)(8) are to be paid in full over the term of the Chapter 13 plan without interest, unless the creditor agrees to alternative treatment. Tax claims to which there is no security to secure the claim, or are not priority claims, are treated as unsecured non-priority or general claims. These claims share pro-rata in distribution with all other unsecured claims, paid generally on the basis of the debtor’s disposable income.
In Chapter 13 bankruptcy, tax debt that is dischargeable and unsecured may be paid nothing pursuant to the bankruptcy. In a Chapter 7 bankruptcy such classified debt may be entirely discharged through the bankruptcy. Although tax debt so classified may be discharged through the Chapter 13 bankruptcy and eligible to receive no distribution through the plan, other factors may require distribution for payment of tax debt that is dischargeable and unsecured. For example, if the debtor has disposable income available, such disposable income can be paid to the debtor’s creditors holding unsecured and dischargeable claims, including the IRS.
The tax lien qualifies as a secured claim only to the extent of the value of the assets or property to which it attaches, If the lien does not attach to any value, meaning the debtor does not have any assets possessing equity for the lien to attach to, the debtor may use the Chapter 13 bankruptcy eliminate the tax lien and otherwise use the Chapter 13 to pay his taxes according to the respective classification of his tax debts, as either priority and non-dischargeable tax debt, or non-priority and dischargeable tax debt.
The filing of the Chapter 13 bankruptcy also freezes the amount of the secured portion of the tax debt, or that portion of the tax debt that is subject to the tax lien. For example, if the tax lien attaches to an asset that may appreciate in value, such as a house, the Chapter 13 bankruptcy filing freezes the value of the lien as the value of the asset at the time of the filing of the Chapter 13 bankruptcy. Any increase in value of the asset, even within the duration of the Chapter 13 bankruptcy plan, is not subject to the tax lien.
CHAPTER 7 TREATMENT OF TAX LIENS
A valid federal tax lien usually is not extinguished through the process of Chapter 7 bankruptcy. Most Chapter 7 bankruptcies are “no asset” cases, meaning there are no available assets that may be seized by the Chapter 7 bankruptcy trustee, which may be liquidated or sold, to satisfy the claims of creditors. Furthermore, one of the primary functions of the Chapter 7 bankruptcy trustee is to preserve the rights or claims of the unsecured creditors. If the bankruptcy trustee sells an asset of the debtor, and only the IRS as a secured creditor benefits, this action is contrary to this essential function.
The automatic stay in bankruptcy prevents the imposition of a tax lien after the filing and pendency of the bankruptcy. However, the IRS may impose a tax lien if it filed notice of the lien before the filing of the debtor’s bankruptcy.
Claims for penalties, even if secured, are subordinated to all other claims in a Chapter 7
7 case from the highest priority to the lowest priority, payable only after the general unsecured creditors are paid in full, through the operation of Bankruptcy Code Section 726(a)(4).
If the debtors tax debt is otherwise eligible for discharge in the Chapter 7 bankruptcy, absent the tax lien, the remaining tax debt subsequent to Discharge, is limited by the value of the assets subject to the tax lien.
In such instance, the debtor has a number of options. The debtor may pay the tax lien, and receive a release from the IRS. The debtor may negotiate a payment plan with the IRS, or a compromise with the IRS, to pay the tax lien, and receive a release. The debtor may elect to redeem an asset through the process of the Chapter 7 bankruptcy.
The debtor may also elect to do nothing. The property attached to the tax lien may have nominal value. It may not be in the best interest of the IRS to seize the debtor’s broken down car or old sofa. Furthermore, such assets are continually depreciating, creating additional disincentives for the IRS to seek seizure.
Jay Weller is a bankruptcy attorney in the Tampa Bay area. Mr. Weller practice is concentrated in the representation of debtors in Chapter 7 bankruptcy and Chapter 13 bankruptcy. Weller Legal Group PA has offices in Clearwater, Port Richey, and Lakeland, Florida. If you are a debtor in need of representation in bankruptcy proceedings, or an attorney wishing to solicit legal advice and counsel, please contact our office, through our website, or via our toll free number at 1-800-407-3328 (DEBT).
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