Taxes & Bankruptcy 101 (first in a series)

Clients faced with substantial federal or state tax liabilities frequently consider whether bankruptcy may be their best option to obtain a new start and financial freedom. Tax professionals should understand and counsel their clients on the extent to which the client may benefit from bankruptcy, to help the client make an informed decision whether to proceed. This article explains some basic bankruptcy concepts and how bankruptcy and tax law interact.

There are three main types of bankruptcy filings. A “Chapter 7” bankruptcy filing seeks to discharge all of the debtor’s debts so that the debtor has no future obligations. In exchange, a Chapter 7 trustee is appointed and must liquidate all of the debtor’s assets that are not exempt. Interests in certain assets may be exempt from bankruptcy liquidation, such as a debtor’s primary residence (up to a certain dollar threshold), limited personal property including motor vehicles, and certain qualified retirement accounts. The Chapter 7 debtor may be an individual or an entity. Individuals who qualify for Chapter 7 bankruptcy relief will be able to make monthly payments on loans covering assets they wish to keep, while getting rid of other debts. Entities which file Chapter 7 bankruptcy must cease business operations and will be liquidated through a Chapter 7 proceeding. The benefits of a Chapter 7 bankruptcy include the speed (compared to other types of bankruptcies) at which a client can obtain a discharge and begin rebuilding their credit if all qualifications are met.

A “Chapter 13” bankruptcy filing requires a debtor to pay all or part of her debts from future income over a period of three to five years through a “plan of reorganization.” Whatever debt cannot be paid within the time period will be discharged or wiped out. Plan terms vary depending on the debtor’s situation, and the debtor may end up paying 100% of the debts, none of the debts, or somewhere in between. Under a Chapter 13 plan, most long term debt such as home mortgages must be paid normally, except for any payments that were delinquent at the time the debtor filed the bankruptcy, which would be included in the plan of reorganization. Only individual debtors (or a husband and wife, jointly) may file for Chapter 13 relief.

A “Chapter 11” bankruptcy filing allows business entities such as corporations, partnerships, and limited liability companies to reorganize their debts and continue operating. Chapter 11 may also be used by individuals or married couples who have large amounts of debt (e.g., up to $269,250 in unsecured debt or $807,750 in secured debt). Debtors who file for Chapter 11 relief may be able to reduce or eliminate unsecured and unwanted debts while restricting payment of debts needed for the business to continue operating. However, Chapter 11 is a very complex and time consuming process, and the debtor may lose control of the proceeding to the court and creditors who will be actively involved in the debtor’s financial situation.

The discharge granted to a debtor through a bankruptcy proceeding will not include certain taxes, as the following taxes are non-dischargeable: (1) income taxes incurred within 3 years of the bankruptcy filing date; (2) non-trust fund employment taxes incurred by an entity within 3 years of the bankruptcy filing; (3) excise taxes (e.g., corporate franchise tax or highway use tax) incurred within 3 years of the bankruptcy filing date; (4) customs duties incurred within 1 year of the bankruptcy filing date; (5) trust fund taxes (e.g., the portion of employment or sales taxes collected from the employee or customer), which are never dischargeable by an entity or by a responsible officer; (6) taxes arising from tax returns which have never been filed; (7) taxes arising from a “substitute for return” assessment by the IRS for an unfiled return; (8) taxes arising from fraudulent returns; (9) taxes arising from a debtor’s attempt to evade or defeat a tax; or (10) property taxes payable within the last year. See 11 U.S.C. §523(a)(1). Thus, in general, only those allowable taxes which are “ripe” (i.e., old enough) are dischargeable.

In addition, courts are split as to whether taxes arising from late-filed returns are dischargeable. A recent case in the Tenth Circuit Court of Appeals (covering Colorado, Kansas, Oklahoma, New Mexico, Wyoming, and Utah) found that filing a late return did not constitute a “return” for purposes of dischargeability in bankruptcy, even though the late return was filed before any IRS assessment. In re Mallo, 774 F. 3d 1313 (10th Cir. 2014). See also In re Johnson, 2016 WL 1599609 (Bankr. S.D. Fla. Apr. 18, 2016); In re Fahey, 779 F.3d 1 (1st Cir. 2015). Other courts have held to the contrary that the term “return” includes a late-filed return. See, e.g., In re Davis, 2015 WL 5734332 (D. N.J. Sept. 29, 2015); In re McBride, 534 B.R. 326 (Bankr. S.D. Ohio Apr. 9, 2015). However, the Seventh Circuit (including Illinois) has not yet weighed in on this issue, leaving some uncertainty whether tax liabilities arising from late-filed returns are dischargeable.

Bankruptcy filings are listed on a client’s credit report for up to ten (10) years. The bankruptcy filing can be discovered by a client’s present and future creditors and will adversely affect a client’s credit score. A client’s credit cards will be cancelled. Bankruptcy attorneys can assist clients in minimizing the impact of the bankruptcy on their credit, as well as discuss ways to improve the client’s credit score as quickly as possible after completing a bankruptcy case.

There are many factors that can determine whether a taxpayer should file bankruptcy, and if so, the type of filing. For example, the strategy may depend on the amount of a client’s unsecured debt (e.g., credit cards or medical expenses), secured debt (e.g., house or car loan), type and age of tax liabilities, health and financial situation, and future economic prospects. If a tax client appears to qualify for bankruptcy and has potentially dischargeable tax debts, a bankruptcy attorney should be consulted to conduct a more thorough review of the client’s tax liabilities, secured or unsecured debts, and other financial information. A bankruptcy attorney can also help your client determine whether any other options may be available to avoid the repercussions of bankruptcy, such as a loan modification or short sale of a home, direct negotiation of payment plans on credit card debt, reduction of interest rates, or IRS collection alternatives for tax liabilities.

We will continue our discussion of the tax implications of bankruptcy in the second part of this series.

Prepared by Sandra D. Mertens Esq. & Richard M. Dale, ESq. of Dale & Gensburg, P.C., 200 West Adams Street, Suite 2425, Chicago, IL 60606  Phone: 312.263.

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