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Federal Income Tax And Bankruptcy

Article written by Nicholas Gebelt, Los Angeles Bankruptcy Attorney - Law Offices of Nicholas Gebelt

This article discusses three important connections between federal income tax law and bankruptcy law. You should discuss these and any other factors relevant to your particular circumstances with a competent bankruptcy attorney before making any decisions about bankruptcy.

I. Dischargeability Of Taxes

A. Chapter 7, 11, 12, Or Chapter 13 Hardship Discharges Of Income Tax

One of the main goals in any bankruptcy is the discharge of debts. Some debts are easily discharged, while others are not. Contrary to popular belief, some taxes are dischargeable in bankruptcy. For a federal income tax debt to be discharged in a Chapter 7, 11, or 12 discharge, or in a Chapter 13 hardship discharge under 11 U.S.C. § 1328(b), the debt must satisfy three requirements pursuant to 11 U.S.C. § 523(a)(1). (As we will see in subsection B below, only the first two requirements apply to a non-hardship Chapter 13 discharge under 11 U.S.C. § 1328(a).)

First, the debtor must file the bankruptcy papers more than three years after the date the tax return was due - with extensions. For example, if the tax year in question is 2007, then the date the tax return was due, with extensions, was October 15, 2008. Therefore, to satisfy this requirement the debtor cannot file the bankruptcy papers before October 16, 2011. Notice that this requirement does not focus on whether the debtor actually filed the return, just on when the return was due.

Second, the debtor must have actually filed a legitimate, non-fraudulent return for the tax year in question at least two years before filing the bankruptcy papers. Continuing with the previous example, for the debtor to be able to file bankruptcy papers on October 16, 2011, the debtor must have filed the return no later than October 15, 2009. It should be noted that if the IRS files a "substitute for return" on behalf of the taxpayer because the taxpayer never filed a return, then this requirement cannot be satisfied.

Third, the IRS cannot have assessed the tax liability during the 240-day window immediately prior to filing the bankruptcy papers. Thus, in the previous example, for the debtor to file bankruptcy papers on October 16, 2011 the IRS cannot have assessed the tax after February 18, 2011. This particular requirement can be problematic because the 240-day clock is tolled during an offer-in-compromise, plus 30 days, and during any time in which a stay of proceedings against collections in a prior bankruptcy was in effect, plus 90 days. In applying this third requirement, one determines the applicable chronology by reviewing the tax transcript available from the IRS.

In sum, an income tax debt that satisfies all three of these requirements is dischargeable under any chapter. However, things are less stringent in a non-hardship Chapter 13 discharge.

B. The Chapter 13 Non-Hardship Discharge Of Income Tax

There are two ways a debtor can receive a Chapter 13 discharge. First, the debtor can receive a non-hardship discharge under 11 U.S.C. § 1328(a) upon completing all of the Chapter 13 plan payments. Second, the debtor can receive a hardship discharge under 11 U.S.C. § 1328(b), without making all of the plan payments, if: (1) the debtor becomes unable to complete the plan due to circumstances beyond the debtor's control, (2) the debtor has repaid the general unsecured creditors through the plan at least as much as they would have received in a Chapter 7 liquidation, and (3) modification of the plan is not practicable.

The difference in federal income tax dischargeability between the non-hardship and hardship discharges lies in the third requirement listed above. The third requirement does not have to be met in a non-hardship Chapter 13 discharge.

II. Cancelation Of Debt Income Tax

One reason debtors seek bankruptcy protection is to avoid cancelation of debt income taxation. Cancelation of debt income arises when a debt is discharged. A common scenario is when the debtor loses a home through foreclosure. If the state is a nonrecourse state - California is one such state - then after the foreclosure sale the foreclosing entity is prohibited from collecting any post foreclosure sale deficiency. Instead, the foreclosing entity will report the loss to the IRS, which will then credit the loss amount to the (former) homeowner as taxable income.

The Internal Revenue Code - in 26 U.S.C. § 108(a)(1) - has five exceptions to the usual cancelation of debt income tax liability. The first exception is for debts discharged in a title 11 case - i.e., in a bankruptcy. As long as the debtor files the bankruptcy papers before the foreclosure sale takes place, and eventually receives a discharge in that bankruptcy, then the debtor's personal liability on the mortgage will be discharged in a title 11 case. This means that the debtor will not owe income tax on that discharged debt.

However, if the debt is discharged before the debtor files for bankruptcy protection, then the debtor may face cancelation of debt income tax, unless one of the other exceptions of 26 U.S.C. § 108(a)(1) applies.

III. Shortened Tax Year Election

A. Splitting The Year In Two

In an individual bankruptcy filed under either Chapter 7 or 11, the debtor is permitted to split the year in which the bankruptcy papers are filed into two shortened tax years pursuant to 26 U.S.C. § 1398(d)(2). The first shortened year begins on January 1, and ends on the day before filing the bankruptcy papers. The second shortened year begins on the filing day and ends on December 31.

If the debtor makes this election, then the federal income tax liability for the first shortened tax year becomes an allowable claim against the bankruptcy estate, as a claim arising before the bankruptcy filing.

If the debtor does not make the election, then the IRS cannot collect any of that year's income tax liability from the liquidation of the nonexempt assets in the bankruptcy estate. However, the IRS can certainly collect the tax from the debtor's postpetition earnings.

B. The Nonexempt Asset Requirement

An important limitation to splitting the tax year is the requirement the debtor have nonexempt assets. These assets are available to pay creditors - including the IRS - in a bankruptcy.

If the debtor does have nonexempt assets, and if the debtor anticipates a tax liability for the prepetition portion of the year, then it makes sense to make the election. This is because the tax liability for the first shortened year is a prepetition claim that will be paid, at least in part, from the proceeds of the liquidation of the nonexempt assets - which the debtor wouldn't get to keep anyway. Consequently, the debtor's personal tax obligation for the year is reduced by the amount paid through the bankruptcy estate liquidation.

IV. Conclusion

This article has covered just a few of the many connections between federal income tax law and bankruptcy law. To get a more complete picture of the interaction between tax law and bankruptcy law, please discuss your case with a knowledgeable bankruptcy lawyer.

© Nicholas Gebelt, 2012

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