The intended beneficiaries of the humorously titled “Bankruptcy Abuse Prevention and Consumer Protection Act of 2005″ (BAPCPA) were the big banks and credit card companies — lobbying pays. The new law also helps those with alimony and child support awards. But a third winner was your friendly, neighborhood tax collector. In general, the BAPCPA makes bankruptcies more cumbersome and expensive. But it also exempts certain taxes that were previously dischargeable, and lengthens waiting periods before other taxes become dischargeable. In addition, delinquent taxpayers are now required to file unfiled returns, to stay in compliance thereafter, and to provide copies of returns to creditors and to the trustee. Nevertheless, for some people, bankruptcy can still be useful in dealing with unmanageable tax debts. In the paragraphs below we will outline the relevant rules as amended by the BAPCPA (though a full explanation of the complexities of the Bankruptcy Code is impossible in an article of this length).
Choose your Chapter.
Individual debtors typically use either Chapter 7 or Chapter 13. In Chapter 7, a trustee protects the interests of unsecured creditors. (Secured creditors are already protected by liens on the debtor’s assets.) Nonexempt assets, if any, are sold. Fully encumbered assets are usually abandoned, subject to the liens. No payments from post-petition earnings are required. However, in many cases filed after October 17, 2005, the effective date of the BAPCPA, this kind of simple Chapter 7 (which accounted for three out of four non-business bankruptcies) will be unavailable to many debtors.
Chapter 13 is for those who can make monthly payments. A debtor can’t have unsecured debts of more than $307,675, nor secured debts of more than $922,975. Payments are based on the debtor’s ability to pay. The trustee makes distributions to the creditors in accordance with their priority under the Bankruptcy Code. For a Chapter 13 plan to be confirmed, the payments must cover all priority debts in full. After the required payments, all dischargeable debts that remain unpaid are discharged. In the past, payments ran for as little as three years. But under the BAPCPA, some debtors will be required to make payments for five years. Worse yet, the computation of the ability to pay will now be based on the IRS’s standards for allowable living expenses. (Consequently, many bankruptcy lawyers who never before thought about taxes or IRS procedures are now getting a crash course in “IRS-speak.”)
Prior to the BAPCPA, Chapter 11 was rarely used by individuals, but was mostly for businesses seeking to “reorganize” their debts. A Chapter 11 is more complex and expensive than a Chapter 7 or Chapter 13. But after the BAPCPA, there will be debtors who can’t use Chapter 7, but who owe too much for a Chapter 13. These unfortunate souls may have to use Chapter 11, with the attendant difficultly, delay and expense.
Secured versus unsecured.
In bankruptcy, the IRS can be secured or unsecured, depending on whether a Notice of Federal Tax Lien has been filed. It can also be partially secured if a lien has been filed but the taxes exceed the equity reached by the lien. Liens for debts not paid during the bankruptcy survive the discharge. So while the debtor’s personal liability for a dischargeable tax is eliminated, the IRS’s claim against property encumbered by a pre-petition lien remains, and can be enforced by the IRS later.
Priority versus nonpriority.
Tax debts (like other debts) are categorized as to “priority,” or order of distribution. Certain taxes have an eighth priority, effectively making them nondischargeable. Under BC §507(a)(8)(A), a tax measured by income is a priority debt if the return was due (with extensions) less than three years prior to the petition date, or assessed less than 240 days prior to the petition date.
Computing these timing rules has been made more complicated by the BAPCPA. First, the Act changed the pre-reform rule that extends the BC §507(a)(8)(A)(ii) 240-day period for the time an offer in compromise is pending, plus 30 days, by expanding the operative phrase to read “pending or in effect. . .” Once filed, an offer is pending until withdrawn, rejected, or accepted and implemented. But what does “. . . in effect” mean? One requirement of an offer is that the taxpayer must timely file all returns and pay all taxes for five years after acceptance. If the taxpayer violates this “future compliance” obligation, the compromised taxes are revived. And in this brave, new, post-BAPCPA world, the IRS argues that an offer is “in effect” during the entire five year future compliance period.
In addition, language at the end of BC § 507(a)(8) extends both BC § 507(a)(8)(A) priority periods for the time the IRS is barred “from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days. . .” This includes a request for a collection due process hearing, or an appeal of an IRS decision rejecting an offer in compromise, installment agreement, or request for innocent spouse relief.
Third, the BAPCPA extends the priority periods for the time IRS collection action was barred by a prior bankruptcy, plus 90 days. A suspension of the BC §507(a)(8)(A)(i) 3-year from due date period was already required by cases culminating with the Supreme Court’s decision in Young v. U.S., 535 U.S. 43 (2002), but the BAPCPA codifies this result (and adds 90 days).
In short, computing when a tax debt becomes dischargeable, will require more knowledge of the history of the case. This added complexity will lead to greater uncertainty, more litigation, and more mistakes in pre-bankruptcy planning.
To round out the picture, BC §507(a)(8)(C), both before the BAPCPA and now, gives priority status to “a tax required to be collected or withheld and for which the debtor is liable in any capacity.” This covers the withheld portion of employment taxes, and the trust fund recovery penalty imposed against those who have responsibility to collect and remit such taxes, and who willfully fail to do so. This also prevents the discharge of sales tax debts.
Exceptions to discharge.
Other rules determining how taxes are treated in bankruptcy are found in BC §523(a)(1). These “exception to discharge” provisions don’t make the taxes “priority” debts, but taxes that fall outside either set of rules are not discharged.
In a Chapter 7, the order of distribution is determined by the relative priority of the debts. Unsecured taxes that are excepted from discharge under BC §523(a), but that are not priority debts under BC §507(a)(8), are grouped with other nonpriority unsecured debts, to be paid by the trustee when and if there is anything to distribute. If these nondischargeable debts are not paid, they survive, and must be resolved after the discharge.
To be confirmable, a Chapter 13 plan must provide for the full payment of all priority debts. But as noted, some taxes excepted from discharge may not be BC §507(a)(8) priority debts, and thus would not need to be paid under the plan. However, if such debts are neither paid nor discharged, they would have to be addressed later.
One important exception to discharge is found in BC §523(a)(1)(B): Taxes are excepted from discharge if the return was filed less than two years prior to the filing of the bankruptcy petition (or was not filed at all). This was true even in the good old pre-BAPCPA days. But as odd as it may seem, there is considerable debate over exactly what constitutes the filing of a tax return for this purpose, particularly in the context of “substitute for return” (SFR) assessments.
The IRS’s position is that after an SFR assessment has been made, submitting the delinquent Form 1040 does not constitute the filing of a return. The argument is that submitting a Form 1040 under these circumstances is a hollow gesture, since the IRS has already assessed the tax on its own. Thus, what purports to be a tax return does not serve the purpose of a tax return, i.e. to self-report one’s income and liability for tax. By this standard, no “return” has been filed. Therefore the two year from date filed requirement of BC §507(a)(8)(A)(i) is not satisfied, making the liability a nondischargeable priority debt.
The SFR assessment process starts with the issuance of a report giving the delinquent taxpayer 30 days to appeal by filing a “protest letter.” If the taxpayer doesn’t respond, the IRS issues a statutory notice of deficiency, starting a 90-day period in which a petition can be filed with the Tax Court. Absent a petition, the IRS assesses the tax shortly thereafter.
Sometimes the 90-day letter prompts the taxpayer to file a petition with the Tax Court, asserting that the IRS’s computation of the tax is erroneous. (Indeed, the IRS’s computation is often wrong; without a return, there is much information the Service doesn’t have, such as the basis of assets sold, and the taxpayer’s itemized deductions.) However, the typical nonfiler case is not litigated, but results in a negotiated stipulation, which is then incorporated into the Court’s order closing the case.
As amended by the BAPCPA, BC §523(a) now provides that the term “return” includes “a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal.” Accordingly, the mere commencement of the SFR process will not bar the discharge of the tax if the somnolent taxpayer wakes up and files a Tax Court petition before the assessment. The Tax Court’s order is considered a return for BC §523(a)(1)(B). So, sometimes a tax return is not a tax return, and sometimes something that is not a tax return is a tax return. Who writes this stuff?
The situation of a nonfiler who doesn’t file a Tax Court petition before the SFR assessment is made is less certain. As amended, BC §523(a) says that “(f)or purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).” The IRS will argue that this supports its side of the debate, in that a return filed so late that the Service is reduced to making an assessment on its own can hardly be viewed as satisfying the applicable filing requirements, which specify not only what is to be filed, but when. Taxpayers will argue that providing the information required by a Form 1040, and mailing it to the address specified by the IRS, constitutes compliance with the filing requirements. We will have to see how this addition to BC §523(a) will be interpreted. However, getting a post-SFR tax return to be treated as a return for BC §523(a)(1)(B) will probably remain an uphill battle.
A recent case presenting this issue is the decision of the Eighth Circuit in Colson v. U.S., 2006 U.S. App. LEXIS 11039 (Feb. 6, 2006). Mr. Colson filed his missing returns after SFR assessments were made, and more than two years thereafter he filed a Chapter 7. The IRS argued that these tardy documents were not “returns,” and that the taxes were nondischargeable priority debts. The Eighth Circuit rejected the IRS’s position that the debtor’s subjective intent in filing had to be determined. Following Beard v. Commissioner, 793 F.2d 139 (6th Cir. 1986), it held that “if a document contains enough information to permit a tax to be calculated, and purports to be a return, is sworn to as such, and evinces an honest and genuine endeavor to satisfy the law, it is a return.” The debtor’s subjective intent, the Court said, is irrelevant. Since this was a pre-BAPCPA case, the Court decided it without applying the new language of BC §523(a) defining a return as something that “satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”
Unfortunately, this is in conflict with the law in the Fourth Circuit. In Moroney v. U.S., 352 F.3d 902, 907 (4th Cir. 2003), the Court found that the debtor’s intent in filing was relevant, and that evidence of intent could be found in the fact that the return was not filed until long after its due date, and after the IRS had already made an assessment. The IRS’s use of the new information contained in the document to abate a portion of the previous SFR assessment did not make the filing sufficiently useful to call it a return. Similarly, the Seventh Circuit held in In re Payne, 431 F. 3d 1055, 1057 (7th Cir. 2005), that the main purpose of a return is to spare the IRS the burden of computing the tax on its own, and that anything filed after the IRS had done so was not a reasonable attempt to comply with the obligations to timely file and pay the required tax.
This question is even more important after the BAPCPA, because an escape hatch previously available to deal with unfiled or late filed tax returns has been slammed shut. As mentioned, prior to the BAPCPA, Chapter 13 had a superdischarge aspect that permitted the discharge of many debts that weren’t dischargeable in Chapter 7. In the past, Chapter 13 permitted the discharge of taxes when the returns had been filed less than two years before the petition date, or had not been filed at all. But the list of debts excepted from discharge under BC §1328(a)(2) has now been expanded by BAPCPA to include a debt “of the kind specified . . . in paragraph 1(B) . . . of section 523(a).” Thus, when no return has been filed, or when a return was filed late and within two years of bankruptcy, the resulting tax liability will no longer be dischargeable in Chapter 13.
Another nasty kind of liability that in the past could be handled in Chapter 13 is one arising due to fraud. Such debts have always been nondischargeable in a Chapter 7 because BC §523(a)(1)(C) excepted from discharge any tax “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat. . .” But again, BC §1328(a)(2) has been revised by the BAPCPA to prevent the discharge of such liabilities even in Chapter 13. A finding of nondischargeability under BC §523(a)(1)(C) is not limited to cases in which the taxpayer is convicted of tax evasion, but that will certainly do the trick.
Restrictions on access to bankruptcy.
Even while the treatment of taxes in Chapter 13 has grown to more closely resemble that of similar liabilities in Chapter 7, the BAPCPA has imposed a new means testing system for those with “primarily consumer debt,” preventing many debtors from filing under Chapter 7 at all. However, income taxes are not considered consumer debt. And thus a debtor whose biggest creditor is the IRS may avoid the problem altogether. Consequently, an element of all future pre-bankruptcy planning will be measuring and perhaps managing the balance between the client’s consumer and nonconsumer debt.
Under the BAPCPA, a Chapter 7 involving primarily consumer debt will be dismissed (unless first converted to Chapter 11 or Chapter 13) upon a finding of abuse. Such a finding can be based (1) on a presumption applicable under certain circumstances, or (2) on general grounds including bad faith considering the totality of the facts. If the debtor’s income is above the median income for the state in which the case is filed, either the presumption or the general grounds standard can be raised by the Court, the trustee, or a creditor. The presumption is inapplicable if the debtor’s income is below the median income level for the state.
If the means test applies, it compares monthly income to “allowable” deductions. Income is defined as the debtor’s average income over the six full months prior to the petition date. (Even if only one spouse files bankruptcy, income includes that of the nonpetitioning spouse.)
The deductions start with those used by the IRS in determining how much a taxpayer could afford under an installment agreement, or whether to accept an offer in compromise. These include the IRS’s national standard for food, clothing, etc.; a local transportation standard; a county-specific standard for housing and utilities; plus “other necessary expenses.” The BAPCPA provides that these include health care costs; health and disability insurance; expenses for an elderly, chronically ill or disabled family member; up to $1,500 per year per dependent child for public or private elementary or secondary school; and contributions to charity up to 15% of gross income. Alimony and child support payments will also be allowed. Next, because the purpose of the means test is to determine what the debtor could afford to pay to the nonpriority unsecured creditors, the computation deducts contractually scheduled payments to secured creditors for the five-year period after the petition date.
The conversion to Chapter 11 or Chapter 13 will permit the discharge, but at the price of making monthly payments. As noted above, Chapter 13 plans will require payments for five years if the debtor’s income is above the median income level for the state. In addition, payments under Chapter 13 plans may be higher. The reason is the legislative transplanting of the IRS’s collection standards into the Bankruptcy Code (with modifications that are too complex for an article of this length, but that must be carefully applied to the facts in each case). In the pre-BAPCPA era, Courts and trustees were often more liberal in evaluating a debtor’s budget than the IRS would have been.
Unfortunately, many debtors can’t fit into Chapter 13 because of the debt limitations. If the debtor is tossed out of Chapter 7, but has debts exceeding the Chapter 13 limits, the only remaining option is a Chapter 11. A Chapter 11 is more complicated, cumbersome, expensive and unpredictable than a Chapter 7 or a Chapter 13. This will be a significant disincentive to the debtor seeking a fresh start through bankruptcy if Chapter 7 and Chapter 13 are unavailable.
Another victim of BAPCPA was the “Chapter 20″ technique. In the past, under some circumstances a debtor could file a Chapter 13 immediately after receiving a Chapter 7 discharge. The Chapter 13 could deal with debts that survived the Chapter 7 (using the now departed superdischarge aspects of Chapter 13). The BAPCPA imposes restrictions on successive bankruptcies, effectively killing this approach. A Chapter 13 discharge is now barred in a case filed within four years from the petition date in a prior Chapter 7 if a discharge was entered, or for two years from the petition date in a prior completed Chapter 13. (The time between discharges in Chapter 7 cases also has been extended — from six years to eight years.)
New obligations to file tax returns.
In a further melding of the tax and bankruptcy worlds, the BAPCPA contains several new provisions regarding the filing and disclosure of tax returns.
First, under BC §521(d)(2)(A)(i) a debtor in Chapter 7 or Chapter 13 must give the trustee a copy of the tax return (or a return transcript) for the year preceding the year in which the petition is filed. In addition, BC §1308(a) now requires that no later than the day before the BC §341 hearing in a Chapter 13 the debtor must file all tax returns that were due for the four tax years prior to the year in which the petition is filed. Within limits, the trustee can continue the meeting of creditors to give the delinquent debtor more time to file the returns.
Compliance with the new BC §1308(a) obligation to file pre-petition returns is coupled with new BC §1325(a)(9), permitting the Court to confirm a Chapter 13 plan only if the debtor has filed the required pre-petition returns. And in addition to catching up on unfiled returns, the BAPCPA requires that the debtor file post-petition returns by their due dates (with extensions). Upon a request by the Court, the trustee or a party in interest, the debtor can be required to file with the Court copies of all returns due while the case is pending, including returns required during the life of the Chapter 13 payment plan.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 has made it more difficult for many people to obtain relief from their debts in bankruptcy. For those faced with overwhelming tax liabilities, bankruptcy is still worth considering. But whether relief is available will depend on how the facts of the case fit with the new rules. Those with substantial consumer debts (including home mortgages) may find that bankruptcy will no longer work. And all of this comes at a time when offers in compromise, as an alternative to bankruptcy, are getting even more difficult and more expensive due to the new offer deposit requirements imposed by the Tax Increase Prevention and Reconciliation Act of 2005. All things considered, owing taxes is not nearly as much fun as it used to be.