The intersection of tax law and bankruptcy is a complex and esoteric area of the law. Classes in this area are often taught too fast for most people to absorb, and many simply never get it. Helping people realize that they have a problem and then bringing in help is sometimes what works. I think issue spotting is as essential as problem-solving, and I have put together a checklist of some things to be aware of as we focus on bankruptcy tax.
First and foremost, every business owner needs at least the following essential ingredients to be successful: (1) a good accountant, (2) a reliable bookkeeper, (3) QuickBooks or other software, and (4) a payroll service provider such as ADP or Paychecks. Advising a client to have these four cornerstones in place can go a long way in helping a client either avoid a problem or help right the ship.
The following is a list of common tax issues faced by individuals and businesses under the microscope of the Internal Revenue Service or one of the California taxing authorities. When meeting with a client considering bankruptcy or who just needs help with restructuring debts, ask the client about these issues to better handle the situation. This list will help you spot the problems to address them later with tax counsel or an accountant.
The Bankruptcy court may determine the amount or legality of any tax, fine or penalty, whether or not the IRS has not assessed the taxes or the taxes were paid. [11 USC 505(a)(1)]
The court may not determine the amount of a tax, fine or penalty if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case under this title.” [11 USC 505(a)(2)]
So, if the Tax Court has already decided the issue, the debtor cannot re-litigate the case in Bankruptcy Court.
Example: Taxpayer files petition in U.S. Tax Court and the Court decides the issue. Taxpayer/debtor cannot re-litigate the issue in bankruptcy court. But, if the IRS issued a notice of deficiency, and the taxpayer defaulted on the notice, the taxpayer/debtor can litigate the issue in Bankruptcy Court. The debtor does not need a new notice of deficiency to litigate the case in Bankruptcy Court.
In summary, if the Tax Court decided the issue, you can’t relitigate it. Debtor does not need a need a notice of deficiency or Collection Due Process Rights. IRS files claim, debtor files objection. The bankruptcy court has broad authority. Another way for debtor to resolve tax disputes that the taxpayer was unable to do in audit, Tax Court, a Collection Due Process Hearing. It’s almost like a second or third bit of the apple!
The IRS enters the bankruptcy case and “frames” its case by filing a Proof of Claim for Internal Revenue Taxes, and an annotated samples are attached at the end of this manual. It’s important to know how to read and understand the IRS Proof of Claim, and below are a few key things to know.
Unsecured Priority Claims
This column details the priority claims under 11 USC 507(a)(8), and below are a few key things to know about the IRS Proof of Claim.
If the IRS has filed a proof of claim, determine whether the IRS properly filed the Notice of Federal Tax Lien. If the lien is not filed correctly, the IRS has an unsecured claim. Also, determine whether the lien has expired because a NFTL generally only lasts ten years.
Place of Filing
Lien Rides Through Bankruptcy – in Rem
The lien also attaches to property that the debtor acquires post-petition. [11 Collier on Bankruptcy P TX4.04 (16th 2022) (The IRS’s tax lien continues as an in rem claim against the debtor’s assets until an amount equal to the fair market value of the assets subject to lien is paid in full.)]
When and How the Lien Arises
Transfer of Property Subject to Lien
Duration of the Lien
A Chapter 7 discharge does not include certain debts that are nondischargeable under § 523. [B.C. § 727(b)]
A discharge under Chapter 11 “does not discharge a debtor who is an individual from any debt excepted from discharge under section 523 of this title.” [11 USC § 1141(d)(2)]
Section 1328 provides that a court shall grant a debtor a discharge of all debts provided for by the plan except a debt for trust fund taxes [§ 507(a)(8)(C)], unfiled or late-filed returns [§ 523(a)(1)(B)], and fraudulent returns [§ 523(a)(1)(C)].
Section 1322 provides that the plan shall provide for full payment, in deferred cash payments, of all claims entitled to priority under § 507. This means that you must determine whether the IRS has a priority claim and if so, the plan must full pay the balance due.
Section 523(a) sets forth the exceptions to a discharge in a Chapter, 7, Chapter 11, and a hardship discharge under Chapter 13. [11 U.S.C. § 523(a), § 1141(d)(2), § 1328(b)].
11 U.S.C. § 523(a)(1)
A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
(1) for a tax or a customs duty—
(A) of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed;
(B) with respect to which a return, or equivalent report or notice, if required—
(i) was not filed or given; or
(ii) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition; or
(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax;
Section 507(a)(8) provides that certain allowed unsecured claims of governmental units (e.g., IRS, Franchise Tax Board, California Department of Tax and Fee Administration) are entitled to eighth priority. These unsecured claims include the following:
Priority claims generally are the first unsecured claims to be paid in a bankruptcy case following distribution to secured creditors.
11 U.S.C. § 507(a)(8)(A)
(a) The following expenses and claims have priority in the following order:
(8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for—
(A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition—
(i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
(ii) assessed within 240 days before the date of the filing of the petition, exclusive of—
(I) any time during which an offer in compromise with respect to that tax was pending or in effect during that 240-day period, plus 30 days; and
(II) any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240-day period, plus 90 days; or
(iii) other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case;
The required tax return was last due (including extensions) within three years of the petition date [11 USC § 507(a)(8)(A)(i)]. To determine whether an unsecured tax claim qualifies under the three-year rule, ask the following questions:
Did the debtor obtain a valid extension of time to file the return? If so, the due date for filing the return is October 15.
If the due date falls on a weekend or holiday, the due date moves forward to the next day.
The IRS extended the due date for filing returns during COVID-19.
Example: Debtor’s 2012 tax return is due 4/15/2013. Debtor obtained a valid extension to file by 10/15/2013. Debtor filed a return early on 7/1/2013. Petition filed 8/1/2014.
Internal Revenue Service Filing Deadlines
California Franchise Tax Board Filing Deadlines
Sales and Use Tax Returns Filing Deadlines
Extension of Time to File Tax Return
IRS Account Transcripts
The IRS Account Transcript will tell you the due dates of the returns, date(s) of assessment, account balances, and other helpful information. The transcripts can be obtained online after submitting Forms 2848 and 8821 online. https://www.irs.gov/tax-professionals/submit-forms-2848-and-8821-online
The Centralized Authorization File (CAF) Unit will process Forms received online on a first-in, first-out priority. Once the IRS processes the form, the IRS Account Transcript can be obtained online if you have established an account with the IRS. https://www.irs.gov/individuals/get-transcript
Similar information can be obtained from the California Franchise Tax Board. Send a fax to the FTB Bankruptcy Section with Form 3520 (power of attorney) and request the information. See FTB Publication 933 C for contact information.
Even if the governmental unit passes the Three-Year Rule, the tax claim nevertheless may be classified as an eighth priority if the claim satisfies the 240-day rule.
Any income taxes and gross receipts taxes assessed within 240 days prior to the filing of a petition will be classified as eighth priority, nondischargeable tax liabilities in Chapter 7 and 11. [11 USC § 507(a)(8)(A)(ii)]
Tolling of the 240-Day Rule
If a taxpayer files an offer in compromise, the 240 days are extended by the time the offer was pending plus 30 days. [11 USC § 507(a)(8)(A)(ii)(I); U.S. v. Klein (In re Klein), 189 B.R. 505 (C.D. Cal. 1995)]
If a stay against collection in a prior bankruptcy case was in effect, the 240-day period is extended by the time during which the stay was in effect plus 90 days. [11 USC § 507(a)(8)(A)(ii)(II)]
The 240-day period is also suspended under the hanging paragraph at the end of 507(a)(8). A request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days.
IRS issued a Statutory Notice of Deficiency on January 1, 2018. The taxpayer failed to file a Tax Court petition timely within 90 days, and the IRS assessed the taxes on May 1, 2018. Chapter 13 petition filed June 1, 2019; case dismissed 60 days later on July 31, 2019. Chapter 7 petition filed February 2, 2020. 240-day lookback period: February 2, 2020 to January 8, 2019 (Petition Date – 390 days (240 days + 90 days + 60 days). No priority status under § 507(a)(8)(A)(iii). An IRS claim could still be entitled to priority status if the three-year rule is met.
IRS Assessment Dates
FTB Assessment Dates
California Sales and Use Tax
The third rule under 11 USC 507(a)(8)(A) grants priority status to an unsecured governmental unit claim for taxes that were not assessed but are assessable (under applicable law or by agreement) after the filing of the petition, other than a tax liability for unfiled or late-filed returns, fraudulent returns, and tax evasion.
(iii) other than a tax of a kind specified in section 523(a)(1)(B) [unfiled or late-filed returns] or 523(a)(1)(C) [fraudulent return or willful attempt to evade or defeat such tax] of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case ….
The key to determining whether the governmental unit can assess taxes after the debtor has filed bankruptcy is knowing the statute of limitations for assessing taxes. The rules are complex and detailed, but below are a few highlights:
Statute of Limitations – IRS
Statute of Limitations – California Franchise Tax Board
FTB Notification Responsibilities
Taxpayers have notification responsibilities to California if the IRS examines a return and makes adjustments that increase the tax for any year. [Cal. Rev & Tax C § 18622(a)]
Two Years – If a taxpayer reports the change or correction within the six-month months after the final federal determination (or the IRS reports that change within six months), the FTB has two years from the date the FTB receives a report of the federal change to apply the federal change to a taxpayer’s California income tax return. [Cal. Rev & Tax C § 19059(a)]
No Statute of Limitations – If a taxpayer fails to report a change made by the IRS, the FTB can mail a NPA resulting from the adjustment to the taxpayer at any time. [Cal. Rev & Tax C § 19060(a)]
Four Years – However, if the FTB receives the change or correction after six months, the FTB has a much longer time, four years, to issue a NPA to a taxpayer. [Cal. Rev & Tax C § 19060(b)]
Whatever you do at the federal level, you must also match and do at the state level.
The debtor’s state tax liability was not dischargeable under § 523(a)(1)(B)(i) where the debtor failed to report IRS tax assessments to the California Franchise Tax board. [Berkovich v. Cal. Franchise Tax Bd. (In re Berkovich), 619 B.R. 397 (B.A.P. 9th Cir. 2020)]
Statute of Limitations – California Sales and Use Tax
A property tax incurred before the commencement of the case and last payable without penalty after one year before the date of filing the petition. [11 USC § 507(a)(8)(B)]
Trust fund taxes are income taxes, social security taxes, and Medicare taxes you withhold from an employee’s wages as their employer. The income tax, employee share of social security tax, and the employee share of Medicare tax that you withhold from your employees’ pay are part of their wages you pay to the Treasury instead of to your employees. The taxes are called trust fund taxes because they are held in trust until they are paid to the Treasury, and your employees trust that you will pay the withholding to the Treasury by making Federal Tax Deposits (FTD). [IRS website.]
Employment taxes for which a return was last due within three years before filing a bankruptcy petition is an 8th priority tax. [11 USC § 507(a)(8)(D)]
Employee’s shares of employment taxes (Social Security and Medicare taxes on debtor’s wages)
Tax penalties are dischargeable if the penalty relates to a tax liability that does not fall within the exception to discharge under § 523(a)(1) (gap taxes, 8th priority taxes, no tax return filed, delinquent tax return, fraudulent return, willful attempt to evade or defeat tax). [11 USC § 523(a)(7)(A)]
Tax penalties are also discharged if they relate to a tax year more than three years before filing the bankruptcy petition. [11 USC § 523(a)(7)(B)]
11 USC § 523(a)(7)(B)
(a) A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
(7) to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty—
(A) relating to a tax of a kind not specified in paragraph (1) of this subsection; or
(B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition;
A late-filed return is a tax return filed after the due date and expiration of any extension of time to file the return, and the return is filed two years before the filing of a bankruptcy petition. [11 USC § 523(a)(1)(B)(ii)].
Treatment of late-filed returns can vary depending on where the debtor is located.
Return filed one day late→ not eligible for dischargeability.
Return filed after the IRS assesses a Substitute for Return (SFR)→ the tax amount up to the SFR amount is not eligible for dischargeability; any excess of tax above the SFR amount could be dischargeable
Smith v. United States IRS (In re Smith), 2016 U.S. App. LEXIS 12859 (9th Cir. July 13, 2016)
“Here, Smith failed to make a tax filing until seven years after his return was due and three years after the IRS went to the trouble of calculating a deficiency and issuing an assessment. Under these circumstances, Smith’s “belated acceptance of responsibility” was not a reasonable attempt to comply with the tax code. Many of our sister circuits have held that post-assessment tax filings are not “honest and reasonable” attempts to comply and are therefore not “returns” at all.” Id. at 1097.
Return filed late, but before the IRS finalizes an SFR→ can be dischargeable
What is an SFR? How to know if one was filed on behalf of your client?
A tax with respect to which a return, or equivalent report or notice, if required, was not filed or given, is nondischargeable in Chapters 7, 11, or 13. [11 USC § 523(a)(1)(B)(i)]
If there is an unfiled return and the debtor decides to late-file the return, see discussion above on delinquent returns.
Franchise Tax Board requires taxpayers to report changes or corrections made by the IR that increase the amount of tax owed to the FTB within six months of the final federal determination. [Cal. Rev. & Tax Code. § 18622]
If a debtor fails to report the changes, the state taxes are not dischargeable. See Berkovich v. Cal. Franchise Tax Bd. (In re Berkovich), 619 B.R. 397 (B.A.P. 9th Cir. 2020) (debtor failed to file a report with the FTB following IRS’ assessment, and thus, debtor’s state tax debts were exempted from discharge under § 523(a)(1)(B)).
Any tax with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax. [11 USC § 523(a)(1)(C)]
Look for civil fraud penalty under 26 USC § 6663.
The existence of fraud is to be determined by considering all the facts and circumstances. [Stratton v. Commissioner, 54 T.C. 255, 284 (1970)]
The Government bears the burden of proof and must show clear and convincing evidence of each element of fraud. [26 USC § 7454(a); Rule 142(b), Tax Court Rules of Practice and Procedure]
The IRS must show that the taxpayer intended to commit fraud, which has been described as an “intentional wrongdoing * * * motivated by a specific purpose to evade a tax known or believed to be owing.” [Citations omitted] The elements to be shown are (1) an underpayment of tax, and (2) that some part of this underpayment was due to fraud.” [Hebrank v. Commissioner, 81 T.C. 640, 642 (1983)]
Fraud is established by proving that a taxpayer intended to evade tax believed to be owing by conduct intended to conceal, mislead, or otherwise prevent tax collection. [Clayton v. Commissioner, 102 T.C. at 647; Pittman v. Comm’r, 100 F.3d at 1319]
Declaring a tax debt non-dischargeable under 11 U.S.C.S. § 523(a)(1)(C) on the basis that the debtor willfully attempted in any manner to evade or defeat such tax required a showing of specific intent to evade the tax. [Hawkins v. Franchise Tax Bd., 769 F.3d 662 (9th Cir. 2014)]
Willful attempts include declining to file tax returns, shifting assets to another person or a false bank account, shielding assets, and switching all financial dealings to cash. [Id. at 667-668]
“The primary, but not exclusive, theory of the IRS and FTB was that the Hawkinses’ maintenance of a rich lifestyle after their living expenses exceeded their income constituted a willful attempt to evade taxes.” [Id. 665-66. Remanded to reanalyze the case using the specific intent standard.
Fraudulent failure to file tax returns and pay taxes can be a basis for nondischargeability. [Toti v. United States (In re Toti), 24 F.3d 806, 808 (6th Cir. 1994) (Debtor’s failure to file returns and to pay taxes were willful acts, and thus, he willfully attempted to evade or defeat his tax liability within the meaning of 523(a)(1)(C))]
An important issue to be aware of are unpaid sales and uses taxes, particular with a failing business. The California Department of Tax and Fee Administration can hold a personal personally liable for unpaid sales taxes in certain situations.
Upon the termination, dissolution, or abandonment of a business, a person who is charged with the responsibility of for filing the returns or the payment of the tax, or who is under a duty to act, can be personally liable for any unpaid taxes, interest and penalties, if the person willfully fails to pay or causes to be paid any taxes due. [Cal. Rev. & Tax Code § 6829(a)]
Who Can Be Liable?
An “officer, member, manager, partner, or other person” can be liable for taxes that became due during the period he or she had “control, supervision, responsibly, or duty to act” for the business. [Cal. Rev. & Tax Code § 6829(b)]
What California Must Prove
Personal liability may be imposed only if the California Department of Tax and Fee Administration can establish one of two conditions:
For purposes of section 6829, “willfully fails to pay or to cause to be paid” means that
the failure was the result of an intentional, conscious, and voluntary course of action. This is the same definition of willfulness for civil fraud under 26 USC § 6663.
Statute of Limitations
The statute of limitations for issuing a notice of determination can be either three years or eight years, depending on when the Board obtains a
Practice Tip: A business owner should provide written communication of the termination, dissolution, or abandonment of the business so as to trigger the three-year statute of limitations; and otherwise, the Board has eight years to issue a notice of determination.
Sales and use tax issues can arise in bankruptcy.
If the Board holds an individual personally liable for unpaid sales and use taxes, the taxes are priority taxes. 11 USC § 507(a)(8)(C). See discussion above.
In addition, unpaid sales taxes also can be assessed long after they have not been paid. A debtor’s tax liability for unpaid sales taxes was not discharged because the tax was not assessed but remained assessable under 11 USC § 507(a)(8)(A)(iii). See In re Ilko, 2009 Bankr. LEXIS 4541 (B.A.P. 9th Cir. Oct. 15, 2009).
“… because responsible person liability does not arise under Tax Code § 6829 until a corporation dissolves, terminates or abandons its business, the statute of limitations for issuing a notice of dual determination to a responsible person begins to run when the liability arises. Since debtor was not liable for the taxes until EAS ceased operations on March 31, 2003, which was after the July 3, 2001 commencement of his bankruptcy case, the Board asserts that the taxes were still assessable by law.” Id. at *22-23 (B.A.P. 9th Cir. Oct. 15, 2009).
Example: Trustee Sells Personal Residence
Suppose that the trustee sells your client’s principal residence in a chapter 7 case. Is the trustee allowed to consider 26 USC § 121 exclusion of gain from the sale or exchange of a debtor’s principal residence?
Yes. For purposes of the rules relating to a bankruptcy estate succeeding to a debtor’s tax attributes, a bankruptcy estate succeeds to and takes into account the section 121 exclusion with respect to the property transferred into the estate. Reg §1.1398-3(c). This rule applies to cases under chapter 7 or chapter 11 of the Bankruptcy Code, but only if the debtor is an individual. Reg § 1.1398-3(a). For purposes of Reg §1.1398-3, the Code Section 121 exclusion means the exclusion of gain from the sale or exchange of a debtor’s principal residence. Reg §1.1398-3(b).
If an election is made under section 1398, the debtor’s tax year is divided into two short tax years:
Example: No Election
Tom, a calendar year taxpayer, files a chapter 7 bankruptcy petition on March 15, 2016. Is Tom’s tax year affected by the filing of the chapter 7 case? Does Tom file a Form 1040 for the entire year or only pick up income (and claim any deductions) up to the filing date of her chapter 7 case?
Assuming that Tom does not make a short-year election, his tax year is not affected by the filing of a chapter 7 case on March 15, 2016. Code Sec. 1398(d)(1). Tom files a Form 1040 for the entire year, but her return includes only income and deductions that accrued before the commencement of bankruptcy, as well as those accruing after bankruptcy that relate to property acquired after bankruptcy or exempt property. Code Sec. 1398(e)(2); also see Checkpoint EXP ¶13,984.05 Debtor’s election of short tax year.
If Tom makes an election under Code Sec. 1398, when does the first short tax year begin and end? When does the second short year begin and end?
If the election is made, Tom’s tax year is divided into two short tax years:
See Checkpoint EXP ¶13,984.05 Debtor’s election of short tax year.
Effect on Bankruptcy
What happens if the IRS takes collection action after the debtor receives a discharge?