Bankruptcy: An Overview

An in depth discussion of bankruptcy is beyond the scope of this outline. However, since bankruptcy is often an extremely useful tool in dealing with tax liabilities, some discussion is essential. There are four types of bankruptcies that can be utilized by a troubled taxpayer, the appropriateness of each depending on the circumstances. The choices consist of a chapter 7,11,12 and 13 and the attributes of each one can be summarized as follows

A chapter 7 can be filed by an individual, a partnership or a corporation. It involves the liquidation of debtor's non-exempt assets, with the proceeds being distributed to creditors. The gathering of assets, the sale of the assets, and the payment of creditor's claims, are the responsibility of a chapter 7 trustee. Although a chapter 7 Bankruptcy causes the dissolution of a partnership or corporation, obviously an individual continues to exist after bankruptcy. Therefore, the goal of the an individual chapter 7 is to obtain a "fresh start", even if it is at the risk of losing ones assets. This fresh start is possible because the bankruptcy code provides for the discharge of most pre-petition debts, whether or not they are paid in the liquidation.

Often a chapter 7 can be virtually painless in that no assets are actually lost. This may be due to the fact that the debtor had no assets to liquidate or the assets were exempt. In order to help facilitate the “fresh start", Congress allowed for certain exemptions so the debtor was not left totally destitute. The Code sets forth federal exemptions but also provides that the States can opt out of these exemptions and allow for the utilization of that particular State’s exemptions. New York has opted out of the federal exemptions. Thus, a debtor filing bankruptcy in New York can utilize the New York exemptions available against creditors in non-bankruptcy situations. These exemptions include a $50,000 homestead exemption ($100,000 in a joint bankruptcy), a $2,400 exemption in a motor vehicle and an exemption for a qualified ERISA plan or IRA. [Note: These exceptions also apply outside of bankruptcy against enforced collection by non-consensual creditors. However, these exemptions do not apply to the IRS.]

Unlike a chapter 7, a chapter 11 normally does not involve a liquidation. The goal of a chapter 11 is to reorganize the debtor and to come up with a plan to pay creditors over time. The Code requires that the debtor provide a disclosure statement to creditors which sets forth financial information regarding the debtor and explains why the creditors should vote for the confirmation of the plan. The code also sets forth specific requirements for the contents of the plan and what type of creditors have to be paid in full. Unsecured creditors normally only have to receive what they would receive in a chapter 7 liquidation, which is often pennies on the dollar. The plan must provide for creditor’s treatment by breaking down creditors into different classes. The creditors are entitled to vote to accept or reject the plan. To be accepted, creditors who vote “yes” must hold at least 2/3 in amount and ½ in number of the claims of those who voted. If this is met and the plan meets all other statutory requirements, the plan will be confirmed. Even if a class votes against acceptance, the Court can still confirm the plan if it finds that it is fair and equitable. This is referred to as a “cram down”. Once the plan is confirmed, all pre-petition creditors are bound by its terms.

Although available to individuals, chapter 11 is usually utilized by corporations. This is primarily due to the fact that individuals, subject to certain debt limitations, can utilize a chapter 13, which is more advantageous due to its simplicity and broader discharge provisions. Chapter 11 differs from a chapter 7 or 13, in that there normally is no trustee in an 11 and the Debtor continues to operate as a "debtor in possession”or “DIP”. A trustee is appointed only in rare instances, usually when there is mismanagement or fraudulent conduct by the DIP. However, the United States Trustee, and in some cases a creditor's committee, provide some oversight of the debtor's activities.

As in the case of a chapter 11, a chapter 13 allows the debtor to pay his or her creditors over time through a plan. The plan can go a maximum of 5 years, and must pay creditors what they would have received in a chapter 7. There is also a requirement that if creditors are not being paid in full, the debtor must be fully using his or her disposable income to fund the plan. Plan payments are made to a chapter 13 trustee, who then pays the creditors pursuant to the plan. Use of a chapter 13 is limited to individuals with regular income. Also a debtor can not qualify for a 13 if he or she has more than the unsecured debt or secured debt limits (adjusted for COLA). As discussed more fully below, the discharge provisions of a chapter 13 are broader than a chapter 7 and individual 11.

As with any creditor, bankruptcy can be a valuable tool in dealing with a State or Federal tax liability. A major benefit applicable for all chapters is the automatic stay that goes into effect immediately upon the filing of the bankruptcy petition. Section 362 of the bankruptcy code provides for the stay of all collection activity. Creditors, including the IRS, must immediately cease any collection action against the debtor. Even telephonic or written communication relating to collection is prohibited. Violations of the stay provisions may constitute contempt and damages can be awarded. The IRS Restructuring and Reform Act of 1998 provides for damages against the Service up to $1,000,000 for stay violations.

The automatic stay provides breathing space to a financially troubled debtor. If the IRS, or any other creditor is threatening to seize assets, a bankruptcy petition will immediately stop any action. Moreover, even if the creditor has already seized or levied on an asset that is necessary for a successful reorganization, as long as the asset is not cash and has not yet been sold, the debtor generally can force the return of the asset or release of the levy. If the asset involved is not returned and does not have an equity cushion, adequate protection can be demanded by the secured creditor. This usually involves periodic cash payments to protect the creditor from depreciation of the property during the period the debtor is developing a plan. Since a chapter 13 plan is usually confirmed shortly after the petition is filed, adequate protection is not usually an issue. On the other hand, in a chapter 11, it often takes more than a year before a plan is confirmed. In such case, adequate protection becomes a significant issue.

In addition to the stay on collection and the ability to force seized property to be returned, both a chapter 11 and a chapter 13 allow the payment of taxes over time, sometimes without interest. Moreover, under certain circumstances, tax liabilities, like other creditors, can be discharged in bankruptcy without full payment. As with other dischargeable debts, if a tax liability is discharged, the Service is normally forever barred from trying to collect the liability. Therefore, in order to adequately represent a client with serious tax problems, it is imperative to understand what is dischargeable in a bankruptcy.

The Bankruptcy Code sets forth an order in which certain types of creditors will be paid. The type of creditors consists of secured creditors, administrative creditors, priority creditors and unsecured creditors. Secured creditors are creditors possessing a pre-petition lien on an asset or assets of the debtor. The Service will be secured if a notice of federal tax lien was filed prior to the bankruptcy and the debtor had property to which the lien attached. It should be noted that the federal tax lien attaches to all property and rights to property belonging to the debtor. Generally, secured creditors must be paid the full value of the asset securing their claim or must be given the asset.

Administrative creditors are creditors whose claims came into existence after the bankruptcy filing. Examples of administrative claims includes attorney's fees, trustees fees, and taxes arising during the pendency of the bankruptcy but prior to plan confirmation. The Code provides for these claims to be paid as a first priority. The Code also provides for certain pre-petition claims to be paid as priority. Tax claims are paid as an eighth priority. As a "priority claim" these taxes will be paid ahead of other unsecured creditors. Since the Code provides that priority taxes are not dischargeable in a Chapter 7 or individual 11, and full payment of priority taxes must be provided for in order for a Corporate 11 or Individual 13 plan to be confirmed, whether a tax liability qualifies as a priority claim is a critical question. This is addressed more fully below.

Creditors holding secured status in a bankruptcy context are entitled to receive full payment on their claim or to be given the asset for which the claim is secured on. In a Chapter 13 or Chapter 11 context, a secured creditor is entitled to interest on their claim paid through the course of the plan. In order to be a secured creditor, two criteria must be met. The creditor must have a validly perfected secured claim prior to the filing of the bankruptcy petition and, two, there must be an asset or assets for which the lien attaches. If the asset is of less value than the amount of the debt, the creditor is undersecured, having a secured status only to the value of the asset encumbered.

In order for the Internal Revenue Service to be given secured status in a bankruptcy, the Service must file a Notice of Federal Tax Lien prior to the bankruptcy petition. Additionally, there must be an asset or assets for the lien to encumber. The Internal Revenue Service is a unique creditor in that the tax lien attaches to all property belonging to the taxpayer. Unlike a UCC filing or a mortgage document, which specifically identifies the property that is encumbered, the federal tax lien attaches to real, personal and intangible property. If the IRS has a lien on file prior to bankruptcy and there is property for it to attach, the secured claim includes the tax, interest and penalties that are set forth on the Notice of Federal Tax Lien.

Whether a tax liability qualifies as a priority claim is a crucial question, both in determining order of distribution of estate assets and dischargeability of the liability. Section 507 (a) (8) sets forth the criteria in determining whether a tax claim qualifies for priority status. Although somewhat confusing, the section can be simplified as follows:

1. The tax relates to a tax period in which a return is due within 3 years of the date of the petition. For example, a 2005 tax liability would be due April 15, 2006. If the bankruptcy is filed before April 15, 2009, the tax is a priority. The statute also provides that in determining the relevant date, you must add the time of any return extension. If in the previous example, the debtor had an extension until October 15 to file his 2005 return, and the petition was filed before October 15, 2009, the tax is a priority. [See §507(a)(8)(A)(i)].

2. The tax is assessed within 240 days of the bankruptcy. The term assessment is a term of art. It is the statutorily required administerial act that must be done by the Service in order for there to be an enforceable tax liability. The actual date in which the assessment is made is crucial and can be obtained from the Service. It should be noted that the 240 day period is extended by the amount of time an offer-in-compromise is pending with the service, plus 30 days. [See §507(a)(8)(A)(ii)].

3. The tax has not yet been assessed but is still assessable at the time the petition is filed, unless the reason the tax is still assessable is failure to file, evasion or fraud. [See §507(a)(8)(A)(iii)]. To understand this provision, one must know that under the Internal Revenue Code the Service normally has 3 years from the date the return is filed to make an assessment. There are various reasons why this period can be extended. For example, the period can be extended by agreement, by the pendency of a Tax court case, or from 3 years to 6 years if there is a 25% omission from gross income for that year. Also, the assessment period is extended indefinitely if there is fraud, a willful attempt to evade tax or a failure to file the return. However, in cases of fraud, willful evasion or failure to file, even though the tax is always assessable, Congress specifically excluded under this subsection, priority treatment for taxes that are still assessable for these reasons. The rationale for such exclusion is that Congress did not desire to penalize unsecured creditors by making tax liabilities priority as a result of the debtor's bad acts and/or the Service's lack of diligence in obtaining a delinquent tax return. Instead, Congress made tax liabilities falling under these situations non-dischargeable. [See § 523(a)]. Other factors that would toll the timing periods stated above would include a prior bankruptcy (tolled while BK was pending), plus 90 days, and the request for a Collection Due Process Appeal.

Trust taxes are always a priority tax claim pursuant to §507(a)(8)(C ). This would include any tax withheld from employees for their taxes and Social Security, often referred to for the federal liability as the “trust fund recovery tax” or previously the “100% penalty”. State withholding tax would also be a trust fund tax. Additionally, State sales tax is a trust tax. In contrast with the income tax, timing is not important for trust fund tax claims since they will always be granted priority status.

§507 of the Bankruptcy Code sets forth the order of priority in which pre-petition creditors are paid, and as stated, §507(a)(8) sets forth what taxes qualify for 8^th priority status. However, it is §523 of the Bankruptcy Code that sets forth the exceptions to discharge. §523(a) specifically states that a discharge under a Chapter 7, a Chapter 11, a Chapter 12 or a hardship discharge in a 13 will not discharge an individual debtor from a tax specified as a priority under §507(a)(8). [§1322 requires priority taxes to be paid in full in a Chapter 13.] §523(a)(1)(B) further states that a discharge under the above-cited sections will not discharge a tax in which a return was not filed or was filed delinquently, within two years of the date of the bankruptcy petition. Lastly, §523(a)(1)(C) states that a tax which a fraudulent return was made or where there was a willful attempt to evade or defeat said tax will not be discharged under the provisions mentioned above.

Upon the filing of an individual Chapter 7 or 11, a separate taxable estate is created under IRC §1398. §1398(d)(2) provides for the right to make an election to terminate the debtor’s year when the case commences. The debtor may elect to treat the debtor’s taxable year, which includes the commencement date, as two taxable years, with the first year ending on the date before the commencement of the bankruptcy and the second year beginning on the bankruptcy filing date. An election under this section must be made on or before the 15^th day of the fourth full month following the end of the first short year and should state on top of the return “§1398 Election”. The section further provides that the bankruptcy estate succeeds to all of the tax attributes of the debtor. At the end of the bankruptcy, the debtor succeeds to the tax attributes of the estate.

It is very important for practitioners to be aware of the right to make a 1398 election. The Internal Revenue Service will not sever an income tax year. Therefore, any tax liability that had accrued up tot he date of filing the bankruptcy petition, even if the petition is filed December 31^st, will be treated as a post-petition tax liability, since it will have been determined at the end of the year. Therefore, any income tax liability for the year of bankruptcy cannot be claimed against assets of the estate and will not be paid out of the bankruptcy proceeding. It will, however, be a liability facing a debtor after he receives his discharge. However, since §1398 allows a debtor to elect to split the tax years, the liability that has accrued during the first “short taxable year” will be considered a pre-petition priority tax claim and can be paid out of the bankruptcy assets. This will perhaps reduce the amount paid to unsecured non-priority creditors, however, they would be dischargeable in any event and the debtor would benefit from eliminating or reducing a nondischargeable tax. However, an election would not be desirable if the debtor would benefit from retaining the tax attributes of the year of bankruptcy. Under these circumstances, an election should not be made.

IRC §61(a)(12) states that gross income includes income from the cancellation of indebtedness or C.O.D. income. However, §108(a) states that C.O.D. income is not taxable if it arises in a Title 11 case (bankruptcy). §108(a)(1)(B) states that a discharge of a debt that occurs when the taxpayer is insolvent is also excludable from gross income. Since lending institutions are now required to issue 1099’s where debts were written off and/or settled, it is very common to have clients who receive proposed changes to their tax returns from the IRS based on debt forgiveness income. Being aware of the §108 exclusions is often critical.

Although beyond the scope of this outline, the Internal Revenue Service, since the IRS Restructuring and Reform Act of 1998, has had a more objective Offer in Compromise Program. Basically, an offer in compromise can now be submitted based on doubt as to liability and a relatively objective formula is applied to determine how much the taxpayer must pay to compromise one’s liability. There are two parts to an equation to determine the amount necessary. The first part consists of the value of the assets belonging to the taxpayer. The IRS will apply 100% value for cash, bank accounts, IRA’s, etc. It should be noted that IRA’s and ERISA qualified plans are not exempt from the IRS collection. However, assets, such as a home, vehicle or any other item that would have to be sold to enforce collection, is reduced to quick sale value or 80%. The total of the assets is thereafter added to the second part of the equation.

The second part, or income response side, consists of the taxpayer’s monthly gross income minus a laundry list of allowable living expenses, to arrive at a net monthly income. This net monthly income is thereafter multiplied by a factor of 48. This total figure is added to the asset figure to determine the total amount hat must be offered to compromise the liability. For example, an individual had assets valued after taking a quick sale reduction where appropriate, at $5,000 and the net monthly income equaled $100 times the 48 multiplier factor, for a total of $4,800, the amount that would have to be offered would be $9,800. The same amount would have to be offered whether the liability was $10,000 or $100,000. The IRS, however, according to their manual can take the dischargeability in bankruptcy into consideration if the income and expense analysis makes the offer in compromise unworkable. This is often a negotiation tactic in trying to convince the IRS to accept an offer less than what the amount would be based on the net monthly income. It should also be noted that collection action must be stayed while an offer in compromise is pending. The Internal Revenue Service is taking an exceedingly long period of time to process offers due to the large volume that they receive. Under certain circumstances, while an offer in compromise is pending, the tax liabilities may transform from nondischargeable priority taxes to dischargeable general unsecured taxes. This is a consideration that a practitioner should take into account when trying to assist a client. Bankruptcy as a fallback position should always be considered where appropriate.

Payments made to a creditor within 90 days of bankruptcy can be considered a preferential payment and a Bankruptcy Trustee can require the funds to be returned by the creditor to the bankruptcy estate. ( See Bankruptcy Code §547.) However, the Supreme Court in the United States v. Begier has held that the pre-bankruptcy payment of trust fund liabilities are not a preference since the funds were to be held in trust for the Government and would never belong to the debtor in the first place. Therefore, a practitioner who has a client with an extremely troubled business should consider picking the debts that would most benefit the client if they were paid prior to bankruptcy. Since most Chapter 11’s fail, it may be beneficial to try to pay off nondischargeable trust fund taxes prior to bankruptcy. If a client with a troubled business has a sum of money available through cash reserves and/or collectible accounts receivable, it may be preferable to take said funds and pay trust fund taxes before filing a bankruptcy petition. This will insure that the responsible officer will be off the hook. Once a Chapter 11 bankruptcy is filed, it is very difficult to designate payments to trust fund taxes, verses non-trust fund and other priority and administrative creditors through an 11 plan.

IRC §6323 provides a priority to certain creditors over a federal tax lien. The federal tax lien is created by the assessment of the tax and it attaches to all property belonging to the taxpayer. Certain interests take priority over an assessment lien, such as a secured creditor, judgment lien creditor, mechanic’s lienholder and purchaser, perfected under State law. However, once a Notice of Federal Tax Lien is filed, these interests are inferior to the IRS’ position. However, in a commercial financing situation where a UCC is utilized, a creditor will often secure future accounts receivable and inventory. If the UCC is filed prior to the Notice of Federal Tax Lien, it is superior to accounts receivable and inventory existing at the time the UCC was filed. However, as new accounts receivable and new inventory come into existence, if a federal tax lien has been filed, the UCC and the federal tax lien will attach simultaneously to the “new” asset. Under United States v. McDermott, in a case of simultaneous attaching liens, the Internal Revenue Service wins. This has devastating impact on commercial financing that lends money based on UCC’s attaching to future accounts receivable and inventory.

However, IRC §6323(c) grants a 45-day grace period to lenders. This provision provides that the lien will still be inferior to a priority UCC on new accounts receivable and inventory for 45 days after the lien was filed. Thereafter, the creditor will be behind the Internal Revenue Service for new accounts receivable and inventory. A potentially useful strategy where a business has commercial financing attaching to accounts receivable and inventory and there is a federal tax liability for payroll taxes, would be to request that the IRS file a lien to insure that the 45 days runs. If this can be accomplished, the IRS will be secured on the accounts receivable and inventory. The lender, thereafter, would fall to unsecured status to the extent they are primed by the Internal Revenue Service. Unsecured creditors in a Chapter 11 can often be paid pennies on the dollar. The payroll taxes would have been granted priority status and would have had to be paid at 100% in any event. Therefore, giving the IRS secured status does not increase the amount that will have to be paid through the plan. If this was not done, however, both the IRS and the secured lender would have to be paid 100%. Moreover, if the Chapter 11 fails, any guarantee by the officer of the bank loan may be dischargeable in his own bankruptcy. Trust fund taxes relating to payroll would not be dischargeable. Therefore, there is an advantage to have the IRS secured, rather than the lender.

If an individual has an IRA, ERISA qualified plan or other exempt aset and the income taxes are old enough to be discharged as non-priority, the filing of a bankruptcy petition will eliminate those liabilities and the IRA and/or ERISA plan may be exempt from the bankruptcy. Upon discharge, there will no longer be an Internal Revenue Service liability and the debtor will keep these assets free and clear of any claim. However, if a Notice of Federal Tax Lien was filed prior to bankruptcy, even if the underlying tax is discharged, the lien will remain on the exempt assets up to the value as of the time of bankruptcy.

Bluestein & Muhlbauer, P.C. 333 International Drive Williamsville, NY 14221 716.633.3200

Bluestein & Muhlbauer, P.C.
333 International Drive
Williamsville, NY 14221
716.633.3200