In bankruptcy proceedings, the treatment of tax debts attempts to reconcile two conflicting policies. Although the government is interested in collecting taxes, bankruptcy policy is intended to give honest debtors a fresh start (while protecting creditors) by providing for the orderly liquidation or reorganization of the debtor’s estate.
Partly because of this underlying tension, the provisions of the Bankruptcy Code (11 USC) regarding the dischargeability of tax debts in bankruptcy are quite complex. A debtor’s ability to discharge any tax debt is based upon the classification of that particular tax debt. For the purposes of the Bankruptcy Code, a tax claim can be characterized as either a trust fund tax, a secured claim, an administrative tax claim, a priority tax claim, a general unsecured claim, or a penalty claim.
Trust Fund Taxes
Trust fund taxes that have been collected by the debtor from third parties (e.g., sales taxes and income tax withholdings) are held in trust by the debtor for the appropriate taxing authority. Such amounts held in trust are simply not property of the debtor or of the bankruptcy estate. If, however, the debtor has failed to collect and/or remit to the appropriate taxing authority a trust fund tax, then the relevant taxing authority will have a priority tax claim pursuant to 11 USC 507(a)(8)(C).
Secured claims are those claims that are secured by a lien on the debtor’s property. A claim is secured to the extent of the value of the property securing the claim. For example, a claim for $40,000 secured by a piece of property worth $10,000 would be a secured claim of $10,000 and either a priority tax claim or a general unsecured claim of $30,000. If a creditor has a lien on property that is subject to superior liens in excess of the value of the property, the claim is not secured. Thus, if the IRS files a tax lien upon a piece of property worth $40,000 that is subject to a preexisting lien in the amount of $100,000, the entire tax lien claim would be either a priority tax claim or a general unsecured claim because of the preexisting lien. If the amount of the superior lien is less than the value of the property upon which the IRS filed its lien, then the IRS will have a secured claim to the extent that the value of the property exceeds the value of the superior lien. The remaining balance of the tax claim would either be a general unsecured claim or a priority tax claim.
Administrative Tax Claims
Administrative tax claims consist of taxes that have accrued during the pendency of the bankruptcy. 11 USC 503(b)(1) accords administrative status to any tax that is incurred by the estate. There are two exceptions. The first are taxes of a kind specified in 11 USC 507(a)(8) that constitute priority tax claims. The second are those tax claims that are attributable to an excessive allowance of a tentative carry-back adjustment that the estate received, whether the taxable year to which such adjustment relates ended before or after the commencement of the case. 11 USC 503(b)(1) further accords administrative tax claim status to any fine, penalty, or reduction in credit relating to an administrative tax.
Several courts of appeals have found that interest on administrative tax claims is accorded administrative status by implication. Accordingly, any tax that accrues during the bankruptcy proceeding (together with any penalty or interest associated with such tax) will generally constitute an administrative tax claim entitled to treatment as a 507(a)(1) first priority claim. Note, however, that the Supreme Court has recently accepted certiorari on a case holding that administrative tax penalties are subject to equitable subordination under 11 USC 510(c), notwithstanding 11 USC 503(b)(1)(C). (See United States v. Noland (In re First Truck Lines, Inc.), 48 F.3d 210 (6th Cir. 1995), cert. granted, 116 S.Ct. 558 (1995).)
Priority Tax Claims
Priority tax claim status is granted to certain “allowed unsecured claims of governmental units” under 11 USC 507(a)(8). Note that the terms of this section of the Bankruptcy Code preclude a tax claim from being treated as both a priority tax claim and a secured claim. The categories of priority tax claims include the following:
- Taxes “on or measured by income or gross receipts” as defined in detail by statute.
- Unsecured property taxes assessed prior to the bankruptcy but last payable without penalty less than one year prior to the filing of the petition.
- “A tax required to be collected or withheld and for which the debtor is liable in whatever capacity.”
- Certain employment taxes as defined in detail by statute.
- Certain excise taxes as defined in detail by statute.
- Certain customs duties as defined in detail by statute.
Pre-petition interest on priority tax claims and penalties compensating for actual pecuniary losses related to the priority tax claims are also entitled to priority status.
The most complicated of the detailed statutory definitions of priority tax claims is the definition located at 11 USC 507(a)(8)(A), which provides priority status to allowed unsecured claims of governmental units to the extent that they are for a tax on (or measured by) income or gross receipts (e.g., federal income tax) but only if such tax is: (1) for a taxable year ending on or before the date of the filing of the petition, where the return for such taxable year (if any return is required) was last due less than three years before the date of the filing of the petition (the “three-year rule”); (2) assessed within 240 days (plus certain additions related to offers in compromise) before the date of the filing of the petition (the “240-day rule”); or (3) generally, taxes not assessed before, but assessable (under applicable law or by agreement) after, the commencement of the case (the “post-petition rule”).
The “three-year rule.” Priority status is accorded under the “three-year rule” if a tax has been assessed for a taxable year ending on or before the date of the filing of the bankruptcy petition. In other words, post-petition taxes are not priority tax claims. (They are administrative tax claims.) Next, the return, with any extensions, must have been due less than three years prior to the date of filing. The date upon which the return is finally due is critical to determining priority status. The three-year period did not begin to run with respect to a Form 1040 until it was due on April 15, 1996, for example, even though the Form 1040 was actually filed on January 30, 1996.
This principle also applies to extensions to file that effectively move the return’s due date to a later date. Accordingly, if the due date for a federal income tax return, Form 1040, was originally April 15, 1992, but the taxpayer extended the due date until August 15, 1992 (by filing with the IRS an Automatic Extension to File Federal Income Tax Return, Form 4868, which automatically extends the due date for a Form 1040 by four months), then filing bankruptcy on August 14, 1995, would result in the taxes being classified as a priority claim, whereas filing bankruptcy on August 16, 1995, would result in the 1991 taxes being classified as a general, unsecured claim. Keeping track of these dates is crucial–courts have held legal counsel liable for malpractice, for example, when the bankruptcy petition was filed prior to the date on which a tax debt would have become dischargeable.
Of course, taxes due from the 1992, 1993, and 1994 tax years would constitute priority claims. Whether the 1995 taxes would be priority claims depends upon whether the debtor elects (under IRC 1398(d)(2)(A)) to declare a short tax year ending August 15, 1995 (the day before the filing of the bankruptcy petition). The taxes owed on the pre-petition short year will constitute a priority claim under the three-year rule. If no election to declare a short year is made, then the tax liability that has accrued before the date of the petition may not be a claim against the bankruptcy estate, but rather an (undischarged) obligation of the debtor.
The “240-day rule.” Priority status is generally granted under the “240-day rule” if the taxes are assessed within 240 days of the petition date. Typically, the 240-day rule applies when additional taxes are assessed as a result of an IRS examination or the taxpayer’s filing of an amended return. Taxes are usually assessed after a taxpayer is given notice of an alleged deficiency in the taxpayer’s return and the taxpayer has had an opportunity to challenge the deficiency. The date of assessment is the date upon which the proposed tax described in the notice of deficiency becomes final.
For example, assume that a debtor filed for bankruptcy on April 16, 1996, and filed his 1992 tax return on April 15, 1993, which was the date upon which the return was due. In this situation, the tax would not qualify for priority tax claim status under 11 USC 507(a)(8)(i). If, however, pursuant to an examination, additional taxes were assessed on January 1, 1996 (less than 240 days prior to April 16, 1996), the additional taxes would qualify for priority tax claim status.
The 240-day timeframe is subject to certain modifications. If the 240th day prior to the bankruptcy petition falls on a Saturday, Sunday, or legal holiday, then the relevant period is extended back to the next prior business day. The period for assessing taxes is also extended with respect to any periods for which an offer to compromise was under consideration (plus an additional 30 days). For example, if debtor filed a bankruptcy petition on May 1, 1996, and a tax liability had been assessed on May 1, 1995 (366 days prior to the filing of the bankruptcy petition), the tax liability would qualify for priority tax claim status if an offer to compromise the assessed liability had been under consideration for 96 days or more (366 days less the sum of 96 days plus 30 days equals 240 days).
Caution should be exercised in determining whether an assessment has been made. Do not rely on the verbal statements of an IRS representative. If the debtor has any doubts as to when an assessment was made, debtor’s counsel should request a Certificate of Assessments (Form 23-C) from the IRS.
The “post-petition rule.” Priority tax claim status is also accorded to some taxes that are assessed after the bankruptcy petition date. These are taxes for which the statute of limitations for additional assessments has not run out on the date the debtor files bankruptcy. The IRS may assess income taxes prior to the expiration of the three-year period beginning the day after the date on which the return was filed or is deemed filed. Returns that are filed early are deemed to be filed on the last day when the return is due without penalty. Thus, if the IRS can still assess additional taxes without being barred by limitations on the date the petition is filed, these taxes are also entitled to priority status. A taxpayer may also agree to extend the statute of limitations. This agreement extends the period for which priority status will apply.
Several other rules are relevant to calculating the statute of limitations. Note, however, that the post-petition rule does not apply to a tax of a kind specified in 11 USC 523(a)(1)(B) (relating to taxes for which returns were never filed or for which returns were filed late and less than two years prior to the filing of the bankruptcy petition) or 11 USC 523(a)(1)(C) (relating to fraudulent returns and willful attempts at tax evasion). Also note that the priority scheme detailed above does not apply to taxes that are required to be withheld, such as federal withholding taxes and state sales taxes, and for which the debtor is liable in whatever capacity. These taxes will be priority tax claims regardless of when they arise or are assessed.
General Unsecured Claims and Penalty Claims
General unsecured taxes are taxes that are not entitled to secured, administrative tax claim, or priority tax claim status. Typically, these taxes are not entitled to qualify for priority tax claim status because they are old claims.
Nonpecuniary tax penalties are a class of unsecured claims that may be subordinated to general unsecured claims in some cases. A nonpecuniary tax penalty is one that is intended to punish rather than to compensate. Although opinions are split, two circuits have held that an “excise tax” may be considered a tax penalty even though it is labeled as a tax. The Supreme Court should soon resolve this split of opinion; it recently accepted certiorari for a case in which the Sixth Circuit held that the “tax” label accorded by the IRC is not determinative and that pre-petition excise taxes actually constitute penalties subject to equitable subordination under 11 USC 510(c). (See In re CF&I Fabricators of Utah, Inc., 53 F.3d 1155 (10th Cir. 1995), cert. granted, 116 S.Ct. 558 (1995).)
Dischargeability of Taxes
Taxes may be discharged in bankruptcy either through liquidation or reorganization. In a liquidation proceeding (Chapter 7 case), the taxes of an individual may be discharged under 11 USC 727. Taxes may also be discharged pursuant to a plan under either Chapter 11 (11 USC 1141), or Chapter 13 (11 USC 1328(b)).
Enhanced Dischargeability under Chapter 13
Discharges under Chapter 13 are available to individual wage earners upon the confirmation of a plan of reorganization. Although the amount of debt that may be discharged under Chapter 13 is limited, certain tax liabilities may be discharged under Chapter 13 that would not otherwise be dischargeable. For example, the exception to dischargeability under 11 USC 523(a)(1) is not applicable when payment of all priority tax claims is provided for in the plan of reorganization, and the debtor makes all of the plan payments. Thus, a debtor may obtain a discharge for tax liabilities for which the statute of limitations has not expired and for tax liabilities related to unfiled, or even fraudulent, returns.
Furthermore, under Chapter 13, creditors (including taxing authorities) must file a proof of claim with the Bankruptcy Court. If payment for priority tax claims is provided under the plan, but no proof of claim is submitted by the relevant taxing authority, there is no requirement that the debtor pay the priority tax claim. If the taxing authority’s proof of claim is not filed in a timely manner, the claim could be objected to and the debtor would not be required to pay the priority tax claim.
Sidebar: Exceptions to Dischargeability
The general exceptions to discharge are provided at 11 USC 523(a). 11 USC 523(a)(1) provides for nondischargeability with respect to three types of tax debts. First, if a tax is a priority claim under 11 USC 507(a)(2) (claims arising prior to entry of an order for relief in an involuntary bankruptcy proceeding) or 11 USC 507(a)(8), it is nondischargeable. Whether taxes are priority tax claims or general unsecured claims determines their dischargeability.
Second, if the taxpayer did not file a tax return, the taxpayer cannot get a discharge of the tax liability. If the taxpayer files the return late, the taxes are nondischargeable if the return was filed less than two years prior to the filing of the bankruptcy petition. Generally, a return will only be deemed to have been filed for the purposes of 11 USC 523(a)(1) where the document filed with the IRS purports to be a return, is sworn to as such, and evidences an honest attempt to satisfy the law.
The following do not constitute a “return” for purposes of 11 U.S.C. 523(a)(1): an automatic extension request, a return that is not signed by the debtor, and an amended return filed by a debtor who never filed an original return. However, a court has deemed that a return was filed under 11 U.S. C. 523(a)(1) when a debtor met with the IRS, admitted to owing taxes, signed certain forms with sufficient information to calculate the debtor’s tax liability, and delivered the documents to the IRS.
Third, if the debtor files a fraudulent return or willfully attempts to evade or defeat taxes, the taxes are nondischargeable. Under IRC 7454(a) and related case law, the IRS has the burden of proving fraud by clear and convincing evidence. Fraud has been held to include such activities as submitting false withholding statements for the purpose of eliminating withholding and failing to report embezzlement income. Willful attempts to evade or defeat tax liabilities include such activities as concealing assets and failing to either file returns or to pay taxes over an extended period. Mere understatement of income, however, is not fraud.
Federal tax liens are not discharged even if the underlying taxes are discharged. Thus, secured taxes essentially are nondischargeable, although personal liability may not be asserted.