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Orange County, New York Bankruptcy Lawyers Discuss Income Taxes

Bankruptcy, in several instances, can be an effective way of dealing with past-due federal and state income tax debt.

In a Chapter 7 or Chapter 13 bankruptcy, income tax obligations are dischargeable if the tax return for the year in question was filed and:

(1)  The 3 Year Rule: The tax return was due more than 3 years prior to the bankruptcy filing. If the debtor obtained an extension, the due date would be the extension deadline.

(2)  The 2 Year Rule: For a late filed return (filed after its due date and any extensions), if the delinquent return was actually filed more than 2 years prior to the bankruptcy filing.

(3)  The 240 Day Rule: If there has been an assessment by a taxing authority, it was made more than 240 days prior to the bankruptcy filing.

(4)  The debtor did not file a fraudulent return or willfully attempt to evade paying taxes.

Example #1 – Debtor timely filed their 2003 tax return (due on April 15, 2004). There have been no recent assessments by the government and the return was not fraudulent. The taxes still owed from the 2003 return are dischargeable if the bankruptcy is filed after April 15, 2007 (“the 3 Year Rule”).

Example #2 – Debtor files their 2001 tax return late, on October 31, 2005. There have been no recent assessments, and the return was not fraudulent. The taxes still owed from the late filed return are dischargeable if the bankruptcy is filed after October 31, 2007 (the “2 Year Rule”).

“Trust fund” taxes, such as payroll withholding and social security withholding by an employer and sales taxes are never dischargeable in Chapter 7, and are dischargeable in Chapter 13 only if paid in full over the life of the Chapter 13 Plan.

In Chapter 7, if the underlying tax obligation is dischargeable, the interest and penalties thereon are also dischargeable. However, if the underlying obligation is non-dischargeable, so are the related interest and penalties.

Tax liens are not discharged in Chapter 7 even if the tax obligation that forms the basis of the lien is dischargeable. However, the remaining lien from a dischargeable tax obligation will only be enforceable against assets owned by debtor at the time of the bankruptcy filing, and only to the extent of the assets’ value. This is very important because if the underlying tax obligation is discharged, the remaining lien will not attach to any assets acquired by the debtor after the bankruptcy filing. Conversely, when the underlying tax obligation is not dischargeable, the remaining lien will attach to assets acquired after the bankruptcy filing. In this situation, the nature of the surviving tax lien (i.e. IRS tax lien or New York State tax lien) can impact the quality of your “fresh start”.

New York State tax lien

  • Non-dischargeable tax debt is collectible for 20 years, with the 20 year period being renewed whenever a payment is made.
  • Tax lien is created by filing of NYS Tax Warrant, which attaches for 10 years to all personal property in any location, and to all real estate located in the County where it is filed.
  • New York State exemptions limit the State Tax Department’s ability to collect, protecting many assets from seizure, including: the 10% limit on salary garnishments; the $50,000.00 homestead exemption for residences; the protections afforded qualified pension plans, profit sharing plans, IRA’s and most retirement plans.

IRS tax lien

  • Non-dischargeable tax debt is collectible for 10 years after date of assessment, which usually occurs when the return is filed.
  • Tax lien created at time of assessment, without any further IRS action required. However, the IRS will also file a Notice of Federal Tax Lien to establish its priority among other lien creditors. The tax lien applies to all personal property, and to all real estate located in the County where it is filed. The lien is effective for 10 years from the date of assessment.
  • New York State exemptions do not apply to an IRS tax lien; only the exemptions set forth in IRC §6334(a) apply, which provide much more limited protection:
    1. The familiar 10% NYS limitation on salary garnishments does not apply. There is a limited federal exemption, but no one could survive on it.
    2. The NYS homestead exemption does not apply. The limited federal exemption basically only applies if the levy amount is less than $5,000.00.
    3. The federal tax lien attaches to all qualified pension plans, profit sharing plans, IRAs and retirement plans. Fortunately, thus far it appears that the IRS does not have in place the necessary systems to track “non-obvious” assets such as these.

The IRS has far greater collection powers at its disposal, but it can exercise them over a shorter period of time. New York State, on the other hand, can collect against fewer assets, but it can do so over a longer period of time. It should be noted that collection periods are extended for certain activities, such as time spent in bankruptcy or while engaged in an offer in compromise, etc.

Options for dealing with non-dischargeable tax debt

  • Lump sum payment of full amount due.
  • Installment Agreement or Payment Plan: Full repayment of the tax debt by agreed upon monthly payments. The IRS may still file a tax lien while such an agreement is pending, and certainly will seize both federal and state income tax refunds during said period, but usually will not engage in any other collection efforts. New York State has a similar program, and will also seize state and federal income tax refunds while the payment plan is in effect.
  • Offer in Compromise: A settlement with the IRS calling for repayment of less than the full amount due. A debtor in an open bankruptcy is usually not eligible, and the IRS will only participate if (1) it does not think that the tax liability can be fully collected through normal methods, such as an installment plan; (2) a legitimate doubt exists that the tax liability is correct; or (3) some exceptional circumstance exists that would render it unfair and inequitable for the IRS to collect the full amount. The amount settled upon will reflect the IRS’s view of the tax collection potential of the debt. New York has a similar program whose scope was expanded by legislation effective August 17, 2011. Previously New York offered this relief only in cases involving bankruptcy or insolvency, but its availability has been expanded to now include those suffering from undue economic hardship as well.
  • Innocent Spouse Relief: Both spouses are fully responsible to the IRS for the total tax due on a joint tax return, even if a subsequent divorce decree makes one spouse fully responsible. However, if the “innocent spouse” can establish that when the joint return was filed that said spouse did not know, and had no reason to know, that there was an understatement of income or tax due, said spouse can be relieved of the tax liability.

In Chapter 13, claims for priority taxes (i.e. do not meet the “3 Year Rule”) and secured taxes (tax liens filed) must be paid in full; however, secured claims are only paid in full up to the value of debtor’s assets. Your bankruptcy attorney can bring an application under Section 506(a) to determine what portion of the secured claim must be paid in full. The balance of the “unsecured portion” will be paid with the rest of the unsecured claims, often for a fraction of its full value.

In addition to eliminating the “Chapter 13” super-discharge that existed under prior law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (hereafter referred to as “BAPCPA”) made other tax-related changes, particularly concerning Chapter 13. BAPCPA requires a Chapter 13 debtor to file tax returns for the four taxable years preceding the bankruptcy filing no later than the day before the first scheduled Section 341 Meeting of Creditors. A debtor who fails to file these required tax returns cannot have his Chapter 13 Plan confirmed by the Court, and his case is subject to dismissal.

Under BAPCPA, there are more instances where tax refunds can be intercepted by interested parties. The automatic stay created by the bankruptcy filing no longer prevents the interception of tax refunds for payment of a domestic support obligation (i.e. past-due child support), and  it no longer prevents taxing authorities from exercising  setoffs  against tax refunds (i.e. taking your refund) for prepetition tax periods to cover prepetition tax debt.

Many tax liabilities can be successfully dealt with in both Chapter 7 and Chapter 13, and an experienced bankruptcy attorney can be of immeasurable assistance in this very tricky area.