Tom Scottt Law Indy

Bankruptcy Attorneys in Indianapolis Since 1980

Taxes

How Filing Tax Returns Late and Unpaid Taxes Affect Your Bankruptcy Case

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Filing Tax Returns Late and Unpaid Taxes Affect Your Bankruptcy Case

A recurring theme bankruptcy lawyers deal with is tax returns not filed on-time. Determining tax liabilities in bankruptcy cases can be very complex. If a debtor pays back taxes through a bankruptcy plan, when the case is discharged the IRS can charge the debtor for the unpaid interest on those taxes. Even if you cannot pay your taxes, you should file your tax returns on or before the deadline, because filing just one day late can mean your tax debt will not be dischargeable through bankruptcy.

We recently discussed several aspects of bankruptcy with Christopher Holmes and Jess M. Smith, III, partners at Tom Scott & Associates, P.C. The discussion focused on the affect filing tax returns late has on a bankruptcy case, along with the related topics of: non-priority taxes; the impact of the revisions to the bankruptcy code in October 2005; the position taken by the Indiana Department of Revenue; unpaid taxes as they relate to the priorities for allowed unsecured claims of governmental units; and a benefit of a Chapter 13 bankruptcy versus a Chapter 7 bankruptcy, for people who have tax problems.

The simplified explanations in this conversation cannot be taken as legal advise, because every situation is different and complicated. Each case is very fact-sensitive and there is no one-size-fits-all explanation of how a tax liability relates to a specific bankruptcy case.

Q: What bankruptcy issues have you been dealing with lately?

Jess Smith III: One issue that keeps popping up concerns people who did not file their tax returns with the Internal Revenue Service (IRS) when they were due. As a result, the IRS is billing people who’ve received a bankruptcy discharge to collect the accrued interest on either priority taxes that were paid through their bankruptcy plan or non-priority taxes that are nondischargeable, that are due and payable despite the bankruptcy discharge because the debtor did not timely file the returns.

Q: What are the differences between priority taxes and non-priority taxes?

JS: Generally speaking, though there are exceptions to every rule, if you file a bankruptcy case, priority taxes are those taxes due and owing on any tax return that was required to be filed within the three years prior to the date the bankruptcy case is filed. As a general rule, the debtor must make provisions in his or her Chapter 13 Plan to pay those taxes in full to the taxing authorities.

For example, if priority taxes are owed, the debtor must pay the IRS and/or the Indiana Department of Revenue (IDR) the amounts due through their plan. But, on those priority taxes, if that tax return was filed within two years of the date the bankruptcy case was filed – whether or not it was due and even if you filed it timely – the IRS will assess interest on those taxes throughout the three to five year period of the plan. As a result, debtors can pay the amount the IRS claims is owed, but the debtor will be receiving a tax bill after the bankruptcy is discharged for the unpaid interest.

(NOTE: That is the part of the fallout from the significant revisions to the bankruptcy code in October of 2005, which the IRS was not enforcing until some favorable rulings were issued in some other Circuits within the last few years. Now they’re starting to whack debtors and intercept their refunds after discharge.)

I had a case in which the debtor worked out an agreement with the IRS. The bankruptcy was discharged after five years. Then recently the IRS came after the debtor for accrued interest on taxes from the two years before the bankruptcy was filed, because the debtor had timely filed those returns within two years of the filing of their bankruptcy case.

Moreover, the debtor had been curing a massive amount of pre-bankruptcy mortgage arrears, so the taxes weren’t, as a matter of law, paid until the fifth year of the plan; therefore, the IRS kept charging the debtor whatever statutory interest rates they could and then came after the debtor when his bankruptcy was discharged. Based upon decisions from other Circuits, the IRS action is lawful.

The IRS filed a Proof of Claim for whatever taxes were due, including accrued interest and penalties, up to the point of the bankruptcy. Even if the Trustee paid the claim as filed, the IRS still charges interest on the balance during the time the debtor is in bankruptcy. Then the IRS collects the unpaid interest after the bankruptcy has been discharged.

CH: Prior to the changes in the Bankruptcy Code in October of 2005, any taxes that were due for the three years before the filing of the bankruptcy could be paid through the plan, without penalty and interest. Once the underlying tax had been paid in full, upon discharge there were no penalties and no interest to worry about. Also, all unsecured taxes that were more than three years old when the bankruptcy case was filed were discharged whether those returns were filed in a timely manner or within two years of the filing of the bankruptcy case (or even if the returns were filed AFTER the bankruptcy case had been filed).

JS: Fortunately, the Indiana Department of Revenue is not taking a similar position.

Q: In situations in which this applies, are you anticipating those accrued interest payments coming down the pike and accounting for them in the payment plan?

JS: We can’t, because debtors can’t offer interest on those taxes unless they pay every other creditor in full. It’s difficult to get around

CH: Sometimes, in certain cases, we’ll offer some interest through the plan, to try to mitigate the bill for the accrued interest on those taxes that the debtor might receive after discharge.

Q: So, you try to pay off some of that interest that you know is coming?

JS: If we know and we can get the trustee to agree to it, but there are only certain circumstances in which the trustee will consent to that.

CH: Before the revision of the bankruptcy code in October 2005, one of the primary benefits of a Chapter 13 bankruptcy case was that we could tell people who owed taxes that at the end of the case, when they received their discharge, they were done. They had paid all of the taxes they had to pay and the taxes that weren’t paid through the plan would be wiped out in their entirety.

Since the new tax-related provisions came into effect in 2005, even if a debtor pays the underlying taxes through the plan, the interest on those taxes is still due. Accordingly, we need to refrain from filing some bankruptcy cases for at least two years and a day after a debtor has filed tax returns late, to account for that rule.

Q: What happens if a debtor filed a tax return on time, but did not pay the tax liability due until they started paying the IRS through their bankruptcy plan? Can the IRS still charge interest in that circumstance?

CH: If the tax return was submitted to the IRS within two years of the filing of the bankruptcy case, then the IRS is taking the position that the interest becomes nondischargeable and has to be paid after the case is over.

In conclusion, debtors with unpaid taxes often have complicated situations that require the expertise we have accumulated after handling hundreds of cases over the past 20 years to know how and when to file such cases at the appropriate time.

JS: There are no guarantees, because every case is different and the IRS rules for Processing Chapter 13 Bankruptcy Cases are complex, which is why you need to discuss your situation with an experienced attorney.

There are some rulings from other circuits that state even if you file the return more than two years before the petition date, but you filed it one day late, it’s never dischargeable. That’s a very harsh decision from one district. The issue has not come up in the 7th Circuit, so I don’t think the IRS is being aggressive enforcing it in this circuit.

CH: The tax code section that outlines the priorities for allowed unsecured claims of governmental units—U.S. Code Title 11, Chapter 5, Sub-chapter I, Section 507(8)(A)—gets deep into the weeds.

CH: Also, any tax liability incurred after the date a bankruptcy case is filed is deemed to be a post-filing debt that is not included in the bankruptcy case; however, it is possible, with the IRS’s permission, to add post-filing tax liabilities to the plan. In other words, we can modify or amend the plan to add money to the money that is already in the plan to pay those post-filing taxes.

Recently, I received a call from a client who complained that the IRS had taken her post-filing tax refund and applied that money to a post-petition tax liability we had added to her plan. Given this was a clear violation of the law, I contacted the IRS and I demanded the return of the debtor’s post-filing tax refund. Once the IRS realized it had taken that post-filing refund to apply to a tax that was being paid through the debtor’s plan, it promptly admitted its mistake and sent the ill-gotten refund to the debtor.

Q: Is the Proof of Claim that the IRS files any different than the Proof of Claim that any other creditors would file?

CH: It’s on the same form, but the IRS breaks down its claims into different categories, such as secured non-priority taxes, unsecured non-priority taxes, and unsecured priority taxes.

Q: What would be some examples of non-priority taxes?

JS: Taxes that are more than three years old when the bankruptcy case is filed, that arise out of tax returns that were filed in a timely manner, and the taxing authority has never recorded a notice of a tax lien.

Q: Is the circumstance of filing the taxes compared to paying the taxes a determining factor as to whether or not it becomes a priority or non-priority tax claim by the IRS? For example, let’s say someone reading this article is in financial trouble and foresees an approaching need to file for bankruptcy in the future. That person hasn’t filed tax returns for the past 10 years, so he files those tax returns, but does not pay the taxes due for those previous 10 years. Then, more than two years after the day all of those delinquent tax returns were filed with the IRS, that person files for bankruptcy in Indianapolis. Would those unpaid taxes be considered by the IRS to be priority or non-priority tax claims?

CH: We would hope the answer is that those delinquent taxes would then be become dischargeable. But, recent rulings seem to indicate that if you don’t file a tax return when it’s due, you’re going to be penalized forever and those taxes may be nondischargeable.

JS: There is a decision from one Circuit that says if you file one day late, you never discharge that debt. That’s a bit of an extreme position, but there is one Circuit–not the 7th Circuit–that reached that decision.

Q: So the bottom line is, regardless of your financial situation, file your taxes by April 15 every year. Is it safe to say that advice might save you from a lot of trouble down the road?

JS: Yes. Even if you cannot pay your taxes, you should file your tax returns on or before the deadline. The other issue is that we’re often contacted by people who will file a return on time, but they forget to report some income (e.g., IRA withdrawals, part-time jobs, Form 1099 income, etc.). After the debtor receives their refund check, the IRS notices the unreported income, the IRS assesses the unpaid tax thereon, and the IRS will send a billing to the debtor demanding payment of the taxes due on that unreported income.

CH: One of the benefits of a Chapter 13 bankruptcy versus a Chapter 7 bankruptcy, for people who we know have tax problems, is that in the Chapter 7 bankruptcy, neither the IRS nor the IDR are required to come forward and assert anything. Neither the IRS nor the IDR must file a Proof of Claim that would enlighten the debtor regarding what taxes are owed, what category the taxes fall into, whether there are any tax liens, or any indication which taxes must be paid and which are dischargeable.

JS: As a result, the debtor must live with that uncertainty until after they are discharged, and then they must wait in suspense to see if the IRS and/or the IDR will resume collection efforts.

CH: Accordingly, I will tell a client that one of the benefits of a Chapter 13 case is that if we are so uncertain about the tax liabilities, both the IRS and the IDR are required by law to come forward and file a Proof of Claim that breaks down the taxes into these different categories; therefore, the debtor has much more certainty about the full extent of their tax problems. Also, we can determine whether a Chapter 13 bankruptcy case might be a more effective way to handle those taxes. In other words, the debtor will not need to deal directly with the taxing authorities if they file a Chapter 13 case because the taxing authorities are compelled by Chapter 13 of the U.S. Bankruptcy Code to accept payment of those taxes through the U.S. Bankruptcy Court. Meanwhile, the taxing authorities can’t contact the debtors, nor can they garnish wages, levy bank accounts, take tax refunds, or impose tax liens upon the debtor while under the protection of the U.S. Bankruptcy Court.

Also, I’ve had such cases filed under Chapter 13 in order to force the IRS and the IDR to prove the nature and extent of the taxes owed, only to be pleasantly surprised that the tax liabilities were not as bad as we feared. As a result,, the debtor and I determined he didn’t need a Chapter 13 case, and then the case was converted to Chapter 7 case. As a further result, the debtor’s case ended in a matter of months rather a matter of years.

Q: When you convert from the Chapter 13 to the Chapter 7, what are the other consequences, in terms of assets?

CH: Before deciding to convert any Chapter 13 case to a Chapter 7 case, we must determine if they are eligible to convert the case and there would be no significant negative consequences if the case is converted. First, we must determine if the debtor makes too much money to file under Chapter 7. Second, we must determine if the debtor has any property that could be confiscated by the Chapter 7 Trustee for the benefit of the creditors. In other words, does the debtor possess any asset that the debtor can’t protect or exempt according to Indiana law. Third, we must determine if converting the case creates a risk that the debtor may lose a house or a car based upon how it had been treated by their Chapter 13 Plan. Lastly, we need to determine if the debtor will reap one of the big benefits of converting a case: Did the debtor incur any dischargeable debts after filing the Chapter 13 case, but prior to converting to a Chapter 7 case, that can be added to, and discharged by, the converted Chapter 7 case.

We’ve talked about how we put people into a Chapter 13 plan just in case they have non-reimbursed or uninsured medical bills after the date of filing, to protect themselves during the three-to-five-year time-frame they’re in a Chapter 13 (Bankruptcy Strategy for Client with Chronic Medical Condition and No Health Insurance). If two years down the road the debtor goes into the hospital, without insurance, and incurs an exorbitant amount of uninsured medical bills, we can then convert the Chapter 13 into a Chapter 7 and add those debts to the list of debts to be discharged. If at any point within that time-frame the debtor incurs a tremendous amount of debt for any reason, and that debt is dischargeable and unmanageable, that would sometimes be a justification for converting from a Chapter 13 to a Chapter 7, to add those post-filing, pre-conversion debts.

Q: Is that type of conversion occurring frequently or infrequently?

CH: I frequently have debtors who incur post-petition debt they can’t afford to pay back and have no good reason to remain in a Chapter 13. They convert to a Chapter 7, add the debts, and get them discharged along with the other previously listed debts.

Q: You mentioned a 240-day period of time during which the IRS can assess a tax debt. When does that 240-day period begin?

JS: That makes a tax liability a priority claim if the IRS does an assessment within 240 days of the petition date. It can be for a tax return that is more than three years old, if they somehow catch omitted income, do an assessment, and then someone files bankruptcy quickly. I had a case recently in which a debtor had a 2011 liability that was caught and assessed by the IRS in 2015, so I had to wait 240 days, until mid-2016, before I could to file the case, so that it was not a priority tax debt.

Q: The 240 days you had to wait seems like an arbitrary period of time.

CH: It can also be 240 days plus 30 days in some cases or 240 days plus 90 days in other cases.

JS: Determining tax liabilities in bankruptcy cases can be very complex.

CH: Sometimes we’ll refer people to a lawyer who specializes in tax law. He’ll do whatever he needs to do outside of the bankruptcy court to buy enough time for some of these taxes, which would otherwise be nondischargeable, to become dischargeable beyond a certain date. Then he’ll refer the clients back to us to file a bankruptcy case for them.

JS: He gets the tax returns filed prior to them being assessed; he gets them into an installment agreement for a while; he tells them to honor the installment agreement for a number of months; and then he tells them that if they want to default to consult with a bankruptcy attorney to file for Chapter 13 or Chapter 7. But you have to at least play the game long enough and pay some of those taxes.

CH: Debtors will file the returns and then wait at least two years and a day to come see us. Then, they’ll have waited long enough for the taxes to become dischargeable. There are some people who’ve filed their tax returns on time, but still owe a bunch of money for some tax years in the past three years. If they filed for bankruptcy in 2017, they’d have to pay that tax back in full.

For example, if someone filed their tax return on time for tax year 2016–before April 18, 2017–and then they found out they owe the IRS $10,000 for that 2016 return, if they file a Chapter 13 or Chapter 7 in 2017, that tax has to be paid back in full, maybe with interest added on. But if they wait long enough–in this example until after April 19, 2020, which is more than three years from the date the 2016 tax was due–that 2016 tax then becomes dischargeable, unless in the intervening three years a tax lien was imposed upon them or some other reassessment took place.

Q: So, as a rule of thumb, as we discussed, file your taxes on time. A second rule of thumb: pay, if you owe taxes. A third rule of thumb: if you haven’t followed either of those two rules, it’s best to establish a relationship with the IRS, perhaps with the assistance of a tax attorney, to start paying your overdue tax liability prior to filing for bankruptcy. Then make sure, in consultation with your bankruptcy attorney, that you file for bankruptcy at the right time as determined by all of the other circumstances related to your specific case.

CH: Absolutely correct. Between the tax lawyer and the bankruptcy lawyer, hopefully you can discern the appropriate time to file the bankruptcy to get the biggest relief afforded by the U.S. Bankruptcy Code. However, we have to advise clients, “Based on what we know, this is what we think we can accomplish. But if the IRS knows something we don’t know, you assume the risk there might be some nondischargeable interest or other problems that could crop up.”

Q: Do you try to place clients into Chapter 13 and then use a conversion to a Chapter 7 as a last resort? Or do you evaluate each case without assuming anything?

JS: Each case depends upon what the debtor’s roles are and their income. Some people have tax issues that they’ll probably need to deal with.

Q: So another rule of thumb would be that if you’re in financial straits, because you have unsecured credit card debt and a tax bill due, pay the taxes and worry about the credit card debt later on.

CH: If you have a debt that won’t go away versus a debt that will go away, obviously you want the benefit of paying the tax or student loan or other debts that won’t be dischargeable, such as child support.

Differences Between Chapter 7 Bankruptcy and Chapter 13 Bankruptcy

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The primary difference between a Chapter 7 bankruptcy and a Chapter 13 bankruptcy is that a Chapter 7 bankruptcy can eliminate debt in a period of three to four months compared to the three to five years it takes to complete a Chapter 13 plan. Under certain circumstances, a Chapter 13 bankruptcy can be converted into a Chapter 7 bankruptcy.

We recently discussed several aspects of bankruptcy with Christopher Holmes and Jess M. Smith, III, partners at Tom Scott & Associates, P.C. The discussion covered several topics, including the means test, the differences between Chapter 7 and Chapter 13, how divorce and child support can affect bankruptcy, and the discharge process. Below is Part 2 of 4 of the transcript of that conversation.

Q: For a debtor, in terms of moving forward with your life after you declare bankruptcy, what are the differences between between Chapter 7 versus Chapter 13? How does that affect your credit score or your standing in the financial world?

Jess Smith, III: In the short-term, a Chapter 7 is probably more advantageous, because when you’re in a Chapter 13 there’s always the risk that you won’t complete the plan and you’ll become eligible to convert it to a Chapter 7. Therefore, you can add debt to your bankruptcy that accrue from the time you file your Chapter 13 to when you convert to your Chapter 7. That makes lenders nervous about extending credit to you while the Chapter 13 is open, because they could take a hit.

Chris Holmes: I always tell people you’re in a case for three to four months under Chapter 7. Your done and you can do whatever you want. In a Chapter 13, you can’t borrow money without permission of the trustee or the judge. As Jess pointed out, debts that are incurred after the filing of the case, if they change their mind and switch to a Chapter 7, they can be thrown into the mix for discharge.

Q: So what would be the circumstance in which someone could switch from a Chapter 13 to a Chapter 7?

JS: A loss of income is the primary one.

CH: People start out and maybe they’re too rich. they make $100,000 a year and can pay back some of the debt. Then their job goes overseas and they’re making $10 an hour; income plummets; no money left over for the creditors; case is no longer feasible. And so we switch to a Chapter 7, dispense with the monthly payments, and just wipe out the rest of the debt.

JS: Another reason someone might want to start as a Chapter 13 and contemplate having the option of a Chapter 7 later is that you have people with substantial medical issues. Perhaps they have a few creditors coming after them now, where they need that protection. But they don’t want to file Chapter 7 now, because they know they’ve got medical issues within the next eight years that are going to crop up. Some of them will go into a Chapter 13, to establish a payment plan with those existing creditors, knowing that if a medical calamity happens before the Chapter 13 is done they can convert to a Chapter 7 and add those debts.

CH: It’s kind of a way to insure against uninsured events over this three- to five-year period, so if something terrible happens—they run up $50,000 of uninsured medical debt and they can’t afford to pay it—the law says we can switch from a Chapter 13 to a Chapter 7 and move those debts. Generally speaking, when you file the case, you’re going to list the debts prior to that date. In a Chapter 13 or a 7, you can’t add debts thereafter. Unless you switch it from a Chapter 13 to a Chapter 7, so that deadline before which debts can be added moves up to the date of conversion to a Chapter 7. So, all of those debts incurred in-between, that otherwise a debtor would have been stuck with, are added to the list.

Q: It seems as if wiping out debts completely under Chapter 7 is a more drastic financial transaction. Does that affect your credit score more negatively than filing a Chapter 13?

CH: You would think that someone filing under Chapter 13 who is paying back some of the debt would get some kind of credit for that. But my understanding is that a bankruptcy is a bankruptcy is a bankruptcy to most creditors, whether it’s a Chapter 13 or a Chapter 7. People don’t get credit, in a sense, for paying back some of their debt through a Chapter 13 plan.

JS: Not until the Chapter 13 discharge, but while you’re in it you get no positive benefit from it.

CH: No one is going to pat you on the back and say, “You’re paying back some of your debt, here I’ll give you more money.”

JS: At the end, if it shows you paid your mortgage on time and you paid your car off in full, you’ll get credit for those things. But your not going to get a boost for running into a Chapter 13 as opposed to a Chapter 7. Not in the short-term, no.

Q: But in the long-term?

JS: Potentially, yes.

CH: I tell people that supposedly debts stay on your credit reports seven to 10 years.

JS: Usually from petition date.

CH: So being in a Chapter 13 for three to five years, as opposed to a Chapter 7 for three to four months, won’t stay on your record any longer.

JS: A Chapter 13 will actually come off the credit report sooner. A Chapter 7 will be up there for up to 10 years; a Chapter 13 for about seven years.

Q: So an advantage to completing a Chapter 13, in the long-term, is that it will help you establish better credit sooner?

JS: Potentially. But in the short-term it’s the same.

CH: People always ask, “What’s a bankruptcy going to do to my credit rating?” Well, if you’ve got $50,000 of credit card debt, $30,000 of medical bills, and people are suing and garnishing and hounding you, your credit worthiness is already shot. In a weird sort of way, when you get a discharge in bankruptcy, you wipe that slate clean. You can’t file another bankruptcy for eight years, but if you have decent income and no debt, I would imagine that one’s credit worthiness is going to be enhanced by wiping the slate clean. We have debtors who tell us that just weeks later they start getting inundated with car loan applications, even though they’re in a bankruptcy. I assume that’s because the creditors are sophisticated enough to know they can’t file another bankruptcy and they can’t add any post-filing debt to the bankruptcy. So, any car loan after the filing can’t be added; they can’t file another Chapter 7 for eight years, and they’ve got decent income and they know all of this debt is going to be wiped out, a new loan can’t be discharged. I assume that’s why they are aggressively marketing to those people.

Q: So, you can’t file another Chapter 7 for eight years after having filed a Chapter 7?

CH: Date of filing plus eight years.

Q: How about if you file for Chapter 13, then complete that 60-month plan and the bankruptcy is discharged?

JS: If you file a Chapter 13 first and complete it, you can file a Chapter 7 six years after your Chapter 13 filing date, under certain circumstances. If you file a Chapter 7 first and then you file a Chapter 13, it has to be four years after your Chapter 7 filing to be eligible for a discharge. We have people who file them so close together they’re not eligible for any discharges. They complete an umbrella, so they can get their things sorted out. With an umbrella, the creditors are told to stay, while the debtor makes some sort of a payment plan. We have people complete those payment plans and then they still have to deal with the debt, because it wasn’t discharged. But, in the interim, that period of the five-year window, they’re able to live their lives and try to get their affairs in order.

CH: Or we put them in one of these bankruptcies just long enough until finally it’s been long enough to file a bankruptcy from which they can get a discharge. So, we let the case be dismissed and then re-file when it’s been long enough.

JS: I just placed someone into a Chapter 13 where basically the primary purpose was that her main debt was student loans. She made about $70,000 salary and, based on her household size, she could file a Chapter 7. But the student loan creditor said, “You owe us over $100,000, so we’re going to administratively garnish 15% of your wages. And she said, “No you’re not. I’m going to file a Chapter 13 and I’m going to pay you $500 a month for the next five years, so I can get my kids out of the house.” Otherwise she knew that 15% was going to have her end up being evicted, because it was too much of her income.

CH: Another reason we do Chapter 13 filings is because student loans are nondischargeable. If, for example, the debtor has other problems and the student loans is just too burdensome, we put them in a Chapter 13, so they can keep the student loan creditor at bay for five years. Meanwhile they can resolve some other cash issues or save their house or do whatever they need to do. But then, of course, because it’s nondischargeable, down the road that student loan is still there. Chances are that what was paid to the student loan through the five year plan won’t cover the interest that accumulates, so that student loan is probably going to be bigger. But at least they can get rid of all their other financial problems and then they can focus on the student loan at the end of five years. Hopefully at that time the money that was in the plan to solve other problems will be there to solve the student loan five years down the road.

JS: We refer to that as a Chapter 26. That’s when you get through your first Chapter 13 and shed everything but the student loan, and then if you’ve got all of the kids out of the house, maybe you’re in another Chapter 13 where your student loan is your only creditor and you try to knock it out during the second five-year plan.

Q: So, regardless of whether you file Chapter 7 or Chapter 13, student loans are not dischargeable?

JS: Correct. By and large, with rare exceptions.

Q: And that’s the same for federal taxes?

CH: Well, no. Taxes are a little different, although that gets complicated, too. But, generally speaking, if the taxes are less than three years old, you’ve got to pay them back. Taxes more than three years old may be dischargeable, but then you have to worry about whether there is a federal tax lien. Some of the tax might have to be paid back. I’m about to file a case for a debtor who had some taxes owed for 2012. The clock didn’t start ticking until April 15, 2013, because taxes are always due by April 15 the following year. So, I said to her, “Look, you’ve got all of these taxes owed for 2012; we don’t have to file your bankruptcy sooner than later. Let’s wait until after April 15, 2016, so they’ll be more than three years old and then maybe those 2012 taxes will be treated just like a credit card or medical bill, and be totally wiped out.” The threat was that in the interim, unbeknownst to me, the IRS filed a tax lien, which would make some of the tax payable. The hope is that the tax is going to fall off as a dischargeable debt.

Part 1 of Conversation: Means Test Helps Determine Filing For Chapter 7 or Chapter 13 Bankruptcy

Part 3 of Conversation: Divorce and Child Support Can Impact a Bankruptcy

Part 4 of Conversation: Being Discharged From Bankruptcy

Accruing Post-Petition Interest on Unpaid Federal Taxes (Interview Part 3 of 3)

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Penalties for unpaid federal taxes are still dischargeable when filing for bankruptcy, but they will accrue post-petition interest that is owed to the IRS. Debt limit amounts have changed for Chapter 13 cases, as of April 1, 2016.

Editor: We recently discussed the changes in the bankruptcy laws with Christopher Holmes, Jess M. Smith, III, partners at Tom Scott & Associates, P.C., along with associate attorney Andrew DeYoung. Below is Part 3 of 3 of the transcript of the conversation.

Q. What else is new in bankruptcy law?

Chris Holmes: Some of our clients have received letters from the IRS. We thought certain taxes or certain penalties or certain interest on taxes were going to go away, upon discharge. But now the IRS is coming after people—after discharge—for non-dischargeable penalties and interest on taxes that were fully paid through the Chapter 13 plan. In the good old days we would tell people that once you’re done with that Chapter 13 plan, you’re done with the IRS; you’re done with the Indiana Department of Revenue; you have no more tax worries. Now we’re finding out that is not always true, depending upon when the tax returns were filed. So, in affect, the IRS is punishing people for not filing their tax returns in a timely fashion. So, if tax returns are not timely filed and they’re filed within two years of the filing of a bankruptcy case, those taxes are not dischargeable nor are the penalties and interest thereon. Previously, you would throw those taxes in the plan, pay them in full, and then the penalties and interest would be discharged.

Jess Smith, III: Now they’re boarding up the penalties, but accruing post-petition interest.

CH: So the penalties are still dischargeable; it’s just the interest that’s still accumulating, and will be there at the end of the road. So, now we get these calls from our clients saying, "Hey, what’s going on? I got this letter from the IRS," and we have to give them the sad news that when the law changed back in 2005, there was a provision in there that allows the IRS to collect these interest charges on debts that were otherwise fully-paid through the plan.

Andrew DeYoung: Starting April 1 of this year, and this only relates to Chapter 13 cases, the debt limits are going up. That means the amount of unsecured debt that you have is increasing about $10,000. Debtor’s going into bankruptcy are able to have another $10,000 owed out and still will qualify for a Chapter 13 case. It’s now $394,725, up from $383,175. For secured debt, the amount is now $1,184,200, up from $1,149,525. It changes every three years and it can be found in the Federal register if you use the code words "109(e)" or "Chapter 13 debt limit." 

CH: It’s pretty rare that someone would have debts of that amount.

AD: One case that we worked on the debtor had purchased some vacant real estate in Florida, when the market was doing very well. He purchased the property for roughly $300,000 to $350,000 per parcel. The value then went down to under $50,000 per parcel. We ran up against the debt limits on that issue. We were luckily able to negotiate with the creditor to work a solution in the Chapter 13, but if the creditor had not agreed to work with us we would not have been eligible for a discharge in Chapter 13 because the secured debt of the debtor was too high. In a case I’m working on now the problem is where the debtor has student loans totaling $370,000. The rest of their unsecured debt is not very high, but with the debt limits only around $390,000, absent an agreement with the Department of Education, we’re not eligible for a Chapter 13.

CH: The consequence would be that they have no choice but to resort to a Chapter 11, which is primarily designed for corporations and individuals with really, really complicated situations — and those cost a whole lot more for attorneys fees and court costs.

AD: In talking to the U.S. trustee, I was advised two days ago that you would be a fool to take a Chapter 11 for under $10,000 (as the attorney fee), which in comparison to our Chapter 13 fee would be a total fee over 60 months of $4000. $10,000 up front in one sum or $4000 over 60 months is quite a big difference.

CH: It’s rare, but once in a while you get a debtor who has that kind of debt, and then you have to really go into how much the really totals out to be. You think it might be a certain amount, but the hope is that it falls under those thresholds so you can just barely make it into a Chapter 13.

Part 1 of Interview: What’s New in Bankruptcy Law in Indiana

Part 2 of Interview: Property You Can Protect When You File for Bankruptcy

Property You Can Protect When You File for Bankruptcy (Interview Part 2 of 3)

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Retirement accounts are exempt from creditors when filing for bankruptcy, but an inherited IRA is not. A recent ruling extending the time to cure arrearage might help you save your house after a tax sale.

Editor: We recently discussed the changes in the bankruptcy laws with Christopher Holmes, Jess M. Smith, III, partners at Tom Scott & Associates, P.C., along with associate attorney Andrew DeYoung. Below is Part 2 of 3 of the transcript of the conversation.

Q: Can you mention some of the things you can protect and some that you cannot protect when filing for bankruptcy?

Chris Holmes: Real estate. If it is your residence, you can protect up to $19,300 of equity. If it’s a joint filing and the property is owned jointly by a husband and wife, they can protect up to $38,600. Sometimes, when only one of them files, the property owned by a husband and wife is totally off limits to the creditors. That comes in handy sometimes.

Q: Based on cases you’ve dealt with, what are examples of the types of property people will include in their bankruptcy filing?

Jess Smith, III: The cash value of life insurance polices.

Andrew DeYoung: 401k accounts. IRA accounts. It can be as general as the clothing on your back. It’s what the exemptions apply to.

CH: But inherited IRAs are not exempt.

JS: It’s complicated and that’s why you should consult with an attorney.

CH: In general, retirement accounts—IRAs, 401Ks, defined benefit pension plans—are exempt, off-limits, no matter how much money is in there. But there was a recent decision where someone inherited a person’s IRA. The person who had the IRA died; someone inherited the IRA. The person who died could have protected that in its entirety from his or her creditors, but when it was inherited by the recipient—the debtor— it wasn’t off-limits to the creditors. It became subject to being taken and liquidated for the benefit of the debtor’s creditors.

Q: Was this decision a case you worked on or a precedent-setting case?

CH: It was a precedent-setting case in the 7th Circuit Court of Appeals in 2013, Clark (debtor) v. Rameker (trustee), in which a decision was made by the judges that an inherited IRA is not exempt in certain circumstances. (ed., The Supreme Court affirmed this decision by unanimous vote in 2014: Funds held in inherited Individual Retirement Accounts are not “retirement funds” within the meaning of 11 U.S.C. §522(b)(3)(c) and therefore not exempt from the bankruptcy estate.)

JS: And there was the case of someone buying a new car on the eve of bankruptcy to protect the lien, or affecting the lien. If the creditor does not affect the lien on the title, sometimes the trustee can take the car itself.

CH: Right. I recently had a case where right before the people came in to sign the paperwork, just two days before, they went out and bought two cars. So I had to change the paperwork and their list of creditors, but then the problem was that we had to know for certain that the creditor had put their lien on the title to each vehicle—and they had to do that within 30 days of whenever the people got the car. Otherwise, in a Chapter 7 bankruptcy, or even in a Chapter 13, the trustee could void the lien, take the car and liquidate it. Unless we did something else to prevent that, we would have to wait 91 days from the transfer of the title to file the bankruptcy. Otherwise, it creates what’s called a “preferential transfer.” With that situation, a trustee could set aside that preferential transfer and try to confiscate and liquidate that car.

There is another recent precedent-setting case that has changed in bankruptcy law. Previously, when a house had been sold by the county treasurer for delinquent taxes, the debtor had one year to redeem the property—pay the taxes plus a rate of interest—to keep the house from going to the tax sale purchaser. In the bad old days, we would have to tell people, "You’ve got to file a Chapter 13 bankruptcy before the tax sale to get the benefit of the three- to five-year Chapter 13 plan, to cure that real estate tax arrearage and save the house. If the tax sale had occurred, we couldn’t use a Chapter 13 plan to give them three to five years to cure that problem. They still had this one-year statutory redemption period, but luckily one of our judges, Judge Carr, ruled that you can now use a Chapter 13 plan after the tax sale has taken place to force everyone to back off for three to five years, to give that debtor ample time to cure that arrearage. So that is a new development we can use to save houses after tax sales.

Part 1 of Interview: What’s New in Bankruptcy Law in Indiana

Part 3 of Interview: Accruing Post-Petition Interest on Unpaid Federal Taxes

What’s New in Bankruptcy Law in Indiana (Interview Part 1 of 3)

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The official bankruptcy forms changed as of December 1, 2015, which will impact pro se debtors filing Voluntary Petitions. Mistakes made by pro se debtors include handling of tax refunds and submission of the document production form. Indiana bankruptcy exemption limitations have also changed.

Editor: We recently discussed the changes in the bankruptcy laws with Christopher Holmes, Jess M. Smith, III, partners at Tom Scott & Associates, P.C., along with associate attorney Andrew DeYoung. Below is Part 1 of 3 of the transcript of the conversation.

Q. What’s new in bankruptcy law in Indiana?

Chris Holmes: First of all the official bankruptcy forms changed as of December 1, 2015, so the forms are much more complicated. I think they require much greater sophistication. It’s probably going to impact the pro se debtor — the people who want to represent themselves in a bankruptcy. The forms are supposed to be simpler, but I believe they are much more complicated and perhaps will drive some people to attorneys to have them filled out properly.

Q: What are the different types of information that those forms are now asking people to include?

CH: The same information is being requested, but in a much more confusing way.

Q: Let’s start with that information. What types of information do the forms require?

Andrew DeYoung: The Voluntary Petition, for example, used to be a three-page document. Now, it’s an eight-page document. They’ve taken the old forms and added more language to read and understand, and it’s increased the size of the paperwork in a petition package to 23 pages per case. (Reference: United States Bankruptcy Court Southern District of Indiana Pro Se Debtor Packet)

Q: What kind of information is included in that Voluntary Petition?

AD: All of the property that a debtor owns; all of the creditors that a debtor owes money to; their income; their place of employment; and money they spend on a monthly basis for their household expenses, so it forces debtors to come up with a budget.

CH: People who think they can do it themselves might be fooling themselves, because the paperwork has become so much more complicated and the law imposes so many more requirements on debtors and their counsel to provide certain information and documents. I saw a story today where a woman was trying to do it herself. She had filed her tax returns, but then she had filed her bankruptcy before she had received and spent her tax refund money. So, the trustee was telling her that he was going to be suing her for his fair share of those refunds, because she had not received and spent them before she filed for bankruptcy. As of the date of filing, the refund was an asset of the bankruptcy estate, and the bankruptcy trustee, on behalf of all of the creditors, is entitled to take his fair share of it and distribute that money amongst the creditors. So, she didn’t know that, because she was doing it herself, and now her case is threatened with dismissal and her debts may never be dischargeable. She’ll be denied a discharge if she doesn’t turn over that money to the trustee.

Q: What other common mistakes do people make when they file for bankruptcy for themselves?

AD: We actually had a client, who retained us at our Shadeland Ave. office last week, whose petition I review at our free consultation. She had done everything correctly, but she paid a petition preparer to get it together, which cost her $300. She showed up at the meeting of creditors, but the trustee sent her home because she did not provide him with the document production form, which is required in Chapter 7 cases. So even though this particular person did everything correctly, it still resulted in the hearing not being held and her coming to retain us to get together her document production and fix the different things in her petition that a trustee may want to see perfected. So, she wound up financially in exactly the same place she would have been, minus $300, if she had just hired us to begin with.

Q: It sounds like cases in which people who file their taxes by themselves receive a letter from the IRS that states they owe thousands of dollar in unpaid taxes, plus interest and penalties, and then they hire an accountant to help them resolve the situation.

CH: Yes. I probably could do my own taxes, but I choose to pay someone to do it for me because it’s complicated and I want it done right. I like to use another analogy. I used to change the oil in my car. It’s doable, but I’d rather pay someone to do it because I want it done right, they can dispose of the oil more efficiently that I can, and I’m also afraid I might not get the lug nut in properly. Who knows what could happen then?

Also in regard to the bankruptcy forms is that the exemptions have changed. Indiana has a statute, Indiana Code 34-55-10-2: Bankruptcy exemptions; limitations, which tells people how much property they can protect from their creditors—or in the bankruptcy context, from the trustee who represents their creditors. Those numbers recently increased. It used to be you could protect $17,600 in equity and real estate; that number has gone up to $19,300. Or people could protect $9350 of tangible personal property; that’s now $10,250. So these are important details. Some people who represent themselves perhaps have valuable property that could be taken by the trustee. Like that tax refund situation, they could protect $400 of the tax refund now, as opposed to only $350 previously. There are some sections in the code that tell you some things that you can protect and some things that you can’t protect that are very critical in determining whether you file a Chapter 7 or Chapter 13 bankruptcy. That’s because something might be lost and liquidated in a Chapter 7, but you can pay your creditors enough money to protect those assets in a Chapter 13 case.

Part 2 of Interview: Property You Can Protect When You File for Bankruptcy

Part 3 of Interview: Accruing Post-Petition Interest on Unpaid Federal Taxes

Tax Returns, the Affordable Care Act (Obamacare), and Bankruptcy

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We recently interviewed Christopher Holmes and Jess M. Smith, III, the senior partners at Tom Scott & Associates, P.C. Below is Part 3 of that interview, which focuses on filing your taxes in relation to when you file for bankruptcy, as well as how a subsidize premium for health insurance purchased through the Healthcare.gov website can affect your taxes.
Q: On another topic, what happens when someone who has filed for bankruptcy has not been filing their taxes on time every time?
JS: A hot issue is tax returns in Chapter 13 filed late.
CH: Pre-2005, if you filed bankruptcy first and you had a bunch of unfiled tax returns, you could turn them in after your bankruptcy and basically all of the taxes were going away except for the ones from the last three years. That gave great incentive for people to get right with the IRS after they’ve file for bankruptcy. Now, they’ve reversed the law to make it much more harsh on debtors. If you don’t file your taxes within two years of the bankruptcy the taxes due are never going away.
Here is a horror story example: A salesman in his late 50s, who lived in Noblesville in Hamilton County, came to us in 2009 with a bunch of letters and documents from his accountant. Based on his recollection and the documents, he thought his taxes from 2000 through 2005 had been filed in 2005. So we were getting ready to file his bankruptcy case in 2009, we made sure he paid his taxes for 2006, 2007, and 2008, which were the three years before his bankruptcy filing. We went through the bankruptcy and he paid those taxes, and then he eventually obtained his bankruptcy discharge.
About two months after his discharge, the IRS started coming after him saying that his returns from 2000 through 2005 weren’t filed until 2008. Because they were filed within two years of the bankruptcy, they were had not been discharged. He swore those returns had been filed and said, “I know my accountant mailed these in.” he gave me power of attorney and I got on the phone with the IRS in Sacramento. Unfortunately for the client, the IRS had scanned the envelopes, with the postmarks, of all of those returns, so they had image files that showed that for some reason the returns had not been mailed in until 2008.
So, he had misrepresented to me the status of those returns when we filed his case in 2009, so as soon as he was out of his bankruptcy when we paid his 2006 through 2008 taxes, we now had to file another bankruptcy to deal with these old taxes, because the IRS was starting to levy his pension.
CH: His old taxes would have been discharged because they were more than three years old, except for the fact that those taxes were filed within two years of the day of the filing of the bankruptcy case, so you don’t get the benefit of that so-called three-year rule, which meant the taxes didn’t go away as they would have back in the good old days before 2005.
JS: Looking back, he had to file his case in 2009, because he had another creditor pursuing him in court, so he didn’t have the luxury of waiting two years and a day to file for bankruptcy. That’s important for people to understand now, if you have not filed your taxes and you want to get resolution on them. Usually, the recommendation is to get them done sooner rather than later to have any hope of discharging them in a bankruptcy.
CH: The moral of the story is to file your taxes every year to avoid that sort of problem.
JS: Another issue that is moving to the forefront of bankruptcy cases – and I don’t know yet how we’re going to resolve it because it is such a new issue – is that people have been signing up for personal health insurance under the recently legislated Affordable Care Act – otherwise known as Obamacare – and then it is turning out that their annual income is too high, so when they file their taxes they no longer qualify for the subsidized premiums they received. they are then getting nailed by the IRS with huge liabilities. I have client coming in tomorrow who owes over $3000 on his 2014 taxes.
CH: So he had a subsidy that was bigger that it should have been because it was based on his current income?
JS: Correct.
CH: So they projected his income as less than what it proved to be, so he received a bigger subsidy than he would otherwise.
JS:  I don’t yet know all of the details, but instead of receiving the refund his accountant projected, the IRS said, “No, you owe us a little over $3000.” What I currently know is that it has something to do with Form 8962 Insurance Premium Tax Credit, referred to as the PTC form. Moving forward, that is probably going to be a common issue that triggers tax liabilities the people don’t anticipate.
CH: Because the subsidy is based on an income means tests.
JS: I don’t know for sure yet, but apparently he sought out a subsidize premium when he applied through the Healthcare.gov website in 2013 for healthcare insurance coverage for 2014. When tax time came in 2015 to recapture, he got nailed. We’ll have to wait and see how this situation gets resolved, but it is an issue that will likely come up more frequently in years to come.

Parts 1 and 2 of This Interview

Part 1: Divorce and Bankruptcy
Part 2: An Experienced Bankruptcy Attorney Can Help You Keep Your Personal Property

Liquidating Tax Debt / Protecting Co-Debtors: Basics of Bankruptcy – Chapter 13 vs. Chapter 7 – Part 4

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The previous installment of our series “Basics of Bankruptcy” discussed some of the reasons to file a Chapter 13 bankruptcy vs. Chapter 7 as they relate to cars and other personal collateral. This last installment looks at reasons why Chapter 13 might be the better choice for personal bankruptcy than Chapter 7 when it comes to liquidating tax debt and protecting co-debtors.

Liquidating Tax Debts

Summary: Chapter 13 is an effective tool for liquidating large tax and other obligations, as it can provide the debtor with more time than a non-bankruptcy setting would allow.
A chapter 13 is a very effective tool for liquidating large tax and other priority obligations, as it sometimes provides the debtor with more time than a non-bankruptcy setting would allow.

  • Generally, we see large income and trust fund taxes paid through the plan, and in the last few years, child support cures have become more common.
  • Also, if the debtor is self-employed, part of the confirmation order may include the requirement that the debtor make regular ongoing monthly estimated tax payments to the IRS.
  • If this becomes part of a confirmation order and is later breached, the IRS can move for dismissal for breach of the order.

a) Secured tax claims: A tax liability is secured to the extent that the debtor has equity in property if the taxing agency has filed a lien in the debtor’s county of residence.

  • One should always verify that the lien was recorded in the correct county.
  • In determining the amount of the secured claim, the equity that the debtor lists in schedules A and B is totaled.

Special note: the IRS asserts that their claims are also secured to the extent that the debtor has any interest in a retirement fund or a 401k, even though this is an asset that is generally excluded from, or exempted out of the bankruptcy estate. See In re Wesche, 193 B.R. 76 (Bankr. M.D. Fla. 1996) stating that federal tax lien attaches to all interests in pension, not just current benefits.
This is very important because if the debtor has a retirement fund, the IRS secured claim that may have appeared to be minimal based on the equity in personal property can become unmanageable, even in a 13. To the extent that the secured claim extends beyond the equity available to support it, the balance will fall to priority or general under the §507(a)(8)* analysis. Also remember, that the equity is applied to oldest liabilities first.
Secured real estate taxes are paid through the plan. Generally only the pre-petition amount due is paid, but if the next semi-annual installment is due shortly, and the taxing agency agrees, that post-petition obligation may also be included. Real estate taxes are paid with interest of 8%.
b) Priority tax claims: Again, taxes are prioritized in §507(a)(8), but briefly they include income taxes due within the prior three years, trust fund taxes and some personal property taxes. One thing to be aware of in determining the priority afforded personal income tax liabilities is the term of art “tolling”, which has now been codified at the end of §507(a)(8).
Tolling is a rule that provides that any time spent in a prior bankruptcy (any chapter) or when the government unit was prohibited from collecting a tax under applicable non-bankruptcy law will extend the reach back period for pulling tax years into priority status; an additional 90 days is added to time period.
Tolling applies only to pre-petition debt, but you need to be aware of any previous bankruptcies, as it can be a rude surprise to find that taxes due in 2003 retain their priority status in a 2009 filing.
As an example: The debtor previously filed a chapter 13 bankruptcy in April, 2004. In this bankruptcy, 2002 taxes (due April 15, 2003) are priority under §507(a)(8)(A)(i) due three years before the date of the filing of the petition.

  • If the 2004 bankruptcy was dismissed in April 2007 (the debtor was in the bankruptcy for 36 months). So, taxes originally due April 15, 2003 would retain priority status for three years, plus three years that the debtor was in the bankruptcy plus an additional 90 days.
  • Starting from the due date of April 15, 2003 the 2002 tax year retains priority status until July 16, 2009! So, a bankruptcy filed anytime before July 16, 2009 will pull the 2002 debt into priority status.
  • Furthermore, if the debtor asked for an extension until October 15, 2003, theses tax debts would be a priority claim until January 16, 2010. These facts may be confusing, but remain extremely important.
  • Other priority taxes that must be fully paid inside the plan include trust fund taxes (that portion that the employer withheld but did not remit to the taxing agency), and personal property taxes due within one year prior to the current bankruptcy filing.

A word about trust fund taxes — they are attributable to the responsible party of the employer. This determination is made by the IRS.
c) General unsecured taxes: ”Stale taxes”, those that are older than three years, and the penalty portion of priority taxes are general unsecured liabilities and are paid with the pro rata distribution afforded to other general creditors.

Protecting a Co-debtor

11 U.S.C. Section 1301* is otherwise known as the “co-debtor stay”, and prevents a creditor from pursuing a co-debtor on a consumer debt. In order to prevent the creditor from seeking relief from stay, the Debtor must propose in his or her Chapter 13 plan to pay the co-signed debt in full. There is no equivalent provision in Chapter 11 or Chapter 7.

* Source: Cornell University Law School Legal Information Institute (opens in new windows)