How 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.


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*Disclosure required by 11 U.S.C. § 528(a)(3): We, the law office of Tom Scott & Associates, P.C., are a debt relief agency. We help people file for bankruptcy relief under the Bankruptcy Code.