Tax and Bankruptcy

    Payroll tax – Can it be discharged in bankruptcy?

    by Michael S. Anderson, P.C. on February 21, 2012

    Small business is the lifeblood of our economy.  Starting a small business is difficult though.  Marketing and management problems, government regulation and taxes all lie in wait to derail the best laid plans.  I typically see the small business owner at the end of what is usually a monumental effort gone bad.

    The owner now has a number of debts.  Vendor related debt, credit card debts, personal loans.  He or she often has a debt that can be difficult to deal with.  Employment tax, or as some call it “payroll tax”.

    This is the tax the business owner may have withheld from the employees’ paycheck, matched with some business income and sent in to the IRS (or failed to send in)

    When this type of debt is floating around, the business owner will usually do some research and decide that the first and best option is the IRS offer in compromise program.   (OIC)

    The OIC can result in a vast reduction of the tax debt, and for some it does.  For most though it doesn’t.  The OIC usually fails for a number of reasons.  I have written about a few here.  There are many others familiar with the offer in compromise process that are generally dissatisfied with it as well.  Some examples here , here and here.  Yes, even the IRS is concerned about it.

    I agree that the OIC must be explored and in some cases it will be successful.  But where it isn’t, does the business owner have other options are short of paying the debt or moving to cave in Borneo?

    1.  Long term payment plan – A payment plan that will fluctuate as the business owner’s income fluctuates but will end when the statute of limitations on collection ends ten years from the date of assessment.  (give or take a few years – read more here)  It can end sooner of course, if the business owner pays the debt off.  There are different types of payment plans as well.

    2.  Bankruptcy 

    But wait a minute.   Bankruptcy can wipe away income tax debt but employment taxes?  No way right?  Not so fast.  Employment tax as mentioned above is divided into two parts:

    The employee portion

    The employer portion

    The employer portion is the part of the tax that includes the obligation to “match” the employee’s 6.2% social security tax and the 1.45% medicare tax.  This portion of the employment tax can be discharged in bankruptcy if:

    1.  There have been more than 3 years between the date the 941 tax return was last due including any extension and the date the bankruptcy filing takes place.

    2.  There have been more than 2 years between the date the 941 tax return was filed and the date the bankruptcy filing takes place and;

    3.  The business owner didn’t willfully attempt to evade the tax (a topic for another day)

    The employee portion or what is often called the “Trust Fund” is NEVER dischargeable.  This portion is withheld by the employer in “trust” and sent in.  This part of the debt survives a chapter 7 bankruptcy and must be paid over a period of time in a chapter 13 bankruptcy.   It can be settled as mentioned in an OIC, and a payment plan coupled with the statute of limitations on collection will eventually kill it off. (see above as well)

    Despite the non – dischargeability of the trust fund portion of the employment tax, a bankruptcy will often makes sense for the business owner with a personal liability for the non trust fund portion.  Especially where other business debt exists.

     

     

     

     

     

    401k and bankruptcy: Will the IRS seize my retirement account after my bankruptcy is over?

    by Michael S. Anderson, P.C. on January 19, 2012

    Scenario

    • You hire a bankruptcy attorney who has explained that the $100,000.00  in your 401k plan is safe from creditors, and therefore safe from everyone inside of a chapter 7 bankruptcy.
    • You also owe the IRS $150,000.00 in back income tax.  The income tax debt meets the criteria to be discharged in the bankruptcy filing.  In other words, when the chapter 7 bankruptcy is over, you won’t owe the IRS the debt. Your legal obligation to pay it will be wiped out along with your credit card and other unsecured debt.
    • Several months prior to the bankruptcy filing,  the IRS recorded a number of “Notices of Federal Tax Lien” documents in the local County Recorder’s office.
    • You file the bankruptcy case.
    • The case goes well, discharge is entered and the case is closed.
    • Six months after the bankruptcy case is closed, you receive a letter from the IRS.  The letter states that the tax debt was discharged, but that the IRS is enforcing it’s tax lien on your retirement account and is taking action to seize the account.
    • You are confused as you believed that the retirement account was safe and that the tax debt was wiped out.   Sleepless nights ensue.
    Explanation
    If you have serious tax debt and/or consumer debt and a retirement plan, this scenario may be important to you.  There are a few things about the law that you need to understand as a result:
    • Most retirement accounts i.e. 401k, IRA, 403B funds are safe or exempt in bankruptcy.  Actually, certain “ERISA” accounts aren’t even part of the bankruptcy estate.   The bankruptcy trustee has no interest in them from the outset.
    • Unlike other creditors, the IRS isn’t subject to exemption rules i.e. social security checks and retirement accounts are theoretically fair game.
    • IRS liens properly recorded, survive a chapter 7 bankruptcy filing even if the underlying tax debt, the tax debt that was the basis for the lien was wiped out.  That tax lien survives and it is worth whatever you were worth on the date of the bankruptcy filing.  If you owned one asset worth $5000.00, like a car, and the discharged tax debt was $100,000.00, the lien is worth $5,000.00.
    • In a way, the IRS is like the lender on a car.  If you file a chapter 7 bankruptcy and you want to quit paying on the car, the chapter 7 bankruptcy will discharge your obligation to do so.  You will not be legally required to make the payment to the car lender.  The car lender however, still has a relationship with the car i.e. a security interest in it and that security interest is worth whatever the car is worth.  When the case is closed, the secured lender can take the car as a result.  It cannot sue you for the balance or deficiency if one exists.
    • The retirement account is like the car.  In our scenario above it is worth however far more than $5000.00.  If it were worth only $5000.00, it is highly likely that the IRS would agree to simply release the tax lien.  The amount of the tax debt was quite high though and more than the value of the retirement account, so the IRS could seize the account based on the lien.
    Solutions
    Some solutions to this problem include:
    • If possible,  file the bankruptcy before the tax lien is recorded.  This can be tricky of course.  The tax debt won’t become dischargeable in the bankruptcy case for a period of time.  (See bankruptcy discharge date requirements). The IRS will try to record that tax lien notice as soon as it can where the debt is relatively large.  There are defenses to the recording of the lien, but their application is fairly narrow if the debt is over $25,000.00
    • Remind the IRS that internal policy requires it to consider collection alternatives before levying or seizing assets.  (Although this may be changing)  Alternatives include IRS installment agreements and IRS offers in compromise.  The fact that you may have been saving money in the 401k plan while ignoring the tax may not bode well for you in this regard.
    • Prove to the IRS that you need the retirement account funds to survive or will need them in the near future.  It may be sensitive to the fact that the proceeds are paying your basic living expenses perhaps for the remainder of your life.
    • Make an offer.  Try to get the IRS to accept a smaller amount than the tax lien is worth in exchange for leaving the account in place.
    If the above scenario is familiar or you think it will be in the near future, the wisest thing to do initially is to speak with an attorney experienced in bankruptcy and tax debt matters as soon as possible.

    Debt forgiven by creditor? Three options exist to avoid the tax

    by Michael S. Anderson, P.C. on January 17, 2012

    When a creditor cancels or “forgives” a debt, it is deciding not to collect that debt.  It does this for various reasons, none of which are for the purpose of helping you.

    When the debt is forgiven following a settlement negotiation, a short sale, or a foreclosure, the creditor must report the amount of the cancelled debt to the IRS on a form 1099-c.

    Under Section 108 of the Internal Revenue Code, the IRS than treats that cancelled amount as income.

    If, for example, you earn $75,000.00 per year and a home sold at short sale for $100,000.00 less than the lender was owed, the IRS will treat you as having earned $175,000.00 in income.

    UNLESS:

    1.  The debt was discharged in bankruptcy

    If the obligation on the debt was included in and than discharged in a bankruptcy proceeding, it isn’t attributable to you as income.  If you received a bankruptcy discharge on the obligation, and a 1099c document from the lender, you will need to file a form 982 with the tax return.  This form tells the IRS how the forgiven debt is being treated and why it is not being included in the income disclosure on the return.

    2.  If the cancelled debt occurred while you were insolvent

    If you were “insolvent” you can reduce the amount of the cancelled debt from your income.  See U.S.C. Section 108(a)(1)(B).  Unlike bankruptcy, a determination of your asset value for insolvency purposes includes all of your assets, including retirement funds like IRA and 401k funds.  In Bankruptcy, these assets are generally out of reach.

    3.  If you qualify under the Mortgage Forgiveness Debt Relief Act of 2007

    President Bush signed this act into law and it is in place through the end of this year 2012.  In essence it protects those who have cancelled debt related to a principal residence.  It doesn’t apply to second mortgages used to buy a boat or pay off debt, nor does it apply to second homes.

    Losing a home, whether as a result of forced sale, short sale or foreclosure is traumatic.  I speak with many people who have made the experience more traumatic than necessary by ignoring the consequences of the 1099c.  If a debt is going to be forgiven and it is relatively large, you will need to determine whether an insolvency or the 2007 act will apply to reduce or eliminate taxation on the amount.  If not, bankruptcy as an option should be reviewed before the debt is forgiven if possible.

     

    McCoy V. Mississipi – The end of late filed tax returns? Probably not

    by Michael S. Anderson, P.C. on January 13, 2012

    About a week ago on January 4, the 5th Circuit Court of appeals in the case “McCoy v. Mississippi State Tax Commission”  ruled that a debtor wasn’t entitled to a discharge of state taxes where the tax return was filed late even though it was filed by the taxpayer.  In essence, they ruled that a late filed state tax return filed by the taxpayer/debtor is not a “return” for purposes of satisfying the “two year rule” in bankruptcy.

    Specifically, the State argued that the debt wasn’t discharged because the return was filed late.  The Appeals Court agreed and added that unless a late filed return is filed under a “safe-harbor” provision of the bankruptcy code, a late filed state income tax return is not a return for discharge purposes under Section 523(a) of the bankruptcy code.

    This case has raised the interest of many who deal with tax debts and bankruptcy, because to some…it stands for the proposition that a tax return filed one day late i.e. one day after it was legally required to be filed, can never be discharged in a bankruptcy unless it was filed with the aid of the State taxing Agency i.e. IRS.

    This line of reasoning has been attempted to some degree before, and in response, the IRS issued at least one notice ( irs-cc-2010-016-late-filed-tax-return) indicating that “form 1040 is not disqualified as a “return” under section 523(a) solely because it was filed late.”  The IRS doesn’t agree that a late filed return should be considered a non return.

    So…for now, and at least in the 9th Circuit, the late filed return still qualifies as a return for purposes of discharge in bankruptcy if filed by the taxpayer more than two years before the filing of the bankruptcy case and before the IRS assesses a debt.  I don’t think this will change in the future, but just in case…file your tax return on time.

     

     

     

     

    Tax Resolution Companies – Are they over-promising solutions?

    by Michael S. Anderson, P.C. on January 12, 2012

    I met with a person recently who has a six figure IRS income tax debt.  Many of my clients do.  As is common, he had been talking to several “Tax Resolution” Companies about his options.  There are hundreds if not thousands to choose from, so finding several isn’t hard to do.

    This person is single, no children and earns a six figure income.  All of his tax returns have been filed.  These facts about him are important because without knowing anything more, they probably mean that he is NOT a good candidate for an IRS Offer In Compromise, i.e. he is not likely a good candidate to reach a settlement with the IRS for less than is owed.

    A quick review of the realities that exist in regards to the offer in compromise program is in order here,  before I get to my point.

    1. Standard Allowances are usually applied

    The IRS will disagree with this person’s amount of living expenses.  It will review his expenses closely in order to calculate how much money he SHOULD have at the end of each month to pay toward his tax debt.  I emphasized the word should on purpose.

    The IRS doesn’t have to pay much attention to what he actually spends each month.  It can rely primarily on some “standard allowances” which have been created to tell it what the “average joe”  lives on each month.  Applying these standards will leave this person with fake or phantom income.  That income will be the basis of the amount the IRS thinks he can afford to pay.  Typically they won’t allow for his payments of credit card debt, retirement investment, vacation, Christmas, birthday, eating out, etc. etc. etc.  If a single person in Maricopa county earns $6500.00 per month after tax withholding, the IRS will probably see an ability to pay a few thousand per month toward the debt.  These standards can be challenged to some degree, but it is not easy to do.

    2.  The Offer in Compromise process isn’t informal

    The taxpayer has to disclose his entire financial life to the IRS.  Bank accounts, work history, paystubs, proof of payment of bills, asset values etc.  This isn’t done based on a chat over the phone.  It is a formal process much like filing a lawsuit, that comes with some rights but mostly responsibilities.  Often, while the taxpayer is in the process of submitting items to the IRS, things change.  Income increases, someone dies and leaves money or property.  The chances that the offer as submitted are accepted are reduced as a result.

    3.  The IRS isn’t interested in settling with most

    On average, the IRS agrees to settle about 20-25% of offers in compromise that are submitted.  When I explain this to people though they still get the impression that this is random.  It isn’t.  The offers that are accepted are those that meet the formal criteria.  What constitutes a good offer varies as well.  One person may have a $100,000.00 tax debt and be able to obtain an agreement to settle for $50,000.00, but have no way to pay it.  Another with the same set of facts may have a rich uncle.  Trying to reach some sort of conclusion about the IRS’ willingness to settle these cases based on their average acceptance rate is almost meaningless as a result.

    4.  Not a quick process

    Most Offers in Compromise take 6-12 months from filing.  Sometimes many more months are spent on the front end getting things right and on the back end appealing a negative result.  If the offer is accepted, the taxpayer either needs to pay the amount now, or spread it out typically over two years adding to the already long time frame.

    5.  Statute of Limitations on collection is extended

    The offer in compromise filing stops the clock.  It extends the timeframe the IRS has to collect the debt from you.  This timeframe is called the “statute of limitations” and it lasts ten years.  If you spend 15 months trying to get the offer in compromise accepted and it doesn’t work,  you will add 15 months to the timeframe.  If there was only a relatively short period of time left on the statute of collection when the offer is filed, filing the offer may have been a big mistake.

    So, the point…(finally).  

    This person had decided to hire a tax resolution company he had heard on the radio before speaking to me.  The company promised to “solve” his problem and requested $10,000.00 + as a flat fee to do so.  What he didn’t understand is what I have laid out above.  He is not going to “solve” the problem with an offer in compromise.  In reality, he will solve the problem with some sort of IRS installment plan in combination with the statute of limitations period or bankruptcy.

    Of course, the tax resolution company isn’t a law firm and has no ethical duty to really explain this…and didn’t. In fact, it probably uses a commissioned salesperson whose main objective is to close the “deal”.

    The company is hoping that it can arrange a payment plan with the IRS, and pocket the $11,000.00 for “solving” the problem.  It is really a play on words.  ”Solving” doesn’t mean reducing via an offer in compromise necessarily. The potential client doesn’t fully get this until it is too late.  He ends up paying  3 times or more than what he should, for the end result…a partial solution.

    Tax resolution companies are not law firms.  They can’t practice in Bankruptcy Court, they have no duty to tell the truth, and for most taxpayers the offer in compromise just doesn’t work.  What these companies are left with are subtle sales pitches that leave the wrong impression.  A very expensive wrong impression.

    If you have serious tax debt, your situation has to be fully reviewed/analyzed, bankruptcy and the statute of limitations must be considered AND a period of planning and adjusting should probably take place as well, before an offer in compromise is filed.  Don’t pay a large fee to someone on the promise of a “solution” until this work is done.

    Used an extension before filing tax return? This may negatively impact the discharge in bankruptcy

    by Michael S. Anderson, P.C. on December 28, 2011

    Several rules exist that govern whether an  income tax debt is dischargeable in a bankruptcy case.  They are all important, but the first one typically mentioned is often given the least amount of thought.  That is the “three year rule”.

    The bankruptcy code, specifically section 523, disallows the discharge of income tax based on a tax return that was due to be filed less than 3 years before the  filing of the bk case.

    If, for example,  the case was filed on Oct 14, 2011, and the tax debt was from the year 2007,  the 2007 tax return should have been filed or was due to be filed April 15, 2008.  This would satisfy the 3 year rule.

    But…what is often missed is when the return was actually due to be filed.

    As stated above, the 2007 tax return would have been due to be filed on April 15th 2008.  This would be more than three years prior to the filing date of the bankruptcy and the debt would meet the first requirement in obtaining a discharge of the debt.

    BUT…what if the taxpayer filed an extension to file the tax return on April 14th, 2008.  The due date for that return would have been moved to October 15, of that same year.  Given the above filing date of the bankruptcy of October 14, 2011, the bankruptcy would have been filed a  day too soon to meet the 3 year rule and the debt wouldn’t be discharged in the bankruptcy.

    This extended time period adds an equal amount of time to the calculation of the three year rule for purposes of discharging the income tax debt.  Taxpayers with serious tax debt and their counselors need to be aware of this glitch in the law.  I have been contacted often by many filers after the fact,  who didn’t understand why their tax debt wasn’t wiped away.  Often, it is because they filed three years after the April 15th due date and not three years after the extension date.

     

     

    IRS and the Bankruptcy Code: Will filing for bankruptcy stop IRS levy activity?

    by Michael S. Anderson, P.C. on December 22, 2011

    Yes. Filing for Bankruptcy will stop the IRS levy.  That’s an easy one.  The bankruptcy code trumps the tax code…every time it is tried.

    Why?  The filing of the bankruptcy case creates an “automatic stay”    This automatic stay applies to ALL creditors, and this includes the IRS.  The law literally places a hold on activity and as a result the IRS is required to stop the process of levying or seizing property.  It’s purpose is to provide some breathing room in order to use the bankruptcy code to start over or gain a “fresh start” as so many are fond of saying.

    The IRS is very aware of the automatic stay.  When notified of the bankruptcy filing the IRS will, at least in my experience, immediately start the levy release process.  If it doesn’t it can be sanctioned by the bankruptcy judge.

    Here is the important thing to understand.

    In most cases, the IRS has discretion about whether it has to release a levy.  Section 362(a) of the bankruptcy code demands that the levy or seizure end and quickly.  i.e. that discretion is removed, i.e. gone.

    And…the IRS is also forbidden from filing any tax lien notices related to the pre-bankruptcy filing tax debt.

    Stopping IRS collection activity is only the beginning of what bankruptcy can do in relation to tax debt problems.  Chapter 7 Bankruptcy can actually eliminate the tax debt.  At a minimum, chapter 13 bankruptcy can stop the IRS from adding new interest and penalty to the debt, discharge penalty and related interest, and in many cases, dramatically reduce or eliminate the tax debt as well.

    For many with serious income tax debt, bankruptcy makes the most sense in the end.  Not just because it stops the levy.

     

    If I file for bankruptcy will I lose my bank account?

    by Michael S. Anderson, P.C. on December 2, 2011

    Once the chapter 7 bankruptcy has been filed with the Bankruptcy Court, the Chapter 7 trustee assigned to the case is in charge of all assets.  Some would say that the chapter 7 trustee owns the assets, including bank accounts.

    But…just because the Chapter 7 bankruptcy trustee “owns” the asset or the bank account,  doesn’t mean that he or she will “liquidate” the asset.

    If the asset is exempt or not worth the time and effort to liquidate, the bankruptcy trustee will leave it alone.  In Arizona, only $150.00 is exempt per person in one bank account on the date of the filing of the petition.  If $151.00 or more is in the account on that day, in theory… the chapter 7 bankruptcy trustee could take the extra amount above the exemption.  If the amount in the account is $1500.00 on the date of filing, than the bankruptcy trustee will be very interested in the account balance above the exemption amount.

    The fact that the chapter 7 trustee “owns” the asset, doesn’t mean that you will need to close the account prior to filing.  The account can remain open and money earned after filing the case can be deposited, and is not property of the bankruptcy estate.

    In a chapter 13 bankruptcy case, the filer remains in control of the assets and can use the account in most cases without worrying very much about the amount in the account on the date of filing depending on how much creditors are being paid through the plan.

    If the filer has a bank account with a credit union like Desert Schools Federal Credit Union, they must be more careful about the account.  If the filer has a car loan or other loan with the credit union, the bank account funds are probably acting as partial collateral on the loan.  When the bankruptcy is filed the credit union will likely freeze the account and try to offset the funds in the account against the balance owed on the loan.  In order to prevent this, many bankruptcy filers will close the account prior to filing or limit the amount in the account.  Sometimes, non credit union banks will take a similar position.

     

     

     

    Who can file a chapter 7 bankruptcy?

    by Michael S. Anderson, P.C. on December 1, 2011

    Any individual who resides, is domiciled, or owns property or a business in the United States can…believe it or not…file a chapter 7 bankruptcy case in the U.S. Bankruptcy Court.  A business is also allowed to file a chapter 7 bankruptcy but will not receive a discharge.

    Just because a person resides, or is domiciled etc. etc.  doesn’t necessarily mean that once he has filed the chapter 7 bankruptcy case, that he can actually stay in the bankruptcy case.  People get kicked out that shouldn’t have filed the chapter 7 in the first place for a few different reasons.

    Means Test

    The bankruptcy code requires that those individuals with primarily consumer debts to take a “means test”.    This test is a convoluted way the law uses to determine whether the individual has the “means” to pay both living expenses and some amount of debt over a period of time.  If the person fails the means test, they can be kicked out of the chapter 7.  If this occurs, then they will need to file a chapter 13 bankruptcy and pay something toward the debt or deal with the creditors directly.

    Prior Filing

    If the filer has filed a chapter 7 case within the last 8 years and received a discharge, or a chapter 13 case within the last six years and received  a discharge.

    Prior case dismissed within the last 180 days and one of the following are true:

    • A Court Order was violated
    • A Court ruled that the filing was fraudulent or was an abuse of the bankruptcy system
    • The filer requested a dismissal of the case after a creditor asked for relief from the automatic stay

    Fraud 

    The Court can dismiss the case if it thinks the filer tried to cheat.  Things like:

    • Giving away stuff in order to hide it from creditors or from the bankruptcy trustee prior to filing.
    • Running up debts to buy “fancy” stuff when the filer was clearly unable to pay the debt
    • Hiding money or property from the spouse during the divorce
    • Lying about financial situation to creditors
    Failure to tell the truth
    When a petition and schedules are filed that are assumed to be complete and truthful.  They are signed by the filer under penalty of perjury.  (read as potential jail time to some).  If the filer deliberately fails to disclose information, or uses a fake social security number they are going to get kicked out of a chapter 7 bankruptcy.  OR worse.

    IRS Levy – Two ways to stop it without disclosing financial information to the IRS

    by Michael S. Anderson, P.C. on November 30, 2011

    IRS LEVY HELP

    File this under the additional methods to stop an IRS levy folder.

    In order for the IRS to levy your bank account or your paycheck a number of things have to have happen.  No, the IRS doesn’t have to file a lawsuit and obtain a judgement as do other creditors, but it does have to comply with a number of rules.  Primarily, the tax debt has to be assessed, and a “Final Notice of Intent to Levy” has to have been sent by certified mail to the taxpayer’s last known address more than 30 days before the levy starts.

    There are a number of ways to stop a levy once it begins.  Most of them require the IRS to ask a number of questions and the taxpayer to provide a number of answers.

    Two legal avenues exist that will absolutely stop a levy without questions or information exchange.  These two methods can be the quickest way to stop the levy as well.

    1.  Bankruptcy

    The filing of the bankruptcy petition creates a legal “stay” on all collections, even those belonging to the IRS.  There is no requirement that the taxpayer get the IRS’ permission to file or even disclose any information to the IRS. The filing alone stops the levy.

    Whether bankruptcy should be used is a different question of course that will depend on a number of factors.

    2.  Streamlined Installment Agreement

    If the tax debt is $25,000.00 or less, the taxpayer will not have to disclose information or answer financial questions in order to obtain a levy release.  Taxpayers will often pay a tax debt down to $25,000.00 in order to avoid these disclosure rules (and potentially higher payment plan).

    The catch – the debt has to be paid back within 5 years.

    Two legal avenues exist that should stop the levy.

    1.  Filing an Offer in Compromise

    2.  Filing a request for Innocent Spouse Relief

    The IRS is legally required to suspend collection on the account when either of the above are filed.  If you read the law closely you will see that the IRS is simply prevented from sending out future levies, but not prevented from leaving alone the one already in place.  Usually, the IRS will exercise discretion and release the ongoing levy.

    There are a number of rules that govern the release of IRS levies.  It is important to understand them or to get help from someone who does.

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