Filed an IRS extension request before filing your tax return? This may negatively impact the discharge in bankruptcy

Filed an IRS Extension Request before filing your tax return.  Take this into account when deciding whether to use bankruptcy to discharge the debt

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 year1040 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 Substitute Returns: Overstated tax debt that can be solved

The IRS substitute tax return is based on the reported gross income…only.  It doesn’t take into account:clogged-shower-drain-fix-it

  • mortgage interest
  • children (dependency exemptions)
  • business expenses
  • basis amounts – sale of property and stock
  • charitable contributions
  • marriage situation
  • depreciation

In essence, it doesn’t take anything into account that would reduce the tax on the gross reported income.  Therefore, the amount is almost always substantially overstated.  The IRS knows it is substantially overstated and it is hoping that the threat of such a return will cause the taxpayer to supply the correct return.  Unfortunately, many taxpayers don’t file on time to beat the ssessment and feel they are stuck with the incorrect assessment amount.

Fortunately, these returns can be “challenged”  via the audit reconsideration process.  The taxpayer can create a correct return and submit it as a challenge to the substitute return.  As a general rule the IRS will replace the incorrect substitute tax return with the more correct taxpayer created return.

I have prepared many actual returns after the substitute return has been assessed, and have often been able to get rid of many thousands of dollars for clients.   I recently finalized a return for a client and reduced his debt related to one tax year from $100,000.00 to less than $5000.00.  In many cases the reduction results in a refund to the client if the return is filed within 3 years of it’s due date.

In most cases, it is best to get the return filed before they do.  Doing so preserves the ability to use bankruptcy to discharge the debt later.  Where they have  beaten you to the punch, there may be a way to correct it in any event.  If there isn’t… there may be a way to reduce or eliminate the debt.

You should also read:

Reasons why you should file your return now

Will bankruptcy stop IRS levy activity?

Yes. Filing for Bankruptcy will stop the IRS levy. That’s an easy one. The bankruptcy code zymmertrumps 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.

IRS Levy Help – 6 ways to argue for the release of a levy or return of property siezed

IRS LEVY HELP

When the IRS decides it will take or “levy”  a bank account, paycheck or an asset, it will issue a notice of levy to the bank, employer or it will simply seize the asset in person.  Once this IRS levy notice is received by the bank or thenumbers6 employer, it can be difficult to remove. If money has been received by the IRS via the bank levy or asset seizure, it more than just difficult to get it returned.

When you receive a copy of that levy notice, it should contain the name and number of the IRS officer responsible for issuing it or the name, address and phone number of the automated collection service with the IRS.  You can call the number directly on the notice.  When the officer or the employee at acs answers the phone, you can simply ask for the levy to be released and/or any assets to be returned.

Of course they will probably say no.  It will be your job to convince the officer to say yes.

There are certain conditions under which the IRS will return assets that have been physically seized and they are:

  1. The IRS believes that the levy will create a financial hardship on you – i.e. the money in the bank account was from your paycheck and without rent and food won’t be paid for the month; or the car is necessary for work and has little value.
  2. You arrange a payment plan with the IRS.
  3. The statute of limitations on collection has expired – i.e. ten years have passed since the date of assessment
  4. The IRS agrees that the release will facilitate the collection of the tax debt – i.e. returning the tractor will help you plow the field to grow the potatoes for sale at market, to pay the IRS tax debt etc.
  5. The tax debt was paid in full, settled via an offer in compromise or discharged in a bankruptcy.
  6. You appeal.  You can appeal an IRS levy or other collection action. Do this by asking for the manager.  When the manager says no, fill out and fax or mail in a completed form 9423 within two days of speaking to the manager.  That appeal request must usually be decided within 5 days.

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

Bankruptcy and Your Bank Account

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.open-bank-account

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?

Who can file a chapter 7 bankruptcy?

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 7bankruptcy-court 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.

Tax Debt – Why can’t I pay the original balance and receive a waiver of the penalty and interest?

Tax Debt versus penalty and interest

A common  question my clients ask is “why won’t the IRS just accept a check for the original tax amount and waive all the penalty and interest”.Problems-with-Hiring-a-Third-Party-Software-Selection-Consultant1-425x241

This question makes alot of sense and in the real world most creditors will consider making a deal that pays the original balance and waives interest.  In the current economic situation many would be happy

to the original amount back.

But..this is the IRS’ world we are talking about.  So some things you need to understand:

Tax, penalties and interest are all the same to the IRS

The IRS considers the tax, penalty and interest to be all the same once assessed.  It is all principal debt at that moment.

Settling tax debt with the IRS isn’t “horsetrading”

The Free Dictionary defines “horsetrading” as “negotiation characterized by hard bargaining and shrewd exchange”

This type of negotiation works well when discussing a credit card debt, or the price of a car, but at the outset of the discussion with the IRS there is no bargaining.  The process is not informal.

The formal process is called an “offer in compromise“.  In an offer in compromise, rules are followed and at least in theory if the taxpayer fits into and follows those rules, the IRS has to settle the debt…formally.

IRS penalty reduction has it’s own set of rules

If the taxpayer wants to challenge the penalty and try to strip it from the overall debt outside of the offer in compromise process, there is another legal process typically called “penalty abatement”.

This process is administrative and the IRS can forgive penalties that have already been assessed if the taxpayer meets certain formal criteria as well.

No horsetrading at the outset here either.

Bankruptcy must be seriously considered in most cases

From a financial standpoint and because of the formality that exists in relation to trying to “settle” the debt, bankruptcy is often the best long term solution for those with serious tax debt.  If a taxpayer has serious tax debt, bankruptcy has to be considered.