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

401k and Bankruptcy – Post Discharge

Scenario

 

  • The bankruptcy attorney has explained to you that the money  in your 401k plan is safe from creditors, and therefore safe from those creditors and the bankruptcy trustee if you file a chapter 7 bankruptcy.
  • You also owe the IRS some serious 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 have a personal obligation to pay the IRS 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 obligation 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 a retirement plan, the above scenario may be important to you.  There are a few things about the law that you need to understand:

  • 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. a percentage of 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 or request payment of the car’s value in exchange for release of the lien.  It cannot sue you for the balance or deficiency if one exists.
  • The retirement account is like the car.  In the 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, at least in theory, 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 for large debts.
  • 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.

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

Debt Forgiveness?

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.

IRS Offer in Compromise

images (2)The Offer in Compromise is an agreement between the taxpayer and the government to permanently settle a tax debt for an amount that is less then what is owed. The decision to settle is most often based on the IRS’ belief that full collection of the liability in the future is unlikely.. based on the taxpayer’s “reasonable collection potential”.  This reasonable collection standard is based on a formula that uses the facts and circumstances of the individual taxpayer.

There are three types of offers in compromise:

Offers based on doubt as to collectability 

Where doubt exists that the full amount can be paid within the statute period, the IRS must review the taxpayer’s assets, debts, income and budget to determine the reasonable collection potential referenced above.

Offers based on doubt as to liability

If the taxpayer doubts that the assessed tax is correct, he or she can file an offer in compromise and challenge the assessment. This offer must be carefully drafted and provide full documentation of the proof that exists that support the argument. When successful, the taxpayer may avoid paying certain taxes that were unfairly or incorrectly assessed.

Offers based on effective tax administration 

These offers are made when a taxpayer agrees with the amount that the IRS claims is owed and would be able to pay it in full; BUT an exceptional circumstance exists that would create an economic hardship, inequity or an unfair situation if the tax were paid.

OFFER IN COMPROMISE: THE PROCESS

The process required to analyze, prepare, and submit an offer in compromise and then to obtain a final agreement can be very complex and time consuming. The success a taxpayer might have had can be undermined by the failure to understand a minor detail, regulation, procedure or guideline.

Not only must procedure be followed by the taxpayer, he or she must provide a detailed financial statement with proof of income, budget, and assets. These documents must often be updated, as the offer process progresses.

The IRS will review the proposal and documents, and compare the numbers to their own basic standards to compute what it believes to be the reasonable collection potential  of the taxpayer.

If the IRS rejects the Offer in Compromise, the taxpayer may appeal the decision or propose an alternative collection method like a partial pay installment agreement.

If the Offer in Compromise is accepted either on its face or following negotiation or appeal, the taxpayer must make the payments according to the accepted offer’s terms after which the remaining debt is removed and the lien is released AND the taxpayer must remain compliant i.e. file all tax returns for 5 years. If any requirement isn’t completed, the offer will be annulled  and all delinquent amounts will again be owed with interest.

In the past, most with serious tax debt didn’t make good candidates for the IRS Offer in Compromise program.  Recent changes to the program may make it easier from many to qualify.

 

 

Late Filed Tax Returns and Bankruptcy – McCoy V. Mississippi

Late Filed Tax Returns and Bankruptcy

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 evenuniqlo-sorry-im-late-tshirt-735856 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?

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 notsuspicious 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.

IRS Payment Plans – Why they often fail

IRS Payment Plans and Why they often fail 

If you have serious tax debt and the internet, you are likely familiar with the term “national standards”.  The IRS calls them more generally “Collection Financial Standards” and has this to say about them:bag-of-money-dropping-out-bottom

“Collection Financial Standards are used to help determine a taxpayer’s ability to pay a delinquent tax liability.  Allowable living expenses include those expenses that meet the necessary expense test.   The necessary expense test is defined as expenses that are necessary to provide for a taxpayer’s (and his or her family’s) health and welfare and/or production of income.”  See “Collection Financial Standards”

On the page just mentioned, you can find what the IRS uses as “guidelines” to determine how much you should be living on each month as far as it is concerned.  This determines how much you should have leftover to pay toward the debt.  These numbers are used both in an installment agreement setting and in an offer in compromise calculation.

In Maricopa County, the standards for a Family of 3 are as follows:

  • 1812  Housing and Utilities
  • 1171  Food, Clothing and Expenses
  • 992  Vehicle Ownership for 2 cars
  • 582  Operating cost for 2 cars (includes insurance)
  • 180   Out of pocket medical care under age 65

If the car payments and housing/utilities numbers are lower than the standards the IRS will use the lower number.

Examples of other items that are typically allowed in calculated the living expense amount:

  • tax withholdings
  • health insurance
  • term life insurance
  • regular out of pocket medical expenses greater than the standard

If the expenses for the Family of 3 are larger than these numbers, the IRS will try to treat those amounts as if they didn’t exist.  For example, if the Family actually spends 2400.00 per month for mortgage and utilities on the home, the IRS will treat the difference of 588.00 as “available” to pay the tax debt on a monthly basis.

The IRS will consider however the higher number i.e. allow for the actual expense in certain circumstances.  As it states on the same page linked to above:

“If the IRS determines that the facts and circumstances of a taxpayer’s situation indicate that using the standards is inadequate to provide for basic living expenses, we may allow for actual expenses.  However, taxpayers must provide documentation that supports a determination that using national and local expense standards leaves them an inadequate means of providing for basic living expenses”.  (Read more here)

The IRS employee making the determination about whether the standard or whether the actual number should be used, doesn’t have a tremendous amount of discretion.  As a result, most taxpayers who have expenses that exceed the standards find themselves in a no win situation.  i.e. a requirement to pay the same amount of money to two different creditors.

The result is often that the payment plan agreed to fails in the end and the taxpayer is back where he or she started.

There are other solutions to this problem.  Some of which include:

  • paying the debt below 50000.00 in order to avoid basing the payment plan on the standards and the taxpayer’s income
  • using the Taxpayer’s actual budget where the remaining excess income will pay the debt over 5 years
  • filing for chapter 7 bankruptcy where the debt or some large portion of it is dischargeable
  • filing for chapter 13 bankruptcy where the debt is dischargeable and/or the budget allowed in the bankruptcy court is higher than the IRS standards

If your budget exceeds the standards, and you can’t afford to pay the debt over 5 years or pay the debt to 50,000.00, you will probably need to look at other options.

Late Tax Returns and IRS Debt? Yes…the IRS can do bad things as a result

Late Tax Returns and IRS Debt?

Everyone who has either missed the filing of tax returns or owes the IRS significant tax debt wonders, at least once or twice, what it is the IRS can actually do to them…?why-do-bad-things

Unfortunately, it can do a number of things…mostly bad.  Well…all bad really.

I am providing this list of the most common actions I see that the IRS takes against individual Americans.

Substitute Tax Return

Internal Revenue Code Section 6020(b) (1) states:

“If any person fails to make any return required by an internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary, shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise”

This means that the IRS can prepare a return based on information it has at it’s disposal or that it can find otherwise.  It doesn’t have to report deductions, expenses etc.  So the return is done as a single person, with a standard deduction and it’s creation usually results in a debt that is overstated, sometimes by tens of thousands of dollars.

It than uses this return to do some of the other bad things mentioned below.

The good news…if the return is wrong it can usually be “challenged” and fixed.  We have saved clients literally millions of dollars in tax debt by simply doing the correct returns and “challenging” the IRS return during an audit reconsideration process.

Levy

The IRS has the authority to take wages, federal payments, state tax refunds, bank account funds, and monies owed to independent contractors.

They don’t need a court order, all they need is the “assessment of the tax debt” and some time to provide written warnings or final notices of intent to levy, that go unheeded.

If wages or federal payments are levied, the levy won’t stop until of course it is released, you pay the debt or the statute of limitations on collection ends.

If the IRS levies your bank account, your bank must hold funds up to the amount that is owed for 21 days.  This is done to give the bank a chance to make sure you own the account.  After the 21 day period is up, the bank must send money with any accrued interest to the IRS.

Lien

A recorded Notice of Federal Tax Lien provides the IRS a legal claim to your property as security for payment of the debt.  Before this notice can be filed though it must “assess” the debt, (see above), send a notice and demand for payment and you must refuse to pay or neglect to pay within 10 days of that notice.  This process creates the lien and the notice of lien makes other creditors legally aware that the IRS is first in line.

The lien attaches to property even if is acquired after the lien is noticed out.

Releasing a lien can be very difficult.

Sell Property

Yes the IRS can sell your property.  Recently, it has become more aggressive about seizing retirement accounts and homes as well.

The process as it is related to seized property under IRC sections 6335 and 6336, is as follows:

The IRS will post a public notice of sale in a local newspaper and deliver a copy to you or send it certified.

After placing it, the IRS has to wait ten days before holding the sale, unless the items are perishable.

Before the sale, a minimum bid price is created.  This is usually 80% of the forced sale value of the property, after liens are taken into account.  This value can be appealed and sometimes needs to be as the more money that can be brought from the sale the less debt the taxpayer will have in the end.

Trust Fund Recovery Penalty

Where a business has held employment taxes from employee checks and hasn’t sent the funds in to the IRS, the IRS can assess a penalty against the “responsible parties” called a “trust fund recovery penalty“.  That penalty consists primarily of the employees portion of the tax withheld and not the matching portion.  This means that individuals become liable for the businesses debt.  It is a difficult penalty to deal with as it isn’t dischargeable in bankruptcy and the IRS will often assess it against everyone involved and let the chips fall “where they may”.

Late Tax Return? Should I file it if it if I can’t afford to pay the balance?

Late Tax Return?  Should I file it if it if I can’t afford to pay the balance?

Choosing to leave a tax return unfiled because you can’t afford to pay the debt associated with it, is a mistake.  For some, just a small one.  For others…a big one.google-penalty

There are a few important reasons why this is true.  The most common that I see are as follows:

1.  Failure to file penalty

Not only can the IRS assess a civil penalty for the failure to pay the tax debt but it can also assess one for a failure to file.  This penalty is calculated based on the time from the deadline to file your tax return (including extensions) to the date you actually filed it.  It is 5% for each month the return is late, up to a total of 25%.  This percentage is based on the amount of the tax due as it is shown on the tax return.  So..if the amount you owe is quite high, the penalty will be as well.  Filing it on time avoids the penalty entirely.

2.  Criminal Failure to File

Failing to file a tax return on time is a crime.  However, it is the IRS’ internal policy not to recommend prosecution for failure to file if the return is voluntarily filed or arrangements are made to file before the taxpayer is notified of a criminal investigation.  The vast majority of people with late tax returns are not prosecuted but this is probably true because the eventually file and do so before the IRS begins the criminal investigation.

3.  Substitute Returns

The IRS will commonly do a tax return for a non filer.  When it does this, it doesn’t do the return correctly.  No credit for deductions and exemptions etc.  These returns almost always overstate the debt.  They are always used as a basis for the filing of the notice of tax lien and to start the collection process.  They can be fixed but it is often much more difficult to fix them years after the fact.  There are circumstances where an old substitute shouldn’t be replaced by a correct return.  It is wise to get advice before every corrected return is filed.

4.  Lose ability to bankrupt debt

If a substitute tax return is assessed – the debt associated with that tax year whether based on that return or the taxpayer’s later filed correct return is likely never going to be considered dischargeable in a bankruptcy.  This is often a very bad result, as bankruptcy can be the best way for many to remove the debt and get a fresh start.

5.  Lost Refunds

If you are owed a tax refund and you wait more than three years from the date the return is due to file the return, you will lose the refund.  This applies to the earned income tax credit as well.  I have seen taxpayers lose tens of thousands of dollars as a result.