The Current Bankruptcy Code

The current Bankruptcy Code is a very complex set of rules, many of which are poorly drafted and difficult to understand and apply, even for bankruptcy lawyers and judges.  The Internal Revenue Code, considerably longer than the bankruptcy code has long been the subject of criticism for its length, complexity and density.  When you put the two together, the complexities are multiplied.  Trying to decide whether a given tax liability arising under the tax code is dischargeable under the bankruptcy code is a question that must often be answered through expensive and time consuming litigation.   If there were easy answers to this question, we would not need the help of a battery of lawyers and bankruptcy judges to determine whether a tax debt can be discharged in bankruptcy.  

Nevertheless, this article will attempt to handle some of the simpler aspects of this conundrum, those which the typical reader might face.  Presuming that the majority of readers are plain old taxpayers who owe the IRS a big bunch of money, this article will be limited to the issue of personal income taxes resulting from the filing of a Form 1040, the personal income tax form.  It will not cover employment taxes, excise taxes, estate taxes, etc - just personal income tax. Also, it will cover only a chapter 7 bankruptcy, not chapter 13.

WARNING:  This material contained in this article is a guide only.  It is not legal advice and it should not be relied upon without your consulting an experienced bankruptcy attorney licensed to practice in your state.  This is not a substitute for competent legal advice.  It is only meant to familiarize you with the current state of bankruptcy law so that when you speak to your attorney you will be better informed.

If you owe the IRS a lot of money and are considering filing a chapter 7 bankruptcy then one of the most important questions you must answer is whether the tax debt will be discharged in the bankruptcy proceeding.  In many cases, the decision to declare bankruptcy will depend upon the answer to this question.  The Bankruptcy Code provides that when a person files bankruptcy, his debts are compiled in a long list and then divided between secured and non secured debt.  The difference is important. 

What is secured debt?

The best example of secured debt is a mortgage on a home.  If you own your own home then you are probably making payments every month on a mortgage to a bank or credit union.  Before the credit union would be willing to lend you $300,000 to buy a home, it is going to demand that you use the house as collateral for the loan, thereby permitting the credit union to take back the house if you do not pay the monthly note.  Somewhere in the huge stack of paperwork you signed when you purchased the home was a document that gave the credit union the right to take your home.  This is a secured debt, secured by the house.  The same arrangement applies with car loans and many large appliance loans.  If you read the small print you will find that you are giving the lender a security interest in the asset, whether a house, a Maserati or a refrigerator.

What is unsecured debt?

The best example of unsecured debt is your credit card.  If you fail to make the payments on your card, there is little the card company can do except sue you for breach of contract.  If you used the card to buy underwear at the mall, the card company cannot come in and repossess your dainties.  The debt you incurred to buy the underwear is unsecured.

Tax debt may be secured or unsecured.  If the IRS has filed a tax lien in your county offices and has followed all of the rules pertaining to notice, then the debt is secured.  However, in the absence of a lien, the debt is unsecured.  This article will limit its application to unsecured debt.  So if you have a tax lien, you will need to consult an attorney to determine the status of your tax debt in bankruptcy.

The Bankruptcy Code takes the big list of unsecured debt and divides it into two neat categories:  ‘priority debt’ and ‘non priority debt.’  Section 507 of the Bankruptcy Code applies to all of the unsecured debt by creating eight categories of debt that will be considered as having priority.  Those tax liabilities of an individual that fall within the Section 507 definition of a priority will NOT be dischargeable in bankruptcy.  Income taxes fall into the eighth category (Section 507(a)(8))  and are therefore not dischargeable.  You will have to pay them. However, there is a large loophole found in Section 507(a)(8) which may apply to you and may make your income tax debt dischargeable in bankruptcy.  There is hope!

Section 507(a)(8) grants priority status only to those tax debts that are recent AND that have been assessed within 240 days prior to filing.  Now that’s a mouthful.  Assessed?  Recent?  What do these really mean?  The answer is not always easy, but I will make it so for purposes of this article.

Recent simply means the past three years.  Example – Harry owed the IRS $150,000 for tax year 2002 and had credit card debt amounting to another $200,000.  (It happens)  The calendar says that today’s date is January 8, 2008.  If he files for bankruptcy tomorrow, January 9, 2008 will his tax debt be wiped out?   We start the analysis with the date of filing of bankruptcy – 1/9/2008.  Step 2 – back it up three years to arrive at 1/9/2005.  Section 507 says that any taxes due on tax returns due AFTER 1/9/2005 are priority debt and cannot be discharged.  You gotta pay, simple as that.  So, if Harry owed money on his 2004 returns, which are due to the IRS on April 15, 2005, these debts would be granted a priority and would not be dischargeable on Harry’s January 9, 2008 bankruptcy filing.  However we are talking about tax debt for 2002, not 2004.  Remember, the 2002 returns are due on April 15, 2003.  The law says so.  But April 15, 2003 is BEFORE 1/9/2005, not AFTER.  Does this mean that this debt is dischargeable in bankruptcy?  Is Harry off the hook?  Maybe. If you reread the paragraph above you will see there is a two part test, not a one part test.  Both parts must be satisfied.

The second part of the test involves a strange concept – assessment.   After the IRS has reviewed your tax return and concludes that you owe money, it will send you a letter advising you as such demanding that you pay.  If, like most taxpayers, you ignore the letter and place it in a drawer hoping it will disintegrate, you will eventually receive more letters each one increasingly menacing.  Finally you will get a letter indicating that since you have not responded to the past half a dozen letters, the IRS assumed that you agree that you owe the money and has then assessed the deficiency against  you.  This is a formal act in which the revenue agent signs a form, it is approved by a manager and it is entered into your tax record as a debt.  You now owe the money.  The date upon which the form was signed is the assessment date.  You need to know what that date is.  It is easy to obtain by simply calling the IRS.  They will be happy to tell you.

Armed with that date, you can now perform the second part of the test.  If the assessment date is LATER than 240 days before the filing date then you failed.  You have to pay the taxes.  Remember, the filing date was 1/9/2008.  Go back 240 days to May 14, 2007.  Call the IRS 1-800 829-1040 and ask – “so, what is the date of assessment on my tax debt?”   If the IRS representative says ‘May 15, 2007,’ you are out of luck – of course you can always wait two days to file, right?.  However, if she says May 1, 2007, you are now close to the nirvana of tax relief.  You have passed the two part test – your tax debt is not “recent” i.e. it is older than three years under the test above, AND it was assessed more than 240 days before you filed your bankruptcy petition.  You passed.

If you actually never filed the return you cannot discharge the debt.  If the IRS determines that you committed fraud in filing the return it is not dischargeable.  If you filed an offer in compromise during the 240 day period and the offer was declined you will have to recompute the 240 day period to compensate for the time the offer was pending.  If none of these conditions apply to you, then you might be able to declare bankruptcy and actually walk away from this debt permanently!!

Before you rush out to file bankruptcy you should re-read the warning above and take it seriously.  Bankruptcy in 2008 is much more complicated than it was in 2004, now requiring the debtor to comply with a host of new requirements before the debt will be eliminated.  An appointment with a bankruptcy attorney in your city is crucial to a successful filing.  Most attorneys will work with you on the payments and the filing charges.  They know you have no money. After all, if you had money you would not be declaring bankruptcy! 

This has been a very simplified treatment of the bankruptcy provisions as they apply to the Internal Revenue Code.  The actual application is in many cases far more complex requiring a greater in depth analysis of the factual situation that applies to you. 

If you decide that filing bankruptcy is not for you, there are other options, an installment agreement, an offer in compromise or convincing the IRS to declare you as uncollectible.  Each option has its advantages and drawbacks.  The installment agreement monthly payment may be too high for you.  An offer in compromise costs thousands to have professionally prepared and being declared uncollectible does not nothing to wipe out the debt, which will continue to grow as interest accrues.