Are Taxes Dischargeable in Bankruptcy?

Overview

For Chapter 7 and 11 filers, there is a possibility that taxes could be dischargeable in bankruptcy.  That’s because under those bankruptcy code provisions, a new tax entity is created at the time of bankruptcy filing.  That’s not the case for individuals that file Chapter 12 (farm) bankruptcy or 13 and for partnerships and corporations under all bankruptcy chapters.  In those situations, the debtor continues to be responsible for the income tax consequences of business operations and disposition of the debtor's property.  Thus, payment of all the tax triggered in bankruptcy is the responsibility of the debtor.  The only exception is that Chapter 12 filers can take advantage of a special rule that makes the taxes a non-priority claim.

A new Tax Court case involving a Chapter 7 filer, illustrates how timing the bankruptcy filing is important for purposes of being able to discharge taxes in a Chapter 7.

Taxes discharged in bankruptcy, that’s the focus of today’s post.

The Bankruptcy Estate as New Taxpayer

The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or 11 case.

• Category 1 taxes are taxes where the tax return was due more than three years before filing. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return. 
• Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors. 
• Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate.  If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.
• Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense.  If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor.
• Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.

The Election To Close the Debtor’s Tax Year 

In general, the bankrupt debtor’s tax year does not change upon the filing of bankruptcy.  But, debtors having non-exempt assets may elect to end the debtor’s tax year as of the day before the filing.

Making the election creates two short tax years for the debtor.  The first short year ends the day before bankruptcy filing and the second year begins with the bankruptcy filing date and ends on the bankrupt’s normal year-end date.  If the election is not made, the debtor remains individually liable for income taxes for the year of filing.  But, if the election is made, the debtor’s income tax liability for the first short year is treated as a priority claim against the bankruptcy estate, and can be collected from the estate if there are sufficient assets to pay off the estate’s debts.  If there are not sufficient assets to pay the income tax, the remaining tax liability is not dischargeable, and the tax can be collected from the debtor at a later time.  The income tax owed by the bankrupt for the years ending after the filing is paid by the bankrupt and not by the bankruptcy estate.  Thus, closing the bankrupt’s tax year can be particularly advantageous if the bankrupt has substantial income in the period before the bankruptcy filing.  Conversely, if a net operating loss, unused credits or excess deductions are projected for the first short year, an election should not be made in the interest of preserving the loss for application against the debtor’s income from the rest of the taxable year.  Even if the debtor projects a net operating loss, has unused credits or anticipates excess deductions, the debtor may want to close the tax year as of the day before bankruptcy filing if the debtor will not likely be able to use the amounts, the items could be used by the bankruptcy estate as a carryback to earlier years of the debtor (or as a carryforward) and, the debtor would likely benefit later from the bankruptcy estate’s use of the loss, deduction or credits.

But, in any event, if the debtor does not act to end the tax year, none of the debtor’s income tax liability for the year of bankruptcy filing can be collected from the bankruptcy estate.  Likewise, if the short year is not elected, the tax attributes (including the basis of the debtor’s property) pass to the bankruptcy estate as of the beginning of the debtor’s tax year.  Therefore, for example, no depreciation may be claimed by the debtor for the period before bankruptcy filing.  That could be a significant issue for many agricultural debtors.

Consider the following example:

Sam Tiller, a cash method taxpayer, on January 26, 2016, bought and placed in service in his farming business, a new combine that cost $402,000.  Sam is planning on electing to claim $102,000 of expense method depreciation on the combine and an additional $150,000 (50 percent of the remaining depreciable balance) of first-year bonus depreciation as well as regular depreciation on the combine for 2016. However, during 2016, Sam’s financial condition worsened severely due to a combination of market and weather conditions.  As a result, Sam filed Chapter 7 bankruptcy on December 5, 2016.

If Sam does not elect to close the tax year, the tax attributes (including the basis of his property) will pass to the bankruptcy estate as of the beginning of Sam’s tax year (January 1, 2016).  Therefore, Sam would not be able to claim any of the depreciation for the period before he filed bankruptcy (January 1, 2016, through December 4, 2016).

Recent Tax Court Case

In Ashmore v. Comr., T.C. Memo. 2017-233, the petitioner claimed that his 2009 tax liability, the return for which was due on April 15, 2010, was discharged in bankruptcy.   He filed Chapter 7 on April 8, 2013. That assertion challenged whether the collection action of the IRS was appropriate.  As indicated above, the Tax Court noted that taxes are not dischargeable in a Chapter 7 bankruptcy if they become due within three years before the date the bankruptcy was filed.  Because the petitioner filed bankruptcy a week too soon, the Tax Court held that his 2009 taxes were dischargeable and could be collected.  As a result, the IRS settlement officer did not abuse discretion in sustaining the IRS levy.  In addition, the Tax Court, held that the IRS did not abuse the bankruptcy automatic stay provision that otherwise operates to bar creditor actions to collect on debts that arose before the bankruptcy petition was filed. 

Conclusion

The Tax Court’s conclusion in Ashmore is not surprising.  The three-year rule has long been a part of the bankruptcy code.  Indeed, in In re Reine, 301 B.R. 556 (Bankr. W.D. Mo. 2003), the debtor filed the Chapter 7 bankruptcy petition more than three years after filing the tax return, but within three years of due date of return.  The court held that the debtor’s tax debt was not dischargeable.

Timing matters.