Filing Tax Return after the Deadline May Lead to Bankruptcy Trap

A troubling trend has now turned into a full-blown minority opinion in the bankruptcy world. Some bankruptcy and appellate courts are reading the Federal Bankruptcy Code to exclude late-filed tax returns from the definition of a “tax return.”

It has long been held that recent income tax debts are not dischargeable in bankruptcy, but older tax debts (that otherwise qualify under the Bankruptcy Code) may be discharged. Some courts, including the First, Fifth, and Tenth Circuit Court of Appeals, now find that changes to the Bankruptcy Code in 2005 exclude certain late-filed returns from discharge. These courts point to a “hanging paragraph” located at the end of Section 523(a) which defines a “return” as a tax filing “that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).” That paragraph specifies that returns filed by the IRS with debtor cooperation under 6020(a) are “returns,” but those filed by the IRS without debtor cooperation under 6020(b) are not.  

Recently the First Circuit in the case of In re Fahey, --- F.3d --- (1st Cir. Feb. 18, 2015), joined other courts in finding that “applicable filing requirements” includes meeting the tax filing deadline. In other words, a late filed return, even by as little as one day past the deadline, is not a “return” and is therefore not a dischargeable debt in either Chapter 7 or Chapter 13.

The First Circuit joins the Fifth Circuit (McCoy v. Mississippi State Tax Comm'n, 666 F.3d 924 (5th Cir. 2012)) and the Tenth Circuit (In re Mallo, 2014 WL 7360130 (10th Cir. Dec. 29, 2014)) in finding that the plain language of the Bankruptcy Code directs this interpretation. Basing its decision on plain language, the Fahey court found that a tax deadline is an “applicable filing requirement,” thereby rendering a return filed outside that time nondischargeable unless filed under 6020(a). The dissent in Fahey points out that permitting only late-filed returns under section 6020(a) absurdly rewards the tax debtor who sits on his hands and awaits IRS invitation to complete the return while punishing the debtor who voluntarily files his own return even one day late.

Tax Debt Tolling

Despite common myths, personal taxes are dischargeable in bankruptcy, but only if the following conditions are satisfied:

  • The taxes are income taxes;
  • There is no evidence of fraud or willful evasion;
  • The debt was originally due at least three years before the bankruptcy filing (Three Year Rule);
  • A tax return for the debt was filed at least two years before bankruptcy (Two Year Rule); and
  • The tax debt was assessed by the IRS at least 240 days before the bankruptcy was filed (240 Day Rule).

Unfortunately, the rules surrounding discharging taxes can get confusing, especially when attempting to accurately calculate the time restrictions mentioned above. Confusion often occurs when one of these time period is “tolled.” There are several situations which will temporarily stop the clock on these time periods, including:

A prior bankruptcy case. The filing of a bankruptcy case will toll both the Three Year Rule and the 240 Day Rule.

A request for a due process hearing or an appeal of a collection action taken against a debtor. These actions also toll both the Three Year Rule and the 240 Day Rule.

An offer in compromise. An offer in compromise offers to settle a tax debt for less than the full amount due. The submission of an offer in compromise will toll the 240 Day Rule. If the taxpayer makes an offer in compromise within 240 days of filing for bankruptcy, the 240 day time rule will be suspended for the time during which the offer in compromise is pending, plus an additional 30 days.

Tax litigation. Litigation in Tax Court will toll both the Three Year Rule and the 240 Day Rule.

A request for an extension of time to file a tax return. Filing for an extension will: (a) delay the start of the Three Year Rule to the extended due date; (b) delay the start of the Two Year Rule until the actual filing date; and (c) delay the start of the 240 Day Rule until the tax is actually assessed.

 

Can I Keep My Future Tax Refunds After I File Chapter 13?

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 re-emphasized the need for a Chapter 13 debtor to commit all of his or her disposable income to repaying creditors during bankruptcy.  Since that time, Chapter 13 bankruptcy trustees across the country have argued that tax refunds constitute disposable income – income not needed by the debtor to pay reasonable and necessary expenses, such as food, transportation and shelter. Courts have unanimously agreed with the trustees: tax refund money is surplus, and the Chapter 13 debtor must turn over these refunds to the bankruptcy estate.

There are a few ways to combat this loss during a Chapter 13 bankruptcy.  The most obvious way is to not create a tax refund in the first place. This means careful vigilance of your tax situation. Instead of Uncle Sam holding onto your money throughout the year, make sure that you only give the tax man what is owed – and no more.

Another way to avoid an income tax loss is to include language in the bankruptcy plan that excludes income tax refunds. This exclusion must be supported by evidence of the need to pay a reasonable and necessary expense. For instance, you may propose to pay annual property taxes with income tax refunds. These types of proposals have a low success rate and will almost always draw an objection from the trustee or a creditor.  Furthermore, the bankruptcy court may be reluctant to allow this proposal due to the unpredictable nature of using a tax refund as income (the refund may be what you expect, it may be more, it may be less, or it may not come at all).

Finally, many Chapter 13 debtors attempt to modify their plans to excuse a particular refund, or part of a refund. Some courts and trustees will allow a debtor to keep money from an income tax refund when the debtor shows that the money is needed to pay reasonable and necessary expenses.  For instance, if the debtor suffers an unexpected expense, such as an unexpected medical bill, funeral expenses, or a car repair, the debtor may be able to keep tax money to cover the expense.  The bankruptcy court will not allow the debtor to keep tax money to pay for food, utilities, a car payment, or other expenses that should be paid by the debtor’s regular income.

Income tax refunds (and underpayment of taxes) during Chapter 13 bankruptcy always cause headaches, so the best advice is to pay attention to your income. A regular visit to a seasoned CPA will avoid tax issues and keep more money in your pocket. 

Can I Keep My Anticipated Tax Refund if I File Chapter 7?

A Chapter 7 bankruptcy is an erase-your debts-start-fresh bankruptcy. It is meant to give an individual a chance to begin anew on a financial path without the burden of overwhelming debts dragging him or her down. On the other hand, Chapter 7 bankruptcy is not intended as a way to legally hide from debts the person can afford to pay.

That tension that felt most keenly when dealing with an individual’s income tax refund during Chapter 7 bankruptcy. On the one hand, the debtor is excited about his Chapter 7 “fresh start” and is eager to use his after-bankruptcy tax refund to help him along with his new financial future. On the other hand, his creditors are eyeing his income tax refund as a pre-bankruptcy asset that should be used to repay his debts.

Both creditors and debtors have a claim on the debtor’s anticipated income tax refund. The debtor is entitled to the refund, even though it is not yet received. Consequently, the debtor’s interest in receiving this refund must be included in the debtor’s bankruptcy estate. Because it is property of the estate, the debtor is able to use legal exemptions to protect all or a part of the tax refund.  The remaining non-exempt portion must be paid over to the bankruptcy trustee for distribution to creditors.  Often debtors are able to exempt enough of an expected income tax refund that it will make the remaining sum de minimis, or so little that it is not worth the trustee’s time or effort to take and distribute the funds.

The debtor must turn over non-exempt tax money even if the refund is not received until after the debtor receives a discharge. The only timing that matters is whether the debtor had a legal interest in the income tax refund at the time he filed the case. When the refund is actually received by the debtor is of no consequence. In many cases a trustee will leave a debtor’s case open until the debtor has both filed and received his income tax refund. This may mean remaining in bankruptcy for many months longer than expected.

The best way to avoid income tax refund problems during bankruptcy is to file the case after the tax refund is both received and spent. Your attorney can direct you on how to spend your tax money and avoid further bankruptcy complications.

Another way to protect non-exempt money from an income tax refund is to apply the non-exempt portion of the expected income tax refund to next year's taxes. The IRS will keep the tax overpayment and use it for taxes owed in the future. The Tenth Circuit case of Weinman v. Graves, 609 F.3d 1153 (10th Cir. 2010) holds that the bankruptcy trustee cannot force the IRS to turnover a tax refund that is held to pay future taxes. The election to apply the refund to a future tax liability is irrevocable under section 6513(d) of the Internal Revenue Code. Consequently, the debtor’s interest in the refund when he files bankruptcy is limited to what is left after the IRS applies the money to next year's tax liability.

If you are considering filing bankruptcy and expect a large income tax refund, speak with an experienced bankruptcy attorney. Your attorney can discuss your options and help you choose the right course of action for the maximum financial benefit using the federal bankruptcy laws.