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.

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.

 

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. 

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.

As a general rule, any debt cancelled or forgiven by a creditor must be added to the individual’s income for tax purposes. At the end of the year, a creditor who cancels of forgives a debt must send an IRS Form 1099-c to the Internal Revenue Service and to the taxpayer. Called “cancellation of debt” by the IRS, a cancelled or forgiven debt is no longer borrowed money that will be repaid; it is income that the taxpayer must claim on his or her tax return.

For example, say you borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which is generally taxable income to you. Cancelled debts can arise from charged off loans, debt repayment plans, foreclosures, and short sales.

After the housing bubble burst and many Americans lost their homes, Congress enacted the Mortgage Debt Relief Act of 2007. The Act generally allowed taxpayers to exclude income from a cancelled or forgiven debt after they lost their homes. In other words, the Act meant that taxpayers did not have to pay taxes on any loan deficiency if the home was lost to foreclosure or sold in a short sale.

The Act was intended as short-term relief to help taxpayers avoid high tax debt. It was initially set to run until the end of 2009, but was extended for another three years, then extended again to the end of 2013. It will now expire on December 31, 2013. The Washington Post reports that it is unlikely that Congress will extend this relief again.

This is very troubling news to homeowners still struggling to pay or modify underwater homes. Without this relief, many individuals who lose their homes to foreclosure may be charged huge tax bills many months or even years after foreclosure. Since new tax debts are not dischargeable in bankruptcy, individuals will now suffer the injury of tax debt on top of the insult of losing a home. A large non-dischargeable tax debt can make it impossible to financially recover for many years.

Some states avoid this imputed income problem by prohibiting the lender from assessing a deficiency against a foreclosed home. However, most states do not have this provision, and some only protect certain home deficiencies (such as from a primary home mortgage) and not others (such as a deficiency from a home equity line of credit).

If you are facing a foreclosure sale on your property, discuss your options with an experienced bankruptcy attorney. Filing bankruptcy before foreclosure can avoid the nightmare of cancellation of debt income. Your bankruptcy attorney can review your case and offer a legal solution to your financial problems. For more information and a free consultation contact the experienced attorneys at Fears | Nachawati by calling 1.866.705.7584 or sending an email to fears@fnlawfirm.com.

Bankruptcy attorneys use many tools to uncover the debtor’s finances. Actual bills from collectors, a tri-merge credit report, bank statements, pay stubs, deeds, and promissory notes are all commonly requested documents to assist the attorney in drafting the bankruptcy petition and schedules.

Many debtors (and some attorneys) overlook the wealth of information contained in the 1040 tax return. This information is especially useful for completing the Statement of Financial Affairs (SOFA), which is a declaration, under oath, of the debtor’s financial transactions. Since recent tax returns are sent to the bankruptcy Trustee’s office for review, it is prudent to review these documents to ensure that the information provided in the bankruptcy paperwork is truthful and consistent with the Form 1040.

Here are a few gold nuggets that may be discovered when examining the debtor’s 1040:

– Income: Does it match the income disclosed on Line 1 of the SOFA?
– Distributions from retirement accounts: Open retirement accounts must be listed on Schedule B. Closed accounts are listed in the SOFA.
– Gains or losses from sales of stock
– Investment real estate: Does the debtor make the appropriate disclosures regarding real property in his bankruptcy schedules?
– Charitable contributions: This can provide good evidence for means test purposes or SOFA disclosures.
– Business interests including partnerships and estates: Where there is a business, there are usually business assets.
– Form 1099 Cancellation of Debt: The SOFA asks about debt settlement or foreclosures.
– Dividend income
– Student loan interest

Taking the extra time to inspect the debtor’s 1040 can save time scrambling to explain to the bankruptcy Trustee why the information contained in the tax return does not match the information in the bankruptcy schedules. The tax return can also help uncover issues that may be confusing to the debtor when answering questions on the bankruptcy forms. If you are considering bankruptcy, the experienced bankruptcy attorneys at the Fears | Nachawati Law Firm are here to assist you, and are eager to help you make a fresh start financially. To set up a free consultation, call our office at 1.866.705.7584.

 

When you withhold too much during the tax year, the IRS will return your money in the form of a tax refund after your tax return is filed and processed. What happens to this tax refund during a Chapter 13 bankruptcy case depends on the policy of the Chapter 13 trustee.

Many Chapter 13 trustees consider your income tax refund "disposable income." Without getting bogged down with a lengthy discussion of what "disposable income" means in a Chapter 13 case, suffice it to say that a Chapter 13 debtor is expected to repay all debts that he or she can reasonably afford. A trustee may consider your income tax refund as “extra money” that is not needed for your family’s welfare during the year. Consequently, this money should go to repay your debts.

Money is obviously tight during a Chapter 13 repayment plan, and most debtors can ill afford to lose their income tax refunds. This is why it is important to consult with a tax expert and adjust your withholding. Withholding too little may create a heavy tax burden at the end of the year that could cause your bankruptcy to fail. Withhold too much, and your money may be taken by the Chapter 13 trustee. Consequently, having your tax withholding reviewed periodically by a tax expert will avoid these two extremes, keep the money in your pocket, and avoid IRS tax debt. Small withholding adjustments can pay big dividends.

Successfully navigating through a Chapter 13 case requires the care and attention of an experience bankruptcy attorney. If you are dealing with financial hardship, discuss your situation with experienced legal counsel. Your attorney can offer options, including those found in the federal Bankruptcy Code. Bankruptcy offers permanent relief for discharging and restructuring your debts, and presenting you with a fresh financial beginning.
 

Chapter 13 is a powerful legal mechanism to stop IRS harassment and allow you to pay owed taxes over three to five years. For some debtors this type of relief is a long time coming, and often is an on-going problem. However, only tax debts that the debtor owes on the day the bankruptcy is filed are included in the debtor’s Chapter 13 bankruptcy case. A suspected tax debt that the debtor may owe at the end of the year is considered a post-petition debt that is not included in the bankruptcy case.

Fortunately, your attorney has a solution for a debtor who needs to file in the middle of the year and suspects that he owes for the current year: file a partial year tax return before filing the Chapter 13 bankruptcy case. Tax debts are ordinarily only legally recognized at the end of the tax year, or December 31, but the tax code allows a taxpayer to file a partial year return and thereby create a legally recognizable tax debt before the end of the year. Once the tax debt is legally recognized, you can include this debt in the Chapter 13 bankruptcy and pay it alongside tax debts from previous years.

Avoiding future tax debts is a cooperative effort between you, your bankruptcy attorney, and your accountant. A Chapter 13 bankruptcy debtor is required to adjust his or her budget to stay current with any ongoing tax obligations. Consequently, you should not owe a substantial amount for any future tax year, including the remaining portion of the current year.

If you are struggling with debt you cannot pay, including tax debt, speak with an experienced attorney and discuss how the federal bankruptcy laws can help. Bankruptcy can reign in your out of control tax debt and get the IRS monkey off your back for good!
 

Discharging a personal property tax during bankruptcy is like reading a flow chart with a number of “if this, then that” directions. The first question to ask is whether the personal property tax debt was an obligation which was assessed, or otherwise incurred, before the date of the bankruptcy filing. This is called a “pre-petition” tax debt and falls under the jurisdiction of the bankruptcy court. Tax obligations that arise after the filing of the bankruptcy case are generally outside the federal bankruptcy court’s jurisdiction, but taxes that arise during a bankruptcy case are treated as administrative claims. Confused? Read on!

The second question to answer is when the debt was incurred. Section §507(a)(8)(B) of the Bankruptcy Code grants priority status to a tax debt that is (1) a tax on property; (2) incurred prior to the commencement of the case; and (3) is last payable without penalty less than one year before the case filing. Priority tax debts are not discharged through Chapter 7 bankruptcy (see 11 U.S.C.§§523(a)(1) and 727(b)). A tax debt failing to meet these criteria is treated as a general unsecured claim (unless otherwise secured by operation of state law) as is generally dischargeable.

To illustrate this confusing Bankruptcy Code requirement, assume that the law of the state where a debtor resides states that personal property taxes are incurred on whatever taxable personal property the debtor owns on January 1 of each year. Also, assume that the debtor’s taxes are due on January 1 the following year and must be paid by January 31 or penalties are imposed.

Suppose our debtor files for Chapter 7 bankruptcy protection on January 30, 2013. Any personal property taxes owed for 2012 is obviously a priority debt and is not discharged. Additionally, any personal property tax owed for 2011 is not discharged, because the 2011 tax debt was (1) a tax on property; (2) incurred prior to the commencement of the bankruptcy case; and (3) last payable without penalty on January 31, 2012, less than one year before the case began. If the debtor had waited until February 1, 2013 to file his case, the 2011 property tax would be dischargeable.

Confused? You should be! Many experienced bankruptcy attorneys struggle with discharging tax debt. If you owe taxes to the state or federal government, discuss your situation with an experienced bankruptcy attorney. Your attorney will examine your situation and determine which of your tax debts are dischargeable and whether Chapter 7 or Chapter 13 of the Bankruptcy Code is more advantageous to your circumstances.

 

As you’re thinking about how to resolve your troubled finances, selling your house – even at a loss – may be an option you’re considering. Before you make that difficult and potentially costly decision, you should remember some of the subtle advantages of home ownership.

 

First, the federal government’s principal tax law, the Internal Revenue Code, heavily subsidizes homeowners. For instance, the home mortgage interest deduction allows you to deduct from your taxable income the interest you pay on your home loan. For many taxpayers, this law results in thousands of dollars in tax savings every year.

 

Second, the home you purchased isn’t just a residence. It’s also a financial bet that home prices will appreciate and that you’ll benefit from the upside. In recent years, this bet hasn’t paid off the way it did in years past, but with the recovery picking up speed in states like Texas, future years may see future gains.

 

Finally, your home is a store of value. Though financial instruments like home equity loans, you can trade some of the illiquidity in your residence for liquid cash. This isn’t usually a good long-term financial strategy, but as a stop-gap measure during a financial shock to your family – such as a job loss or illness – this liquidity can come in handy.

 

These advantages are worth considering as you think about your financial future. If you’re facing debt-related problems, a financial workout with your creditors or even bankruptcy may be the right move. However, as you enter those negotiations, it’s important to remember what assets you value most highly.

 

Want to find out how the attorneys at Fears Nachawati can help you as you deleverage through a financial workout or personal bankruptcy? Want to find out if holding on to your home is a realistic possibility? Our attorneys and professionals are committed to helping people like you. Contact us today to learn more.