Chapter 13: Tax Considerations 

    BANKRUPTCY & INSOLVENCY 
    by  Arlene Hibschweiler, MBA, J.D., and Martha Salzman, J.D. 
    Published May 01, 2013

    EXECUTIVE
    SUMMARY

    • Photo by iStockphoto/ThinkstockA Chapter 7 bankruptcy involves liquidating assets and discharging debts, whereas a Chapter 13 bankruptcy involves paying debts from future income over a set period of time.
    • If a taxpayer is unable to meet the means test or the other requirements for Chapter 7, he or she may have the option to file the case under Chapter 13.
    • The purpose of Chapter 13 is to repay all or a part of the individual debtor’s debts in installments over a three- or five-year period from the debtor’s regular income received while the plan is in effect. It is often called “the wage earner’s plan.”
    • The passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 greatly changed the treatment of tax debt under Chapter 13. The debt relief that a taxpayer can accomplish by filing a Chapter 13 petition is limited. For debtors looking primarily for relief from tax debts, the new repayment landscape may dictate a closer look at other options for addressing federal tax deficiencies.
    • The timing and other rules for the discharge of tax debt necessitate that any taxpayer who is considering filing a bankruptcy petition consult a tax adviser as well as a bankruptcy attorney to maximize the amount of tax debt that the taxpayer can discharge.

    The challenging economic environment that has gripped the country since 2008 has forced tax advisers to confront the prospect of client bankruptcies. In many cases, clients who face dire financial circumstances use a liquidation, under Chapter 7 of the Bankruptcy Code,1 to pay off creditors to the extent possible and obtain something of a fresh start. Since the bankruptcy law was amended in 2005, however, many individuals have been channeled to Chapter 13, under which a debtor typically pays off a greater amount of debt through a court-approved repayment plan.

    For the 12-month period ended Dec. 31, 2012, Chapter 13 petitions accounted for approximately 30% of all bankruptcy filings.2 Although the percentage of Chapter 13 petitions is much lower for business bankruptcies, the significant number of individual taxpayer Chapter 13 petitions means that tax advisers should understand this type of bankruptcy proceeding, particularly the impact of a Chapter 13 filing on a debtor’s tax obligations.

    This article focuses on Chapter 13, after briefly describing the key differences between Chapter 7 and Chapter 13 bankruptcy proceedings. It also explains the “means test” under which an individual debtor may be eligible for debt relief in bankruptcy via a Chapter 13 proceeding and not a liquidation. After discussing the Chapter 13 bankruptcy process, the article focuses on the treatment of tax obligations in Chapter 13 cases, with particular attention paid to the dischargeability of income taxes. The article concludes with suggestions for the tax adviser representing an individual client who is considering filing a bankruptcy petition.

    Chapter 13: Eligibility and Purpose

    Only individuals, and not business entities such as corporations, limited liability companies, and partnerships, are eligible for relief under Chapter 13 of the Bankruptcy Code.3 However, an individual who owns a business as a sole proprietorship can file a Chapter 13 petition and include the debts incurred in the sole proprietorship business.4 To be eligible for Chapter 13, an individual must have regular income.5 For this reason, a Chapter 13 plan is often referred to as a “wage earner’s plan.”6 The purpose of Chapter 13 is to repay all or a part of the individual debtor’s debts in installments over a three- or five-year period from the debtor’s regular income received while the plan is in effect.

    The eligibility rules for Chapter 13 relief also require that the individual debtor’s noncontingent, liquidated debts not exceed certain dollar limitations,7 which are currently $383,175 for unsecured debts and $1,149,525 for secured debts.8 These debt limitations are adjusted every three years based on the Consumer Price Index and were most recently reset effective for bankruptcy petitions filed on or after April 1, 2013.9

    An individual who had a prior bankruptcy petition dismissed during the preceding 180 days is not eligible to file a Chapter 13 petition if the dismissal was due to the debtor’s willful failure to appear before the bankruptcy court or comply with bankruptcy court orders. This rule also applies if the prior bankruptcy petition was voluntarily dismissed after a creditor sought bankruptcy court permission to seize property10 in which the creditor has a lien.11 Additionally, unless an exception applies, all individual debtors must undergo credit counseling from an approved credit counseling provider within 180 days prior to filing a bankruptcy petition.12

    Chapter 13 vs. Chapter 7 Generally

    In an individual’s Chapter 7 bankruptcy proceeding, the debtor’s nonexempt assets are sold, and the proceeds are distributed to pay all or part of the debtor’s creditors.13 The focus in a Chapter 7 bankruptcy is on liquidating the debtor’s nonexempt assets to pay creditors, whereas the focus in a Chapter 13 case is on the amount of the debtor’s future, regular income available to pay creditors. As noted above, only an individual debtor can file a Chapter 13 petition, including an individual operating a business as a sole proprietorship. By contrast, an individual or a business entity debtor, such as a corporation or partnership, can file a Chapter 7 petition.14 Another major difference between Chapter 7 and Chapter 13 is that while a debtor’s creditors can file an involuntary Chapter 7 petition against the debtor, there is no involuntary Chapter 13 petition.15 As a result, it is solely the debtor’s choice whether to seek Chapter 13 relief.

    While the decision of whether to file under Chapter 13 is the debtor’s, a debtor does not always have a choice between filing a Chapter 7 or a Chapter 13 petition. An individual debtor’s eligibility for filing a Chapter 7 petition is subject to passing a two-part “means test” or otherwise proving that the Chapter 7 petition is not abusive. The means test was added to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA)16 in 2005. The means test requires calculation of a debtor’s annualized “current monthly income,”17 which is compared with the applicable state median income18 amount.

    If a debtor’s annualized current monthly income exceeds the state median, the debtor generally must pass a second test to be eligible for Chapter 7 relief.19 In lieu of having the Chapter 7 petition dismissed, an individual debtor who fails the means test, and cannot otherwise prove that the Chapter 7 filing is not abusive, has the option of converting his or her bankruptcy case to a Chapter 11 or Chapter 13 proceeding. This conversion can occur only if the debtor consents.20 An individual debtor who satisfies the means test can choose between Chapter 7 and Chapter 13.

    Chapter 13 Plan Requirements

    The debtor initiates a Chapter 13 bankruptcy by filing a petition with the bankruptcy court.21 A trustee is appointed to administer the case.22 Filing the petition triggers the “automatic stay,” which, subject to some exceptions and possible creditor remedies, stops collection action against the debtor and the debtor’s property.23 The Chapter 13 petition may include the debtor’s repayment plan. If it does not, unless the bankruptcy court grants an extension, the debtor has 14 days after filing the petition in which to file a repayment plan.24

    A Chapter 13 repayment plan is subject to bankruptcy court approval, following a hearing.25 The plan must provide for payments of fixed amounts, generally over a three-year period. The bankruptcy court can extend the period to up to five years “for cause.” In addition, if the debtor’s current monthly income (described above under the “means test”) equals or exceeds the applicable state median income, the payment period can be up to five years without a showing of cause.26

    Section 1322(a) of the Bankruptcy Code requires a Chapter 13 plan to provide for submitting all or part of the debtor’s future earnings or other future income to the Chapter 13 trustee as is necessary to fund the plan. In addition, Section 1322(a) requires the plan to provide for full payment of all priority claims, unless the holder of a priority claim agrees to different treatment.27 Priority claims are defined by statute and include, among other items, unsecured claims for domestic support obligations, administrative expenses, certain taxes, and certain wages and consumer deposits.28 A Chapter 13 plan also must provide the same treatment for each claim within a class (if the plan classifies claims).

    Example 1: Debtor Q owes $15,000 to creditor A, $20,000 to creditor B, and $5,000 to creditor C, and the claims of creditors A, B, and C are all in the same class and are the only claims in that class. If the plan provides for an aggregate payment of $20,000 (or one-half of the total amount of the claims) to this class of creditors, the plan must provide that A receives $7,500, B receives $10,000, and C receives $2,500, so that each creditor in the class receives an amount equal to one-half of its claim.

    The Bankruptcy Code permits the Chapter 13 plan to modify the rights of holders of secured claims29 or to leave those rights unchanged. A claim is secured if the creditor has the right to collect the debt against specific property of the debtor, such as through a mortgage, pledge, security interest, or other lien. Generally, in a Chapter 13 case a secured claim can be provided for in any of three ways: (1) by having the creditor take the collateral or receive the proceeds from its sale; (2) by having the debtor retain the collateral, cure any defaults, and make all current payments on the underlying debt as they become due; or (3) by having the debtor retain the collateral and paying the secured claim under the Chapter 13 plan.30 Under the third option, the amount of the secured claim that must be paid under the Chapter 13 plan may be limited to the value of the collateral (i.e., if the value of the collateral is less than the amount of the claim).31

    A Chapter 13 plan is not required to provide for the payment of nonpriority, unsecured claims provided that the debtor pays to the Chapter 13 trustee all of his or her projected disposable income32 over the three- or five-year life of the plan.33 In addition, the value of property to be distributed under the Chapter 13 plan for an unsecured claim cannot be less than the amount that would have been paid on the claim if the debtor’s assets were liquidated in a Chapter 7 bankruptcy proceeding.34

    Timing of Discharge in a Chapter 13 Bankruptcy

    In a Chapter 13 case, the debtor is discharged or released from any unpaid, dischargeable debts after completing all of the plan payments.35 The discharge is subject to a number of conditions, including certification that the debtor paid certain domestic support obligations.36 In addition, a debtor is not relieved of debts if a discharge was received within four years in a prior Chapter 7, 11, or 12 bankruptcy, or within two years in a prior Chapter 13 bankruptcy.37 To receive a Chapter 13 discharge, the debtor must also have completed a postpetition instructional course in personal financial management.38

    Chapter 13 also provides for a “hardship discharge” in certain situations where the debtor is unable to complete the plan payments. Under Section 1328(b), after confirmation of the plan and notice and a hearing, the court may grant a hardship discharge “only if . . . (1) the debtor’s failure to complete [the plan] payments is due to circumstances for which the debtor should not justly be held accountable; (2) the value . . . of property actually distributed under the [Chapter 13] plan on account of each allowed unsecured claim is not less than the amount that would have been paid on [the] claim if the estate of the debtor had been liquidated under [C]hapter 7 . . . ; and (3) modification of the plan . . . is not practicable.”39 The debtor’s death,40 “loss of income due to involuntary unemployment,”41 and “[i]njury or illness that precludes employment sufficient to fund even a modified plan”42 have been cited as the type of circumstances that may justify a hardship discharge.

    As discussed below, however, a hardship discharge in a Chapter 13 case is not as generous as a standard Chapter 13 discharge. In particular, a hardship discharge does not relieve the debtor from any unpaid debts that are not dischargeable in a Chapter 7 bankruptcy.43 As also discussed below, this can result in freeing a debtor who completes a Chapter 13 plan from unpaid taxes reported on a late return filed within two years of filing the Chapter 13 petition, while a debtor who receives a hardship discharge would continue to owe those taxes.44

    Chapter 13 and Tax Debts

    So what can a debtor who has delinquent tax obligations expect from a Chapter 13 filing? The short answer is not nearly as much as before BAPCPA. The 2005 bankruptcy legislation essentially eliminated what had been known informally as the “super discharge,”45 by reducing the types of debts that can be discharged without being paid in a Chapter 13 proceeding. This revision, in combination with pre-2005 rules requiring full payment of obligations entitled to priority, means that the debt relief that a taxpayer can accomplish by filing a Chapter 13 petition is limited. For debtors looking primarily for relief from tax debts, the new repayment landscape may dictate a closer look at other options for addressing federal tax deficiencies, including pursuing IRS offers in compromise and installment agreements.

    Payment of Priority Debts

    As discussed above, to be confirmed by the court, a Chapter 13 repayment plan typically must provide for full payment of priority claims, unless a creditor is willing to accept something different.46 Priority claims include income and gross receipts taxes for which a return is last due within three years of the filing of the bankruptcy petition.47 In other words, a debtor who filed a Chapter 13 petition in January 2013 will have to make full payment of federal and state income taxes owed for 2009, 2010, and 2011 and reported on returns due in April of 2010, 2011, and 2012.48

    Income taxes assessed within 240 days before the filing of the petition are also entitled to priority, meaning these, too, must be fully paid.49 Since the IRS typically assesses taxes reported on a timely return shortly after the return’s filing, the 240-day rule tends to apply to additional taxes the IRS claims are due as a result of an examination.50 Also entitled to priority are property taxes due before the petition and last payable without penalty within one year before filing the bankruptcy petition,51 and certain employment taxes on prepetition wages reported on a return due within three years of the petition.52 The IRS has a right only to full payment of priority tax claims over the life of the plan. In other words, a Chapter 13 debtor need not pay priority tax claims in equal installments.53

    Prepetition interest due on tax debts is generally given the same priority as the underlying tax claim.54 The government is entitled to postpetition interest where a tax debt is oversecured, meaning the value of the underlying collateral exceeds the amount of the taxes owed.55 A tax claim is secured if a notice of federal tax lien has been filed before the petition’s filing date.56

    Example 2: G files a Chapter 13 petition on June 1, 2013. Among the assets she owned at the time of filing was a life insurance policy with a cash surrender value of $10,000. Assume the IRS properly filed a notice of federal tax lien prior to G’s Chapter 13 petition for a tax debt of $7,000. Since the value of the insurance policy exceeds the amount of the tax claim, the IRS is entitled to postpetition interest on its claim against G.

    Under Bankruptcy Code Section 511, added by BAPCPA, if bankruptcy law requires payment of interest on a tax claim, the rate is determined under nonbankruptcy law.57 Sec. 6621(a) generally provides for interest on underpayments at the federal short-term rate plus 3%. This rate is higher than the rate that was in effect under prior law, which applied a different rate of interest that was usually lower than the Sec. 6621(a) rate.58

    If the value of the collateral is less than the amount owed, the tax debt is under­secured.59 The Supreme Court has held that postpetition interest is not owed on undersecured claims.60 An undersecured tax claim may include both priority and nonpriority obligations. Courts generally will not allow the debtor’s Chapter 13 plan to force the IRS to allocate the collateral to the priority taxes. This means the IRS can use the collateral against the nonpriority tax debt, maximizing the priority taxes the debtor will be required to pay to get a Chapter 13 plan confirmed.61

    Example 3: D filed a Chapter 13 petition on March 1, 2013, which reported federal income tax debts of $61,000. Of this amount, $40,000 related to the 2011 and 2010 tax years. The remaining $21,000 of tax debt related to 2007. D filed all her income tax returns on a timely basis. Assume the IRS properly filed a notice of federal tax lien, creating a security interest in D’s assets, which were valued at $19,000 at the time of the bankruptcy petition.

    The IRS can treat the 2007 obligation as largely secured by its lien, meaning it will receive nearly full payment of a debt that otherwise would be eliminated by the Chapter 13 proceeding. Since the 2010 and 2011 tax year debts are entitled to priority under the three-year rule, D will also be required to pay these obligations in full to get her repayment plan confirmed.

    In general, a Chapter 13 plan need not provide for postpetition interest on an unsecured tax obligation.62 Similarly, priority tax claims are not entitled to post-confirmation interest in Chapter 13 cases.63 A debtor can owe interest even though there is no underlying tax liability. In64 for example, the bankruptcy court held that prepetition interest that arose before a tax obligation was eliminated by the carryback of net operating losses was entitled to priority.

    A penalty that compensates for actual pecuniary loss and relates to a priority tax claim is also given priority status.65 Penalties that prohibit specific conduct, like filing a tax return after its due date66 or prematurely withdrawing money from an individual retirement plan,67 are examples of noncompensatory levies that are not entitled to priority. By comparison, penalties directly tied to specific government costs, like a statute permitting recovery of “costs, charges and expenses” in connection with delinquent property taxes, are compensatory and would be treated as a priority debt under Chapter 13.68

    Discharge of Tax Obligations

    The tax discharge available under a typical Chapter 13 bankruptcy is now very similar to what can be accomplished through a Chapter 7 liquidation.69 Under Section 1328 of the Bankruptcy Code, as amended by BAPCPA, taxes required to be collected or withheld, for which a debtor is liable in whatever capacity, now survive a Chapter 13 filing. This means it is no longer possible to eliminate trust fund taxes70 or a debtor’s liability as a responsible officer for trust fund obligations by filing under Chapter 13.71

    In addition, no discharge is available where a debtor failed to file a required return.72 In In re Ridgway,73 the court held the failure-to-file exception to discharge did not apply where the IRS prepared substitute returns on a debtor’s behalf. The 2005 Bankruptcy Code amendments revisited this issue, however, and now the law provides, very generally speaking, that a substitute return will count as a return if it was prepared with the debtor’s cooperation and the debtor signed it.74 Where a return is prepared by the IRS based on knowledge of IRS employees, testimony, and other sources, and not signed by the debtor, any associated tax would survive in a Chapter 13 proceeding.75

    Also surviving a Chapter 13 bankruptcy are taxes for which a debtor made a fraudulent return or willfully attempted to evade or defeat the obligation.76 This exception to discharge has been read to include both omissions and affirmative acts to avoid tax obligations.77 In In re Long, the court held that the debtor had knowingly, intentionally, and voluntarily failed to file his 1999, 2000, and 2001 federal income tax returns, and therefore it denied a discharge for those obligations. The court noted that the debtor’s admission that he had gambled his money away evidenced willfulness, and his drug use did not render the omission involuntary or unintentional.78 Where the debtor makes a fraudulent return, the entire associated tax is nondischargeable, even if some of the liability arose from a nonfraudulent failure to report certain income.79

    Notwithstanding the limitations now placed on Chapter 13 under BAPCPA, there are still some differences between the relief offered in Chapter 13 individual repayment cases and Chapter 7 liquidation cases. For example, a Chapter 7 proceeding will discharge compensatory tax penalties, penalties applicable to nondischargeable taxes, and penalties that relate to taxes accruing more than three years before the petition.80 In a Chapter 13 case, penalties related to priority taxes listed in 11 U.S.C. Section 507(a)(8) and designed to compensate for actual pecuniary loss81 must be paid by the plan in full, in deferred cash payments, but otherwise tax penalties are discharged.82

    As discussed above, priority taxes include, among others, taxes for which a return was due within three years, and taxes assessed within 240 days, of the filing of the bankruptcy petition. A further difference is that, unlike a liquidation, a Chapter 13 proceeding can be used to discharge priority taxes paid with a credit card, provided the debtor originally intended to pay the card in full.83 Also, there is no separate taxable estate in Chapter 13, which may allow a debtor to make good use of previously generated tax attributes, such as net operating losses, that otherwise would belong to the bankruptcy estate.84

    Hardship Discharge

    As discussed above, a hardship discharge is available in certain Chapter 13 cases where a debtor is unable to satisfy the terms of the repayment plan due to circumstances beyond his or her control. A hardship discharge is equivalent to the relief granted under Chapter 7.85 This means that to the extent not paid, priority taxes and taxes listed as nondischargeable under Section 523 of the Bankruptcy Code will survive the hardship proceeding.

    Example 4: F filed a Chapter 13 petition on Feb. 1, 2012. At the time of filing, F owed the IRS for income taxes dating from 2008, which F reported on a return filed on April 14, 2009. He timely filed his 2009 federal income tax return and paid the resulting liability using his credit card. Notwithstanding his intention to pay this obligation when he received the bill, he had not paid the credit card debt at the time of the bankruptcy petition. Two years after his Chapter 13 filing, F loses his job. If he is unable to complete the terms of the plan and files for a hardship discharge, he will continue to owe the 2008 and 2009 tax debts to the extent these obligations were not satisfied by payments made by F under the plan’s terms.

    Unlike a regular Chapter 13 discharge, a hardship discharge will not eliminate tax debts tied to late returns filed within two years of filing the bankruptcy petition.86 For some taxpayers, this can mean that very significant tax obligations survive the hardship proceeding. The rule also underscores the importance of timing when trying to use bankruptcy to eliminate tax debt.

    Example 5: B filed for Chapter 13 relief on May 1, 2012. He was delinquent filing his 2007 federal income tax return, which was not submitted within any filed-for extension period. If B filed his 2007 return before May 1, 2010, his 2007 tax debt may be eligible for discharge in any type of Chapter 13 proceeding, since the return was submitted more than two years before the May 1, 2012, bankruptcy petition. However, if B submitted the 2007 tax return after May 1, 2010, the two-year rule will prevent a discharge in a hardship case.87

    Note that taxes covered by the two-year rule are not given priority for Chapter 13 purposes.88 In other words, B’s repayment plan would not have to provide for full payment of his 2007 taxes even if he files his 2007 return after May 1, 2010.89 Assuming B satisfies the terms of his repayment plan without requesting a hardship discharge, any unpaid taxes relating to the 2007 return would be eliminated.

    As discussed above, hardship discharges are granted for factors, such as illness, that are beyond the debtor’s control.90 Given the differences in discharges granted in regular and hardship cases, however, a debtor should not lightly decide to pursue the hardship option. Tax advisers with clients in these circumstances should work with bankruptcy counsel to assess what tax liabilities a client has not paid in full under the terms of the plan and what delinquent taxes the client will continue to owe if the hardship discharge is received. This is particularly important because of the stricter limits now in place under BAPCPA governing new bankruptcy petitions filed subsequent to a Chapter 13 proceeding.91

    The Role of the Tax Adviser

    The tax adviser to an individual client considering filing a Chapter 13 or other bankruptcy petition has a significant role to play, particularly if the client owes taxes. Between the client’s tax adviser and bankruptcy counsel, the tax adviser will likely be in a better position to determine the amount of the client’s income tax debt, type(s) of tax owed, the tax year(s) involved, the amount of interest and amount and type(s) of any penalties assessed, return filing dates, and assessment dates.

    Using this information, the tax adviser and bankruptcy counsel can work together to determine the amount, if any, of the client’s income tax debt that is dischargeable in bankruptcy and the proper timing of the bankruptcy to maximize the amount of tax that can be discharged.92 This will involve taking into account the three-year rule and the 240-day rule discussed above regarding priority taxes.93 Consideration of the two-year rule, described previously, may also be relevant if a hardship discharge request is a possibility.94 Prebankruptcy planning should also include ensuring that the client designates any voluntary tax payments as made toward his or her nondischargeable or priority tax debt.95

    The tax adviser should also be in a position to assess the tax benefits to the client, if any, of filing a Chapter 13 or Chapter 7 petition. For example, the ability of the debtor to retain certain tax attributes, such as a net operating or capital loss, may argue in favor of a Chapter 13 filing over a Chapter 7.96 The tax adviser should be prepared to describe and quantify the tax benefit of the client’s retaining, and the tax cost of losing, any applicable tax attributes.

    Some clients will have a choice between filing a Chapter 7 or a Chapter 13 bankruptcy petition, while others will be limited to a Chapter 13 petition because they fail the “means test” described above. Given the limitations on discharging tax debt and the elimination of the former “super discharge” in Chapter 13, if nondischargeable tax debt is a significant part of the client’s debts, the tax adviser should raise with bankruptcy counsel the possibility of alternatives, such as an offer in compromise or installment agreement, for addressing the client’s tax debt.

    Advising the client on whether and when to file for bankruptcy and, if the client has a choice, whether to file a Chapter 7 or a Chapter 13 petition, requires consideration of all of the client’s debts as well as analysis of nontax considerations, such as the effect of the filing on the client’s ability to obtain credit. The tax adviser’s primary role in this situation is to advise the client and bankruptcy counsel on the tax considerations so that this information accurately enters into the mix of factors to be weighed in determining whether to file for bankruptcy and, if so, which type of petition to file.

    The tax adviser may also assist bankruptcy counsel by reviewing any tax claims made against the debtor and complying with tax-related bankruptcy requirements. For example, in a Chapter 13 case the debtor is required to file “with appropriate tax authorities all tax returns for all taxable periods ending during the 4-year period ending on the date of the filing of the petition.”97 The purpose of this requirement is “to give taxing authorities the information they need in order to file proofs of claim” in the bankruptcy proceeding.98 If the four years’ returns have not already been prepared and filed, a tax preparer may be engaged to perform this service.

    If the debtor’s attorney assists in preparing the returns, the attorney’s fees may be an administrative expense, which has second priority and is paid ahead of other creditors (behind only domestic support obligations). The amount paid to an accountant or other tax return preparer to prepare these returns should qualify as an allowable living expense of the debtor.99 Moreover, the bankruptcy court may authorize the Chapter 13 trustee to employ and pay reasonable compensation to professionals, including accountants, to assist the trustee in administering the bankruptcy estate.100

    Conclusion

    Advising a client whether to file for bankruptcy and, if so, under which chapter of the Bankruptcy Code requires an intricate analysis of the client’s situation from both tax and nontax perspectives. An adviser who understands the tax consequences of a Chapter 13 bankruptcy proceeding and how those consequences can differ from other possible courses of action can be a valuable resource for the financially challenged client.

    Footnotes

    1 Title 11 of the United States Code.

    2 During 2012, 366,532 Chapter 13 bankruptcy petitions were filed. Of those, 363,280 were nonbusiness bankruptcies, and 3,252 were business bankruptcies. Bankruptcy filing statistics are available here.

    3 11 U.S.C. §109(e).

    4 Internal Revenue Manual (IRM) §5.17.11.3.

    5 11 U.S.C. §109(e). The Bankruptcy Code defines an “individual with regular income” as an “individual whose income is sufficiently stable and regular to enable such individual to make payments under a plan under chapter 13 . . . , other than a stockbroker or a commodity broker” (11 U.S.C. §101(30)).

    6 Federal Judiciary, “Individual Debt Adjustment."

    7 11 U.S.C. §109(e).

    8 78 Fed. Reg. 12089 (Feb. 21, 2013). See also American Bar Ass’n, Effectively Representing Your Client Before the IRS at 21.1.1.2 (5th ed. 2011).

    9 Id.; 11 U.S.C. §104.

    10 The “automatic stay” under 11 U.S.C. Section 362 prohibits (at least temporarily) certain collection actions from being taken against the debtor after filing.

    11 11 U.S.C. §§109(g), 362(d); Federal Judiciary, “Individual Debt Adjustment.”

    12 11 U.S.C. §109(h). Exceptions to the prepetition credit counseling requirement include, among others, exigent circumstances, incapacity, disability, and active military duty in a military combat zone.

    13 Federal Judiciary, “Liquidation Under the Bankruptcy Code.”

    14 Id.; 11 U.S.C. §§101(41) and 109(b).

    15 11 U.S.C. §303(a). Currently, for a debtor with 12 or more creditors, the involuntary Chapter 7 petition must be filed by three or more creditors having noncontingent and undisputed unsecured claims totaling at least $15,325; for fewer than 12 creditors, the involuntary petition must be filed by one or more creditors having claims totaling at least $15,325 (11 U.S.C. §303(b)), as adjusted for inflation (78 Fed. Reg. 12089 (Feb. 21, 2013)).

    16 Bankruptcy Abuse Prevention and Consumer Protection Act, P.L. 109-8.

    17 A debtor’s “currently monthly income” is generally the debtor’s average monthly income (whether or not taxable) from all sources for the six-month period ending on the last day of the calendar month preceding commencement of the bankruptcy case. Current monthly income includes “any amount paid by any entity other than the debtor (or in a joint case the debtor and the debtor’s spouse), on a regular basis for the household expenses of the debtor or the debtor’s dependents (and in a joint case the debtor’s spouse if not otherwise a dependent)” and excludes certain benefits, such as Social Security payments (11 U.S.C. §101(10A)).

    18 The applicable state median income, which depends on the debtor’s state of residence and family size, can be found here.

    19 If the debtor’s current monthly income net of allowable expenses as projected over the next five years is not less than the lesser of (1) 25% of the debtor’s nonpriority unsecured claims or $7,475, whichever is greater, or (2) $12,475, the petition is presumed abusive and will be dismissed unless the debtor can demonstrate special circumstances (11 U.S.C. §707(b)(2), as adjusted for inflation). For example, a debtor with nonpriority unsecured debt of $40,000 will meet the means test if his or her current monthly income, net of allowable expenses, multiplied by 60 (five-year projection) is less than $10,000 (25% of the debtor’s nonpriority unsecured debt and less than $12,475). A debtor with nonpriority unsecured debt of $100,000 will satisfy the second part of the means test if his or her current monthly income multiplied by 60 is less than $12,475 (since that number is the lesser of 25% of the debtor’s nonpriority unsecured debt (or $25,000) and $12,475). Allowable expenses are determined under the standards the IRS issues for collection purposes (11 U.S.C. §707(b)(2)(A)(ii)), which can be found here. Two examples of special circumstances in the statute are a serious medical condition or a call to active duty in the Armed Forces (11 U.S.C. §707(b)(2)(B)(i)).

    20 11 U.S.C. §707(b)(1).

    21 11 U.S.C. §301(a).

    22 11 U.S.C. §1302, 28 U.S.C. §586(b). The Chapter 13 trustee attends hearings, investigates the debtor’s financial affairs, examines and objects to creditors’ claims, collects plan payments from the debtor, and disburses them to creditors. See generally Resnick and Sommer, Collier on Bankruptcy, at ¶1302 et seq. (Matthew Bender 16th ed. rev.).

    23 11 U.S.C. §362. BAPCPA permits the IRS to offset prepetition income tax claims against prepetition income tax refunds notwithstanding the stay (IRM §5.17.11.10, citing 11 U.S.C. §362(b)(26)).

    24 Fed. R. Bankr. P. 3015(b). 11 U.S.C. §1321 gives the debtor the exclusive right to file the Chapter 13 plan. See also IRM §5.17.11.11.

    25 11 U.S.C. §§1324, 1325.

    26 11 U.S.C. §1322(d). See also Resnick and Sommer, Collier on Bankruptcy, at ¶1322.01.

    27 Under 11 U.S.C. §1322(a)(4), a Chapter 13 plan may provide for less than full payment of a domestic support obligation only if all of the debtor’s projected disposable income is applied to make plan payments for a five-year period.

    28 11 U.S.C. §507.

    29 Other than a claim secured only by a security interest in real property that is the debtor’s principal residence, which is subject to other rules (11 U.S.C. §1322(b)(2)).

    30 Effectively Representing Your Client Before the IRS, at 21.1.4.2.1.

    31 11 U.S.C. §1325(a)(5)(B)(ii) refers to an “allowed secured claim,” which is determined in accordance with Bankruptcy Code §§506(a) and (b)—an allowed claim may be both secured to the extent of the value of the collateral and unsecured to the extent that the allowed claim exceeds the value of the collateral. For certain secured purchase money debt incurred within certain time frames before the bankruptcy filing (e.g., a car loan), the Chapter 13 plan must provide for payment of the debt in full if the debtor retains the collateral and repayment is not limited to the value of the collateral. See the flush language following 11 U.S.C. §1325(a)(9). See also Federal Judiciary, “Individual Debt Adjustment.”

    32 ‘Disposable income’ means current monthly income received by the debtor (other than child support payments, foster care payments, or disability payments for a dependent child . . . ) less amounts reasonably necessary to be expended” to support the debtor or a dependent of the debtor, for certain charitable contributions up to 15% of the debtor’s gross income, and to continue, preserve, and operate a business (if the debtor is engaged in business) (11 U.S.C. §1325(b)(2)). National and local standards may limit these expenses, see note 19.

    33 The Chapter 13 payment period is three years, or five years if the current monthly income of the debtor and the debtor’s spouse is not less than the applicable state median income. The Chapter 13 plan payment period may be less than three or five years, “but only if the plan provides for payment in full of all allowed unsecured claims over a shorter period” (11 U.S.C. §1325(b)(4)).

    34 11 U.S.C. §1325(a)(4).

    35 11 U.S.C. §1328(a).

    36 Id.

    37 11 U.S.C. §1328(f).

    38 11 U.S.C. §1328(g).

    39 11 U.S.C. §1328(b).

    40 In re Graham, 63 B.R. 95 (Bankr. E.D. Pa. 1986); and In re Bond, 36 B.R. 49 (Bankr. E.D.N.C. 1984).

    41 In re Edwards, 207 B.R. 728 (Bankr. N.D. Fla. 1997); see also Resnick and Sommer, Collier on Bankruptcy, at ¶1328.03[2][a].

    42 Federal Judiciary, “Individual Debt Adjustment.”

    43 11 U.S.C. §§1328(b), 523(a).

    44 See “Hardship Discharge” on p. 308.

    45 11 U.S.C. §1328. See generally Resnick and Sommer, Collier on Bankruptcy, at ¶TX1.08[12]. Originally, a debtor who completed a Chapter 13 repayment plan could shed all obligations except long-term debt, alimony, and child support (Ray, “S.540: The Demise of the Chapter 13 Super Discharge?” 13-5 American Bankruptcy Institute Journal 16 (June 1994)). Over the years, the list of what survived in Chapter 13 grew, with student loans (11 U.S.C. §523(a)(8)), drunken driving debts (11 U.S.C. §523(a)(9)), and moneys owed for restitution and criminal fines (11 U.S.C. §1328(a)(3)) joining the roster of nondischargeable obligations. Until the BAPCPA was enacted, Chapter 13 provided greater debt relief than a Chapter 7 liquidation (Mather and Weisman, BNA Tax Management U.S. Income Portfolios 638-3d, Federal Tax Collection ProcedureDefensive Measures, IX:C:1:d (2010)). For example, it was possible to eliminate debts arising from fraud through a successful individual repayment plan (11 U.S.C. §523(a)(2)(A)).

    46 Federal Judiciary, “Individual Debt Adjustment.” See also 11 U.S.C. §1322(a)(2). Special rules exist for domestic support obligations.

    47 11 U.S.C. §507(a)(8)(A)(i). For a general discussion of priority tax claims, see Salzman and Hibschweiler, “Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy,” 43 The Tax Adviser 104 (February 2012). See also Federal Judiciary, “Individual Debt Adjustment.”

    48 The due date of the return takes into account extensions (11 U.S.C. §507(a)(8)(A)(i)).

    49 11 U.S.C. §507(a)(8)(A)(ii).

    50 Salzman and Hibschweiler, “Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy,” at p. 109. The 240-day period is tolled because of certain events, including an offer in compromise. 11 U.S.C. §507(a)(8)(A)(iii).

    51 11 U.S.C. §507(a)(8)(B).

    52 11 U.S.C. §507(a)(8)(D). Certain excise taxes and custom duties also may be entitled to priority. See generally 11 U.S.C. §507(a)(8).

    53 In re Ferguson, 134 B.R. 689 (Bankr. S.D. Fla. 1991). See also Effectively Representing Your Client Before the IRS, at 21.1.3.2.

    54 In re Larson, 862 F.2d 112 (7th Cir. 1988).

    55 11 U.S.C. §506(b). See also Resnick and Sommer, Collier on Bankruptcy at ¶TX4.05[2].

    56 Resnick and Sommer, Collier on Bankruptcy at ¶TX4.04[1]. See Salzman and Hibschweiler, “Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy,” at p. 106, for more on notices of federal tax liens. Note that federal tax liens may be subject to challenge as preferences under 11 U.S.C. §547.

    57 11 USC §511; In re Meyhoefer, 459 B.R. 167 (Bankr. N.D.N.Y. 2011).

    58 Jenks, “The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: Summary of Tax Provisions,” 79 Am. Bankr. L.J. 893 (Fall 2005) 902–03. The filing of a federal tax lien can have other negative consequences, specifically that assets that are otherwise exempt, meaning assets a debtor would expect to retain, are subject to collection where a notice of federal tax lien has been validly filed (11 U.S.C. §522(c)(2)(B)). This means that if G holds an IRA, the IRS could levy on the account after her discharge in bankruptcy (Iannone, 122 T.C. 287 (2004)). Note there is some question as to whether the exemption provisions of the Bankruptcy Code apply to Chapter 13 cases (9A Am. Jur. 2d Bankruptcy §1395).

    59 Note that tax liens can be stripped in Chapter 13 cases, meaning the lien can be avoided to the extent the tax claim exceeds the value of the property to which the lien attaches. This rule does not apply to a lien on real property that is the debtor’s principal residence. Resnick and Sommer, Collier on Bankruptcy at ¶TX4.04[5][c][ii].

    60 United Savings Ass’n of Tex. v. Timbers of Inwood Forest Assoc., Ltd., 484 U.S. 365 (1988). Note that if the collateral’s value appreciates after the bankruptcy filing, that then would support the payment of postpetition interest (Resnick and Sommer, Collier on Bankruptcy at ¶TX4.05[3]).

    61 In re Bates, 974 F.2d 1234 (10th Cir. 1992).

    62 United Savings Ass’n of Tex. v. Timbers of Inwood Forest Assoc., Ltd., 484 U.S. 365 (1988). See also Resnick and Sommer, Collier on Bankruptcy at ¶TX4.05[4][b].

    63 Resnick and Sommer, Collier on Bankruptcy at ¶TX4.05[4][c].

    64 In re Hopkins, 131 B.R. 308 (Bankr. N.D. Tex. 1991). A somewhat similar situation arose in In re Holway, 237 B.R. 217 (Bankr. N.D. Fla. 1999), where a Chapter 13 bankruptcy was converted to a liquidation proceeding under Chapter 7. The court held that even though Holway had already paid the IRS claim for prepetition taxes under the terms of the repayment plan, the IRS was still entitled to interest and penalties on its claim, since the tax debt in question was dischargeable under Chapter 13 but not in Chapter 7.

    65 11 U.S.C. §507(a)(8)(G).

    66 In re Hovan Inc., 172 B.R. 974 (Bankr. D. Wash. 1994). See generally Res­nick and Sommer, Collier on Bankruptcy at ¶TX4.02[1][d][ix].

    67 In re Cespedes, 393 B.R. 403 (Bankr. E.D.N.C. 2008).

    68 In re Hovan, 96 F.3d 1254 (9th Cir. 1996). The 10% tax on a pension plan’s termination is analogous to an excise tax and therefore also would be treated as a priority debt (Unsecured Creditors Comm., 977 F.2d 137 (4th Cir. 1992), cert. denied, 507 U.S. 1004 (1993)).

    69 Effectively Representing Your Client Before the IRS, at 21.1.3.2.

    70 Id.

    71 In re Gust, 197 F.3d 1112 (11th Cir. 1999). See also 9D Am Jur. 2d Bankruptcy §3576.

    72 11 U.S.C. §1328(a)(2), cross-referencing 11 U.S.C. §523(a)(1)(B).

    73 In re Ridgway, No. 02-30358(ASD) (Bankr. D. Conn. 10/6/09).

    74 11 U.S.C. §523(a), flush language.

    75 See generally Salzman and Hibschweiler, “Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy,” at p. 108.

    76 11 U.S.C. §1328(a)(2), referencing 11 U.S.C. §523(a)(1)(C).

    77 In re Klayman, 333 B.R. 695 (Bankr. E.D. Pa. 2005); see also 9D Am. Jur. 2d Bankruptcy §3583.

    78 In re Long, 419 B.R. 884 (Bankr. M.D. Fla. 2009).

    79 11 U.S.C. 523(a)(1)(C); In re Harris, 59 B.R. 545 (Bankr. W.D. VA 1986). See also 9D Am. Jur. 2d Bankruptcy §3583.

    80 11 U.S.C. §523(a)(7); see also Resnick and Sommer, Collier on Bankruptcy at ¶TX4.02[1][d][ix][D].

    81 11 U.S.C. §507(a)(8)(G).

    82 11 U.S.C. §1328(a)(2). See also Effectively Representing Your Client Before the IRS, at 21.1.3.2.

    83 Effectively Representing Your Client Before the IRS, at 21.1.3.2.

    84 Id. The tax implications of Chapter 7 and Chapter 13 filings must be considered by an adviser in combination with nontax differences between the two proceedings. For example, the Chapter 13 discharge is broader than the relief offered under Chapter 7. Also, although a repayment requires use of future income to fund payments to creditors, Chapter 13 debtors keep all estate property, except as provided by the repayment plan or bankruptcy court confirmation order (11 U.S.C. §1328; 9 Am. Jur. 2d Bankruptcy §72). A Chapter 13 filing also may be less damaging to a debtor’s credit standing (9 Am. Jur. 2d Bankruptcy §72).

    85 IRM §5.17.11.18.

    86 11 U.S.C. §523(a)(1)(B).

    87 For more on the two-year rule, see Salzman and Hibschweiler, “Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy,” at p. 108–9.

    88 11 U.S.C. §507(a)(8).

    89 If assessment of the 2007 taxes, after filing the 2007 income tax return late, occurs within 240 days of the bankruptcy petition, this will be a nondischargeable priority tax (11 U.S.C. §507(a)(8)(A)(ii)).

    90 11 U.S.C. §1328(b)(1).

    91 Under the 2005 changes, a debtor who receives a discharge under Chapter 7 is barred from a subsequent Chapter 7 discharge for eight years (11 U.S.C. §727(a)(8)). A Chapter 7 debtor must wait four years before obtaining Chapter 13 relief. The waiting period between two successive Chapter 13 proceedings is two years (11 U.S.C. §1328(f)). Under prior law, a debtor who received a standard Chapter 13 discharge was not subject to any limits on refiling (In re Yee, 7 B.R. 747 (E.D.N.Y. 1980); 9D Am.Jur. 2d Bankruptcy §3566). See “Timing of Discharge in a Chapter 13 Bankruptcy” on p. 305.

    92 CPAs must be alert for other tax issues raised by a bankruptcy petition beyond those discussed in this article, such as cancellation of indebtedness income.

    93 See also Salzman and Hibschweiler, “Timing Considerations of Discharging Taxes in a Chapter 7 Bankruptcy,” pp. 104–13.

    94 See “Hardship Discharge” on p. 308.

    95 The IRS applies voluntary payments according to the taxpayer’s written instructions. Unless otherwise agreed or required, all other payments are applied “to periods in the order of priority that the Service determines will serve its best interest” (Rev. Proc. 2002-26, 2002-1 C.B. 746). Tax payments made within 90 days of filing the bankruptcy petition may be avoided as a preference (11 U.S.C. §547). Payments made after the debtor has filed the petition can no longer be designated (I.R.M. §5.9.15.2). See also In the Matter of Baker, No. 95-30947 HCD (Bankr. N.D. Ind. 7/2/96). In Energy Resources Co., 495 U.S. 545 (1990), a Chapter 11 case, the Supreme Court held that a bankruptcy court can order the IRS to apply tax payments contrary to IRS policy, if necessary for the reorganization plan to succeed.

    96 Secs. 1399, 1398; Effectively Representing Your Client Before the IRS at 21.1.3.2.

    97 11 U.S.C. §1308(a) requires that the four years of returns be filed not later than the day before the creditors’ meeting, which is to be held within a reasonable period of time after the filing of the bankruptcy petition (11 U.S.C. §341). The bankruptcy court may hold the meeting open and, in certain circumstances, extend the date for filing. Failure to file the returns can be the grounds for a motion to dismiss the case (11 U.S.C. §1307(e)). See generally Resnick and Sommer, Collier on Bankruptcy, at ¶1308.01 et seq.

    98 Resnick and Sommer, Collier on Bankruptcy, at ¶1308.01.

    99 Resnick and Sommer, Collier on Bankruptcy, at ¶1308.02. See also 11 U.S.C. §§507(a)(2), 1326(a)(2), and 1325(b)(3). This will have the effect of reducing the amount the debtor has to pay creditors under the plan.

    100 11 U.S.C. §§327(a), 330(a). See also Resnick and Sommer, Collier on Bankruptcy, at ¶¶1300.26, 1300.29.

    EditorNotes

    Martha Salzman is an adjunct assistant professor, and Arlene Hibschweiler is an adjunct associate professor, both in the School of Management in the University at Buffalo, the State University of New York. For more information about this article, please contact Prof. Salzman at msalzman@buffalo.edu or Prof. Hibschweiler at ah33@buffalo.edu.

     




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