Sam Brotman, JD, LLM, MBA March 12, 2021 14 min read

Know about Tax Debt before Filing for Bankruptcy

Filing for bankruptcy may feel like accidentally stepping off a cliff – it’s not something most people can mentally prepare themselves for in advance. 

When it happens and you find yourself falling, it’s difficult to know if you’ll hit rocks below and suffer permanent damage. Alternately, you could plunge into a lake, bob to the surface and have an easy swim to shore. 

Then there are the issues that accompany the decision to file such as tax consequences. The debtor must try to satisfy not just the creditors, but often federal and/or state tax collectors. 

In this article, I will be addressing a couple of the most frequently asked questions I get regarding bankruptcy as well as some of the tax issues that can arise because of it. I will conclude with some bankruptcy and tax facts as well as a California-specific issue. 

A Bird’s Eye View of Bankruptcy 

Inside of the Internal Revenue Manual (“IRM”) is a portion on bankruptcy. This serves as a guideline for IRS agents when working on a case involving a taxpayer who has filed for it. There are a few sections worth noting:

First, it is the mission of the IRS to enforce tax law with integrity and fairness to all. It continues with the three tenets of enforcing the law:

  1. Ensure fairness to the taxpaying public
  2. Ensure an equitable process for all taxpayers
  3. Ensure fairness to each taxpayer

More guidelines include the standard of respecting bankruptcy. This occurs when the IRS allows bankruptcy law to be the prevailing authority. 

This could come as good news for some taxpayers because it means there is a real possibility of having the tax debt discharged. This can be applicable when: 

  • It’s a certain type of tax debt. For example, individual income tax debt can get discharged in bankruptcy, but other types of tax debt will not.
  • It must also abide by certain rules:
  1. The taxpayer has to file a return and accurately list the debt.
  2. The taxpayer must give the government a reasonable amount of time to collect that debt.
  3. There are also certain circumstances where debt is not dischargeable. 

Bankruptcy is a good option to dissolve large tax debts or for debts that the taxpayer is guaranteed not to be able to pay. 

Bankruptcy is also a good option if you are mixing in large tax debts with other forms of liability that you are never going to be able to pay. 

However, if you only have tax debt, bankruptcy may not be the best option. Why? Because the IRS has created administrative resolutions for dealing with tax debt that do not involve filing bankruptcy. 

In my mind, bankruptcy is usually considered a nuclear option. While it does have its uses, it is definitely worth sitting down and discussing the situation with a tax attorney. This way we can better understand whether you are a good candidate to file for bankruptcy or if your tax debt can be taken care of using a different means. 

If you have already filed for bankruptcy, be aware that there are some common tax consequences and issues. 

The Three-Legged Stool of Bankruptcy Analysis 

Three very important aspects (or legs) of a bankruptcy analysis are:

1.   liquidation analysis

2.   feasibility of the plan, and

3.   type of debt. 

In the liquidation analysis, the taxpayer needs to decide what the creditors would receive under their plan. Additionally, this is where the taxpayer can look for any state or federal exemptions and how they may impact distribution to the creditors. Finally, the taxpayer should add in any trustee fees. 

The second part of the analysis which is the feasibility of the plan, will be discussed in the following In re Ayers case.

The third part, the type of debt there is (secured, unsecured, priority, non-priority), also plays a large role, as will be discussed in the Ayers case. 

The Ayers case uses what is called the “Best Interests of Creditors Test.” In this case, the Debtor’s plan was to count the tax consequences of an over-encumbered property. 

However, to satisfy Section 1225, a Chapter 7 Trustee would have abandoned the debtor’s real property as burdensome under Section 554. 

According to the Court, “the present issue regarding 554 would never have arisen if the Debtor used the proper liquidation standard to satisfy 1225(a)(4).

The Court continued with, “the proper standard is simply to compute the value of unencumbered, non-exempt assets.” And “therefore, the ‘best interest of creditors’ analysis of § 1225(a)(4) should include the liquidation value on the effective date of all unencumbered non-exempt property of the estate, including the estimated value of the crops and CRP payments.”

The Court held that, “if abandonment must be invoked to eliminate draining of unencumbered, non-exempt assets from the tax consequences arising from the sale of over-encumbered assets in actual liquidation under Chapter 7, it should surely be invoked in the hypothetical liquidation required under § 1225(a)(4), so the best interest test is met for the unsecured creditors.”

Ayers shows the importance of step one and two of the bankruptcy analyses. The liquidation analysis and the taxpayer/debtor’s plan are going to be strictly criticized.

According to CFTC v. Weintraub, the trustee has a duty to maximize the value of the estate and not minimize the tax burden on the debtor. 

Another important part of the bankruptcy analysis is in regard to employment taxes and trust fund recovery penalties (“TFRP”). The IRS emphasizes TFRP above all else because this is money that funds social security, and the government will have to make up this short coming if it cannot be recovered. 

Section 6672 of the Internal Revenue Code says that, “any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.”

Time and time again § 6672 taxes/penalties are ruled not dischargeable. The tax court in Barry v. Commissioner held that petitioner’s liability for the TFRP was not discharged in bankruptcy because it is not a dischargeable debt. 

In Washington v. Commissioner the tax court held that although the debtor received a discharge pursuant to Chapter 7 of the Bankruptcy Code, not all Federal tax debts are dischargeable. 

This was solidified in another case in front of the Supreme Court where they held that liability under § 6672 must be held nondischargeable under Bankruptcy Act § 17(a)(1)(e). See United States v. Sotelo

Section 507 of the Bankruptcy code puts taxes as eighth priority for claims. That may seem far down the line, but don’t let it fool you into thinking that the IRS lets tax debtors off the hook that easily. 

California Franchise Tax Board and Bankruptcy 

If you are a California taxpayer, the state’s rules do not differ much from those of the IRS. After the debtor files for bankruptcy, they must also file state taxes.

Even so, the FTB states, “once you have successfully filed for bankruptcy . . . [and] once we know you have filed for bankruptcy, we will stop collections on your tax debt (liens, wage garnishments, or seizures).”

The bankruptcy court could reduce some taxes owed, but if the debtor knows there will still be some tax debt, they can make voluntary payments. Here are the benefits the FTB lists for doing so:

  • It will reduce ongoing interest,
  • reduce tax debt owed after bankruptcy, and
  • prevents collections after bankruptcy 

Finally, at the close of bankruptcy, the FTB will issue a post-bankruptcy letter with remaining tax debt and collection actions will resume.

A Payment Plan Could Save You

As you’ve learned by now, a bankruptcy analysis is not one-size-fits-all. These matters depend on the varying facts of each case. If you’d like a more detailed explanation of tax issues and bankruptcy and how it could apply to you or someone you know, contact Brotman Law today. 

We can get you set up with a tax professional who could save you from slipping off a financial cliff. Working out a payment plan with the IRS or the state could get you back up on your feet if you’re clinging to the edge with your legs dangling below.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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