Discharging Taxes in Bankruptcy

PART III

Discharge in Chapter 13

By

 Morgan D. King, Esq.
Of the California Bar

Originally appearing in the San Francisco Recorder in three parts   

a. In general

Chapter 13 of the Bankruptcy Code provides a mechanism for discharging an overdue tax bill that in many cases has important advantages over a Chapter 7 discharge. In many cases it is easier to qualify for a Chapter 13 discharge of taxes than for a Chapter 7. This advantage is often called the Chapter 13 "Super-discharge," discussed further, below.

A key advantage of Chapter 13 over Chapter 7 is that it does not require a liquidation of assets. Accordingly, it is ideal for the asset-rich debtor or the business having assets, because the debtor may pay off debt through Chapter 13 while retaining control and ownership of property. This makes Chapter 13 a powerful tool for debt relief. One Oakland Chapter 13 trustee has remarked that more small businesses would take advantage of this remedy if they knew what it had to offer.

b. The rules for discharge

A claim for personal income taxes is dischargeable (i.e. capable of being wiped out) in Chapter 13 to the same extent as any general unsecured claim (such as credit cards) if it meets both of the following criteria:

• The most recent due date of the tax return for the tax year in question is at least more than three years prior to the date of bankruptcy filing. 11 U.S.C. § 507(a)(8)(A)(i);
• The tax liability in question has been assessed at least more than 240 days prior to the bankruptcy filing. 11 U.S.C. § 507(a)(8)(A)(ii).

These rules are interpreted the same way as the equivalent rules in Chapter 7. Briefly, the three-year period for the tax year in question starts on the most recent date the return is due, including extensions; The 240-day assessment period starts when the tax is formally assessed by, in the case of I.R.S. claims, the entry of Form 23-C in the taxpayer's tax file.

The "tolling" events which may result in a stretch-out of any of these time periods in a Chapter 7 apply, as well, in a Chapter 13.

c. The super-discharge

Why is a tax discharge often an advantage in Chapter 13? Because, as the reader may have noticed in comparing the criteria for discharge with Chapter 7, it is not required that a tax return have been filed in order to be dischargeable in Chapter 13. In contrast, a Chapter 7 discharge requires that the return must have been filed at least two years prior to the bankruptcy.

How do we reach this conclusion? Because while the tax claim provisions of 11 U.S.C. § 523, Exceptions to Discharge, require that the return have been filed in order to be dischargeable in Chapter 7, they do not apply in a Chapter 13. The Code section describing categories of claims that are not dischargeable in chapter 13 does not include the tax categories found in § 523. See 11 U.S.C. § 1328(a). All that is required in Chapter 13 in regard to tax claims is that, pursuant to § 1322(a)(2), the plan must provide for full payment of priority taxes as defined in § 507(a)(8), and under this code section the failure to file a return does not make the claim a priority, or non-dischargeable, claim. Fraudulent taxes and tax evasion taxes are, likewise, dischargeable in chapter 13. Accordingly, one of the must frequent impediments to wiping out taxes in Chapter 7, to wit the taxpayer's failure to file tax returns, does not rule out discharge of those taxes in Chapter 13.

Note that claims based on fraudulent tax returns or willful attempt to evade a tax may be discharged in Chapter 13, as well, since the exception to discharge of such claims is found in § 523, and not § 507.

d. Penalties are not priority claims

Yet another advantage to discharge in Chapter 13 is that, unlike Chapter 7 which requires that a tax penalty be more than three years old before it can be wiped out, no such requirement exists in Chapter 13. Again, the only tax requirement in Chapter 13 is that priority claims be paid in full, and penalties are never priority under § 507(a)(8). Hence, even a very recent penalty is dischargeable in Chapter 13 to the same extent as other general unsecured claims.

e. Other opportunities for discharge in chapter 13

Even this does not exhaust the potential benefits of handling tax claims through Chapter 13. There are more.

1. The untimely proof of claim

For example, in Chapter 7 it is impossible to ever erase a priority tax (such as payroll withholding, sales taxes less than three years old, and income taxes less than three years old), but there is a loophole in Chapter 13 which results in the lucky debtor sometimes getting out of even these ordinarily nondischargeable claims. If the taxing entity fails to file a proof of claim for an unsecured tax within 180 days of the bankruptcy filing date, the tax is extinguished. This is because only allowed priority tax claims must be paid in Chapter 13, and a tax for which a proof of claim was not timely filed is not an allowed claim, and hence is not paid. Upon final discharge, the unpaid tax, even a priority tax, is discharged. Why? Because no category of tax is excepted from discharge in Chapter 13. See 11 U.S.C. § 1328(a). In re Tomlan, 871 F.2d 223 (1st. Cir. 1989); 11 U.S.C. § 502(b)(9).

2. The unassessed, but assessable tax

Yet another opportunity for discharge in chapter 13 is the situation in which the tax has satisfied the three-year rule, but not the 240-day rule. Where the tax is unassessed as of the date of filing the bankruptcy and hence has not satisfied the 240-day rule, but it has satisfied the three-year rule and the taxpayer has violated one of the tax rules in § 523, then such a tax is not a priority tax by virtue of 11 U.S.C. § 507(a)(8)(A)(iii).

So, where the taxpayer has not filed the return [a violation of § 523(a)(1)], and the tax has not been assessed, and the return due date is over three years old, the tax is dischargeable. This is a very common situation, and debtor's counsel should be aware of it. See In re Muina, 75 B.R. 192 (S.D.Fla. 1987); In re Torrente, 75 B.R. 193 (S.D.Fla. 1987); In re Daniel, 170 B.R. 466 (Bkrtcy.S.D.GA 1994); In re Zeig, 194 B.R. 469 (Bkrtcy.D.Neb. 1996).

3. Key advantage: No interest on unsecured taxes

Another advantage arises where the tax is a priority and must be paid through the Chapter 13 plan. That is, in the case of unsecured tax claims, such claims are ordinarily paid through the Chapter 13 plan without interest. Frequently this makes Chapter 13 the preferred remedy for paying off a priority tax, as opposed to a voluntary payment plan with the I.R.S., where interest always continues to run and can easily double or triple the total amount of money paid to satisfy the claim.

Read about protecting a small business by using Chapter 13.

Proceed to Part IV - Discharge in Chapter 11