PROTECTING A SMALL BUSINESS

FROM TAX SEIZURE

USING CHAPTER 13

by

MORGAN D. KING, ESQ.

 

This article appeared originally in The San Francisco Recorder
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.

What is Chapter 13? Formerly called a "wage earner plan" and now referred to as an "adjustment of debts for an individual," Chapter 13 may be viewed as a court-approved consolidation of debt, together with a rescheduling of payments to fit the debtor's budget and ability to pay. In Chapter 13 a debtor may include husband and wife, or a sole proprietorship business.

PRESERVES A BUSINESS

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 local Chapter 13 Trustee has remarked that more small businesses would take advantage of this remedy if they knew what it had to offer.

TAX DISCHARGE IN CHAPTER 13

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

The tax year in question is at least more than three years prior to the date of bankruptcy filing;

The taxes in question have been assessed at least more than 240 days prior to the bankruptcy filing;

The taxes are unsecured.

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 last 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 tax is unsecured if no lien is recorded, or a lien is recorded but there is no property to which it may attach, or it is legally defective.

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.

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 which require that the return have been filed in order to be dischargeable apply in Chapter 7, they do not apply in a Chapter 13. 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)(7), and under this code section the failure to file a return does not make the claim a priority, or non-dischargeable, claim. 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.

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)(7). Hence, even a very recent penalty is dischargeable in Chapter 13 to the same extent as other general unsecured claims.

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

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 priority tax within 90 days of the first meeting of creditors, the tax is extinguished. This is because only 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 a priority claim. In re Tomlan, 871 F.2d 223 (1st. Cir. 1989).

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.

TAX DISCHARGE IN CHAPTER 11

Now let's take a look at discharge of tax claims in Chapter 11.

A Chapter 11 is, in principal, very similar to a Chapter 13. That is, like Chapter 13 a Chapter 11 is a court-approved consolidation of debt, with a repayment schedule. And, like Chapter 13, it often includes the additional benefit of a partial or total wipe-out of unsecured debt. However, Chapter 11 is a more ritualized and complex program and involves considerably more attorney work, and hence considerably larger fees and costs. Accordingly, it is not suitable for most individual or small business cases.

Are there any advantages to handling tax claims in Chapter 11, as compared with Chapter 13? In many situations the answer is, yes.

Let's look at some of them.

First, unlike Chapter 13 which ordinarily requires that payments under the plan begin immediately, there is usually a "grace" period in Chapter 11 of anywhere from six months to several years before the debtor must begin making his payments under a confirmed plan. Many debtors desperately need this grace period in order to overcome a debt or cash-flow crisis.

Second, while in Chapter 11 unsecured tax claims must be paid within six years of assessment, section 1129(a)(9)(C) places no such time limit on payment of secured taxes. Hence, unlike Chapter 13 which requires that such claims be paid in no more than 60 months, the debtor may be able to confirm a Chapter 11 plan providing for a considerably longer payment period.

Third, unlike Chapter 13 which places debt limitations for eligibility in Chapter 13, there are no such debt limitations in Chapter 11. Therefore a debtor may be ineligible for Chapter 13 because his secured debts exceed $350,000, or his unsecured debts exceed $100,000 (see 11 U.S.C. § 109(e)), yet be eligible for a Chapter 11 reorganization. Note that the pending new "Chapter 10" now under consideration in Congress may substantially eliminate the debt limit problem in such cases.

Now, a glance at some of the most common disadvantages.

First, the criteria for discharge of a tax claim in Chapter 11 is the same as for Chapter 7. So, for example, a debtor who has failed to file tax returns for the tax years in question at least more than two years before filing the bankruptcy is not eligible for a discharge (wipe out) of the claim. Accordingly, the ability to wipe out a tax claim in Chapter 11 is not as great as a Chapter 13, which does not require a filed tax return.

Second, unlike Chapter 13, a priority tax claim paid through Chapter 11 ordinarily continues to accrue interest, substantially adding to the cost of handling the claim. 11 U.S.C. § 1129(a)(9)(C).

Third, priority tax claims paid in Chapter 11 must be paid within six years of date of assessment. 11 U.S.C. § 1129(a)(9)(C). In comparison, the Chapter 13 plan may have up to five years for payment regardless of date of assessment. 11 U.S.C. § 1322(a). Hence, a priority claim that was assessed several years ago may require payment in full upon confirmation of the Chapter 11 plan, something many debtors are not financially capable of doing.

Fourth, unlike Chapter 13 where the creditor has little say over confirmation of the plan, in Chapter 11 tax claims for unsecured, dischargeable taxes probably give the taxing entity a vote along with other general unsecured creditors. This is because the only tax claims that do not get a vote on the plan in Chapter 11 are those that are not classified, and 11 U.S.C. § 1123(a)(1) provides that only priority taxes are not to be classified. See 11 U.S.C. § 1129(a)(8), Voting.

 

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© The Morgan D. King Organization 2000