Discharging Tax Debts In Bankruptcy

In bankruptcy proceedings, the treatment of tax debts attempts to reconcile two conflicting policies.11 min read

by Richard Armknecht,III

In bankruptcy proceedings, the treatment of tax debts attempts to reconcile two conflicting policies. Although the government is interested in collecting taxes, bankruptcy policy is intended to give honest debtors a fresh start (while protecting creditors) by providing for the orderly liquidation or reorganization of the debtor's estate.

Partly because of this underlying tension, the provisions of the Bankruptcy Code (11 U.S.C.) regarding the dischargeability of tax debts in bankruptcy are quite complex. A debtor's ability to discharge any tax debt is based upon the classification of that particular tax debt. For the purposes of the Bankruptcy Code, a tax claim can be characterized as either a trust fund tax, a secured claim, an administrative tax claim, a priority tax claim, a general unsecured claim, or a penalty claim.

TRUST FUND TAXES

Trust fund taxes that have been collected by the debtor from third parties (e.g., sales taxes and income tax withholdings) are held in trust by the debtor for the appropriate taxing authority. Such amounts held in trust are simply not property of the debtor or of the bankruptcy estate. If, however, the debtor has failed to collect and/or remit to the appropriate taxing authority a trust fund tax, then the relevant taxing authority will have a priority tax claim pursuant to 11 U.S.C. 507(a)(8)(C).

SECURED CLAIMS

Secured claims are those claims that are secured by a lien on the debtor's property. A claim is secured to the extent of the value of the property securing the claim. For example, a claim for $40,000 secured by a piece of property worth $10,000 would be a secured claim of $10,000 and either a priority tax claim or a general unsecured claim of $30,000. If a creditor has a lien on property that is subject to superior liens in excess of the value of the property, the claim is not secured. Thus, if the IRS files a tax lien upon a piece of property worth $40,000 that is subject to a preexisting lien in the amount of $100,000, the entire tax lien claim would be either a priority tax claim or a general unsecured claim because of the preexisting lien. If the amount of the superior lien is less than the value of the property upon which the IRS filed its lien, then the IRS will have a secured claim to the extent that the value of the property exceeds the value of the superior lien. The remaining balance of the tax claim would either be a general unsecured claim or a priority tax claim.

ADMINISTRATIVE TAX CLAIMS

Administrative tax claims consist of taxes that have accrued during the pendency of the bankruptcy. 11 U.S.C. 503(b)(1) accords administrative status to any tax that is incurred by the estate. There are two exceptions. The first are taxes of a kind specified in 11 U.S.C. 507(a)(8) that constitute priority tax claims. The second are those tax claims that are attributable to an excessive allowance of a tentative carry-back adjustment that the estate received, whether the taxable year to which such adjustment relates ended before or after the commencement of the case. 11 U.S.C. 503(b)(1) further accords administrative tax claim status to any fine, penalty, or reduction in credit relating to an administrative tax.

Several courts of appeals have found that interest on administrative tax claims is accorded administrative status by implication. Accordingly, any tax that accrues during the bankruptcy proceeding (together with any penalty or interest associated with such tax) will generally constitute an administrative tax claim entitled to treatment as a 507(a)(1) first priority claim. Note, however, that the Supreme Court has recently accepted certiorari on a case holding that administrative tax penalties are subject to equitable subordination under 11 U.S.C. 510(c), notwithstanding 11 U.S.C. 503(b)(1)(C). (See U.S. v. Noland (In re First Truck Lines, Inc.), 48 F.3d 210 (6th Cir. 1995), cert. granted, 116 S.Ct. 558 (1995))

PRIORITY TAX CLAIMS

Priority tax claim status is granted to certain "allowed unsecured claims of governmental units" under 11 U.S.C. 507(a)(8). Note that the terms of this section of the Bankruptcy Code preclude a tax claim from being treated as both a priority tax claim and a secured claim. The categories of priority tax claims include the following:

* Taxes "on or measured by income or gross receipts" as defined in detail by statute. * Unsecured property taxes assessed prior to the bankruptcy but last payable without penalty less than one year prior to the filing of the petition. * "A tax required to be collected or withheld and for which the debtor is liable in whatever capacity." * Certain employment taxes as defined in detail by statute. * Certain excise taxes as defined in detail by statute. * Certain customs duties as defined in detail by statute. * Pre-petition interest on priority tax claims and penalties compensating for actual pecuniary losses related to the priority tax claims are also entitled to priority status.

The most complicated of the detailed statutory definitions of priority tax claims is the definition located at 11 U.S.C. 507(a)(8)(A), which provides priority status to allowed unsecured claims of governmental units to the extent that they are for a tax on (or measured by) income or gross receipts (e.g., federal income tax) but only if such tax is: (1) for a taxable year ending on or before the date of the filing of the petition, where the return for such taxable year (if any return is required) was last due less than three years before the date of the filing of the petition (the "three-year rule"); (2) assessed within 240 days (plus certain additions related to offers in compromise) before the date of the filing of the petition (the "240-day rule"); or (3) generally, taxes not assessed before, but assessable (under applicable law or by agreement) after, the commencement of the case (the "post- petition rule").

THE "THREE-YEAR RULE." Priority status is accorded under the "three- year rule" if a tax has been assessed for a taxable year ending on or before the date of the filing of the bankruptcy petition. In other words, post-petition taxes are not priority tax claims. (They are administrative tax claims.) Next, the return, with any extensions, must have been due less than three years prior to the date of filing. The date upon which the return is finally due is critical to determining priority status. The three-year period did not begin to run with respect to a Form 1040 until it was due on April 15, 1996, for example, even though the Form 1040 was actually filed on January 30, 1996.