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By William L. Comer, Casper P. Connolly & Associates, Claire, Michigan

Individuals who find their "backs against the wall" because of unexpected financial problems, including IRS assessments, may find that their best solution is to file for bankruptcy in the U.S. Bankruptcy Court. This writer has encountered numerous unfortunate individuals who had been erroneously informed by their attorney or accountant that the IRS is a different type of creditor and that taxes cannot be discharged in bankruptcy.

The debtors' conduct and proper timing is crucial to the amount of success that will be achieved in the bankruptcy court. These courts hold that the exceptions to discharge under IRC section 523(a) must be construed very narrowly so as to not "frustrate the fundamental policy of promoting the fresh start of the debtor."

The bankruptcy estate consists of all legal or equitable interests of the debtor in property, wherever in the world situated, at the time the petition is filed. The debtor must file with the court a list of all known creditors, a schedule of all assets (including liabilities), and a detailed statement of the debtor's financial affairs. The debtor must also file a list of all property claimed as exempt from the bankruptcy estate.

When the petition in bankruptcy is filed, an automatic stay immediately arises under 11 U.S.C. section 362(a), and the scope of the stay is very broad. The automatic stay stops all collection efforts, all harassment, and all foreclosure actions. However, with limitations, the bankruptcy stay does not apply to the following situations:

1) The commencement or continuation of criminal proceedings against
the debtor;

2) The payment of alimony, maintenance, or support from assets which are not property of the bankruptcy estate;

3) The commencement or continuation of any action or proceedings by a governmental unit pertaining to the enforcement of its police or regulatory powers; or

4) The enforcement of a judgment, other than a money judgment, obtained in any action or proceeding by a governmental unit engaged in the enforcement of its police or regulatory power.

The IRS may issue notices of deficiency, but issuance of assessments, attempts to levy or seize the debtor's assets, or attempts to conduct tax sales of such properties are clear violations of the stay. The IRS's postpetition creation of a tax lien against the debtor constitutes a violation of the bankruptcy stay, and any acts which violate the stay are null and void.

The courts have often found creditors, including the IRS, guilty of civil contempt and have awarded the debtors the amount of their damages, including attorney fees and costs.

If the debtor's petition for discharge of his or her debts in bankruptcy is challenged by the IRS, the ultimate burden of proof is upon the challenger. The bankruptcy court has full authority to resolve tax issues and determine the debtor's tax liabilities, including determining the validity of the claim itself, and whether attorneys fees should be awarded if the IRS's position was not substantially justified.

When it comes to discharging income taxes and penalties in bankruptcy, timing is everything! The first rule to remember is that the IRS will be entitled to priority status and the taxes will not be discharged to the extent the IRS's claim is for an income tax due within three years of the date of the filing of the bankruptcy petition or assessed within 240 days before the date of the filing of such petition. For clarification purposes, the due date for income taxes is on April 15 of the year following the tax year in question (e.g., April 15, 1998, for the calendar year of 1997) plus any extensions that have been granted.

If the taxpayer files a petition for redetermination in the U.S. Tax Court or a prior action in the Bankruptcy Court involving the tax years sought to be discharged, tolling under the statute of limitations is triggered. Section 108(c) of 11 USC of provides for an extension of the statute of limitations for all creditor actions while a debtor's assets are under the protection of the bankruptcy court, thus activating 26 U.S.C. section 6503(i), which suspends the running of the statute of limitations on IRS assessment and collection activities during the pendency of a bankruptcy proceeding. Similar suspensions are applicable under 26 U.S.C. section 6213 for petitions for redetermination filed in the U.S. Tax Court.

It is imperative that the taxpayer ascertain the correct assessment date in accordance with IRC section 6203, before filing his or her petition. If the IRS issues assessments within the 240-day time period before the debtor files the bankruptcy petition, then these taxes will not be dischargeable because of the prohibitions contained in 11 U.S.C. section 507(a)(8)(A)(ii). Therefore, it is imperative that the taxpayer delay filing until assured that (1) the 60-day or 6-month stays imposed against the IRS because of prior judicial proceedings by the debtor have elapsed; and (2) at least 240 days have elapsed since he or she received the last assessment notice.

Once the timing obstacles have been overcome, debtors are reminded that under the provisions of 11 U.S.C. section 523(a)(1) excepted from discharge are any taxes (B) with respect to which a return, if required-(i) was not filed; (C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.

A substitute return prepared by the IRS to assist it in preparing a notice of deficiency does not qualify as a tax return. However, failure to timely file tax returns will not prevent discharge of the tax liability if the returns were finally filed more than two years before filing the petition, or, more than 240 days after the assessments were made.

Based upon compliance with the three-year and 240-day rules, numerous debtors have successfully discharged their state and Federal income tax, interest, and penalty liabilities by filing Chapter 7 in the U.S. Bankruptcy Court. Furthermore, taxes can be discharged even though the tax collector was not listed as a creditor since there were no known tax liabilities at the time the petition was filed and for a reasonable time thereafter.

The IRS, under Bankruptcy Rule 3002(c), must file its claim for unsecured debts within 180 days after the first date is set by the bankruptcy court for the meeting of creditors, as provided under IRC section 341(a).

A complaint objecting to a dischargeability of a Chapter 7 debtor must be filed within 60 days of the first date set for the creditors' section 341 meeting. No injustice results by barring late claims filed by creditors who have timely notice of the bar date.

Full discovery applies, thus there are no secrets when an individual files for bankruptcy. The Federal Rules of Civil Procedure are applicable as set forth in Bankruptcy Rules 726-737, that provide for discovery by way of depositions, interrogatories, production of documents or things, physical or mental examinations, and requests for admission.

Section 548 sets forth the avoidance provisions for fraudulent transfers and obligations, involving--(1) gifts of property, (2) transfers for too little in return, or (3) obligations incurred that are not genuine. Other grounds for denial of discharge involve the inability or refusal of the debtor to account for obviously missing assets.

In general, discharges will be granted under the provisions of IRC sections 727(a)(2) and (4), unless the debtor has committed any of the following prohibited acts:

1) Transferred, removed, destroyed, mutilated, or concealed property of the estate with intent to hinder, delay, or defraud a creditor within one year before, or after, the date of filing the petition.

2) Concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor's financial conditions or business transactions might be ascertained.

3) Made a false oath or account; presented or used a false claim; gave, offered, received, or attempted to obtain money, property, or advantage, or withheld from an officer of the estate any information, including books, documents, records, and papers, relating to the estate.

A discharge does not entitle the individual to a return of those assets which are secured by certain debts, particularly those involving Federal tax liens. Under IRC section 6321, notice of assessment for unpaid tax liabilities creates a lien on all real and personal property of the taxpayer, and is perfected by filing where it then attaches to all property interests of the taxpayer including homesteads and interests acquired after the date of the lien.

Thus, pre-bankruptcy liens for taxes will not be discharged to the extent they can be satisfied out of assets owned by the debtor at the time of filing the petition. Code section 11 U.S.C.S. 506(a) "limits a creditors' secured claims to the value of its interests in a debtor's property, and claims in excess of this value are deemed unsecured." Postpetition taxes are not discharged and remain the obligation of the taxpayer.

Despite all of the foregoing enumerated procedures and obstacles, if a debtor has met all of the dischargeability criteria set forth in Title 11 of the U.S. Bankruptcy Code, then, despite any creditor or trustee objections, the debtor's petition for relief under either Chapter's 7, 11, or 13 will be granted and the discharge will be issued by the court, even against taxes assessed by the IRS.

The discharge order, signed by the U.S. Bankruptcy Judge, determines that a debtor is entitled to immunity, subject to certain limitations and qualifications, from any actions by creditors to collect debts existing on the filing date of the bankruptcy proceeding.

The effect of the discharge injunction is to void actions taken after the discharge in bankruptcy. Section 524(a)(2) enjoins the commencement or continuation of any action to collect or recover the discharged debt, releases the debtor from any legal duty to repay the obligation, and renders the debt uncollectible by any legal process.

There is one final obstacle, however, that justifies this word of caution for any debtor. The law is clear that if a debtor has engaged in any prohibited conduct which was not known at the time a discharge was granted by the court, but the fraudulent conduct is later discovered, then the debtor's discharge will be revoked. *

The author expresses appreciation for the assistance of attorney Randall L. Frank in the preparation of this article.

Note: References are available upon request and on The CPA Journal, home page, www.cpaj.com.

Milton Mitter, CPA

William Bregman, CPA\PFS

Contributing Editors:
Atan Fogelman, CPA
Clarfield & Company P.C.

David Kahn, CPA\PFS
Goldstein Golub Kessler & Co., P. C.


The article in the February issue of The CPA Journal on Roth IRAs on page 63, incorrectly states that the amount of the IRA that is being converted to a Roth IRA should be included in the taxpayer's Adjusted Gross Income in determining the $100,000 threshold for the four-year spread. The amount of the IRA being converted is excluded from AGI for purposes of that test.

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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