It’s tax time and the hunt goes on for tax deductions to lower your income tax hit.

Tax deductions lurk in the most unlikely places.

If your Chapter 13 plan is catching up home loan arrears, look at your trustee’s annual report for some deductible mortgage interest.

Most likely, the lender’s filed proof of claim in the bankruptcy case is interest on the loan which accrued but was not paid before the case was filed.

Lender’s claim loaded with interest

Until very late in most 30 year mortgages, a substantial amount of each monthly  payment on your home loan  is interest.  That mortgage interest can be deducted if you itemize deductions.

For reasons that I can’t explain, mortgage lenders do not seem to provide a 1099 for mortgage interest paid through the trustee.  But then, the whole business of accounting for mortgage payments made through Chapter 13 seems to be beyond most loan servicers.

How to find the deductible amount

All Chapter 13 trustees have information available on line for debtors whose cases they are administering.  Usually, the instructions for how to access the information about your case is provided at the 341 meeting.

Find the section of the trustee’s site that shows disbursements or payments.  Locate the claim filed by your lender, or its servicer.  The report will show how much has been disbursed on that claim.  You’ll have to isolate what’s been paid in the last tax year.

If you can’t sort the information for disbursements in a given period, you can look at the ledger of all disbursements;  flag and total the payments to your lender.

Making a record

The IRS relies on 1099 forms sent to them, with copies to the taxpayer, to verify your right to the deduction.  Since the lenders don’t seem to acknowledge Chapter 13 payments as interest, you’re on your own to back up your claim for a tax deduction.

I suggest that you get a copy of the bank’s proof of claim, print off the trustee’s disbursement records, and save them along with a copy of your plan with your supporting tax documents.  You’ll want to be able to back up your tax deduction.

Other deductions hiding in the underbrush

The same principle, that payments by the trustee are really payments attributable to you, the tax payer, applies to any deductible taxes or business expenses that the trustee has disbursed.  There is no reason to let those tax deductions go to waste.

Happy hunting.

Image courtesy of bethanne.

Bankruptcy can stop collection and eliminate tax debt in many situations. For more details on tax discharge see the article I wrote about Bankruptcy Tax Discharge on my personal site. While bankruptcy can be a very useful tool in dealing with the Internal Revenue Service and state collectors, it will not solve all problems.  In many cases, a tax debt that would qualify for bankruptcy discharge is rendered non-dischargeable when the taxpayer fails to file a tax return and the IRS or state collection authority uses their statutory authority to assess.  Some types of tax, such as employment tax, are not subject to discharge.  Fortunately, there are other ways to stop or manage collection problems.

Some types of tax can not be discharged and can be collected by the IRS after the bankruptcy case is closed.  Bankruptcy may not be available or appropriate for some delinquent taxpayers.

The IRS allows properly authorized professionals to represent taxpayers and help them get relief from enforced collection such as bank account and wage levies.  Attorneys, CPAs, and Enrolled Agents are given special permission to represent taxpayers, can establish online electronic access to IRS taxpayer records, and can negotiate a resolution for a taxpayer with IRS collections.  Tax professionals can also be authorized to represent taxpayers before most state tax enforcement agencies.  Authorization is done with a power a power of attorney form 2848 for the IRS and similar documentation for state tax collectors.

While individual taxpayers can call the IRS directly and may be able to handle a tax problem themselves, tax practitioners are given access to a special telephone number to call the IRS and are assigned to specially trained personnel to help solve tax collection problems.  In addition, the tax professional usually has experience in calculating payment agreements and is familiar with the regulations governing the tax collection process.  If the collection officer oversteps or makes unreasonable demands, it is often difficult for an unassisted taxpayer to remedy the situation.

We all know that individual tax returns are due on April 15 (or a day or two later if April 15 is on a weekend).  But Congress inserted a little tax time craziness into sections 1308 and 1307 of the new and drastically unimproved Bankruptcy Code of 2005.  Section 1308(a) states:

(a) Not later than the day before the date on which the meeting of the creditors is first scheduled to be held under section 341 (a), if the debtor was required to file a tax return under applicable nonbankruptcy law, the debtor shall file with appropriate tax authorities all tax returns for all taxable periods ending during the 4-year period ending on the date of the filing of the petition.

At first reading, this section appears to only be dealing with those returns the debtor “was required to file” prior to the 341 hearing or “First Meeting of Creditors.”  For example, if it’s February 5th, 2012, and I’m a debtor in bankruptcy, it can’t be said that I “was required” to file my 2011 return.  After all, the IRS gives me until April 15.

But like many provision of the Bankruptcy Code, this one’s a little murky.  And section 1308(b) provides:

(1) Subject to paragraph (2), if the tax returns required by subsection (a) have not been filed by the date on which the meeting of creditors is first scheduled to be held under section 341 (a), the trustee may hold open that meeting for a reasonable period of time to allow the debtor an additional period of time to file any unfiled returns, but such additional period of time shall not extend beyond—

(A) for any return that is past due as of the date of the filing of the petition, the date that is 120 days after the date of that meeting; or

(B) for any return that is not past due as of the date of the filing of the petition, the later of—

(i) the date that is 120 days after the date of that meeting; or

(ii) the date on which the return is due under the last automatic extension of time for filing that return to which the debtor is entitled, and for which request is timely made, in accordance with applicable nonbankruptcy law. [emphasis added].

Reading both 1308(a) and (b) together, along with a few tea leaves and tarot cards thrown in for good measure, we see that the requirement of 1308(a) applies even to returns not yet due. So if you haven’t filed your 2011 return, and your 341 hearing is scheduled for February 6, you’d better have  your return filed by February 5!

And what if I don’t file my return prior to my 341?

If you don’t, the trustee “may hold open that meeting for a reasonable period of time to allow the debtor an additional period of time to file any unfiled returns” as noted above.  At the very least, that holds up confirmation of your plan.  And if you have a not-so-friendly Chapter 13 trustee, she just might not hold the meeting open and instead proceed under section 1307(e), which provides:

(e) Upon the failure of the debtor to file a tax return under section 1308, on request of a party in interest or the United States trustee and after notice and a hearing, the court shall dismiss a case or convert a case under this chapter to a case under chapter 7 of this title, whichever is in the best interest of the creditors and the estate.

What this means is that, in our example, if you don’t have your return filed by February 5, the U.S. Trustee or a “party in interest” (i.e., pretty much anyone including your crazy ex-wife) may file a motion, and the court “shall dismiss a case or convert a case under this chapter to a case under chapter 7.”

This presents huge problems for self-employed debtors

For most W-2 employees, filing tax returns isn’t that big of an undertaking, assuming they get their W-2 from their employers in a timely fashion.  Still, getting the return filed by February 5, or even a few weeks later, can be difficult when the debtor may be dealing with issues in his bankruptcy case.

But for self-employed debtors, this requirement presents an impossibility.  Many self-employed debtors must first file corporate or partnership returns prior to filing their own individual tax returns.

Furthermore, holding the first meeting open accomplishes nothing. Trustees have the right to demand annual tax returns under section 521 or to require the debtor to furnish the trustee the last year’s return even after confirmation. After all, what’s the difference between a case filed on December 31 and one filed on January 1?  Why should one case be administered under the draconian requirements of 1308(a) and the other, filed a day earlier, escape these requirements?

But the IRS needs the returns to file their claims on time!

No they don’t. Governmental creditors already get 180 days to file claims because we assume the government can’t possibly do anything on time. So for that January 1 bankruptcy petition, the IRS has 180 days after that to file its claim–way beyond April 15.

Would the IRS really do this?

Yes, apparently it would.  The IRS Office of General counsel in North Carolina reminded bankruptcy lawyers in the South Carolina bar of this in a letter dated August 11, 2011–which, amazingly was signed by a staff attorney in “Group 1, business/self-employed.”   I say, “amazingly” because the IRS attorney signing this letter should know that there’s no earthly way debtors can pull partnership and corporate returns out of their ears in early February, then follow up with a quick 1040 filing.

Mom says just because you can doesn’t mean you should

There is nothing in the Code requiring the IRS to hassle debtors by filing unnecessary motions like this. As mom used to say, “just because you can doesn’t mean you should.”  Ditto for the IRS.  Searching the hills of North Carolina for illegal stills would be a better use of IRS resources.

And if they persist, there’s the 1040WAG

Okay, I just made that up.  But here’s what it is.  It’s a 1040 return where the debtor takes a wild-assed guess (hence the “WAG”) at what he should put down, then files it.  Voila, no more problems.  He then amends the return at a later date (filing a 1040X–there really is such a thing) when he obtains W-2s, other records, partnership returns, corporate returns, and so on. Problem solved!  This is, after all, what the government asked for.

Of course, this accomplishes nothing but allowing the debtor to assert compliance with a nonsensical rule which should not be enforced. Instead, it would be better if the IRS focused on its core mission–collecting taxes.

Postscript: On both a personal and professional level, I genuinely like the people I’ve come in contact with at the IRS on behalf of my clients.  I do, however, object to the Office of Division Counsel in North Carolina threatening debtors with dismissal for failing to do something which is impossible.  Chapter 13 bankruptcy is about paying creditors back, including the IRS.  The IRS should work to assist debtors to accomplish this goal, rather than threatening hard-working, honest Americans in the throes of the worst economy since the Great Depression.     

For one of the few decisions analyzing this issue, see In re French, Case No. 06-20066 (Bankr. E.D.W.I. 2006).  In addition, United States v. Novello, Case No. 08-2362-JAR, a U.S. District Court case in Kansas , is worth reading.  In Novello, the U.S. District Court reversed the Bankruptcy Court’s use of section 105 (allowing the court to issue any order necessary to carry out the provisions of the Code) to deny the IRS’s motion to dismiss the case.  After explaining that the Bankruptcy Court improperly used section 105–albeit in a common-sense fashion–the District Court admonished the IRS by stating: “In so ruling, the Court repeats the observations of the bankruptcy court in this case as well as in McCluney, that a motion to dismiss brought under § 1307(e) is discretionary and that once a return is filed soon after the motion to dismiss, that statute’s purpose has been fulfilled. The bankruptcy court was understandably frustrated by the tactics of the United States and the resulting inequity to the debtor. As the bankruptcy court noted, just because the IRS has the power to pursue such a motion does not mean it should seek to enforce it with “unwavering tenacity” under any and all circumstances. The United States has succeeded on appeal. Upon remand, however, it would behoove the United States to consider whether the gain incurred by continued pursuit of its motion to dismiss under the circumstances of this case comes at the cost of its goodwill with the bankruptcy court.”  Words of wisdom–sounds like something mom would say.

And for even more reading on this fascinating subject, see “Pre-Petition Tax Returns, Post-Petition Tax Payments, and Proper Characterization of State Tax Claims” by Texas Assistant Attorney General, Kimberly Walsh.

Chapter 12 farm bankruptcy helps family farmers to keep their farms.  It allows family farmers to reorganize their finances and operations. Chapter 12 was originally enacted by Congress in 1986, and was made permanent in 2005.  It helps the farmer and the banker to sit down and work out alternatives for debt repayment.

But according to Senator Charles Grassley, recent IRS actions are threatening family farmers’ ability to properly reorganize in Chapter 12.  Grassley authored a provision which is supposed to allow farmers in Chapter 12 to sell some of their property without having to pay capital gains taxes to the IRS in full.  The provision, enacted in 2005 as 11 USC 1222(a)(2)(A) was intended to make capital gains taxes into unsecured claims (often paid at only a percentage of the total) rather than priority claims (required to be paid in full).

The US Supreme Court heard arguments on November 29^th in the case of Hall v. United States.  The IRS argued that capital gains taxes created by the sale of property during a farm bankruptcy proceeding are payable in full as an administrative expense under the Chapter 12 reorganization plan.  Although the 8^th Circuit in Knudsen v. IRS, 581 F.3d 697 (2009) rejected the IRS position and said there was an exception preventing the IRS having a priority claim on post petition claims, the 9^th Circuit agreed with the IRS position in deciding the Hall case (617 F.3d 1161 (2010)).

Grassley recently went onto the floor of the Senate to create a record of what the Congressional intent was in enacting section 122(a)(2)(a).  Grassley said the IRS position meant that a farmer couldn’t sell a portion of his farm to reorganize, pay creditors and become profitable again.  “Why should the IRS be allowed to veto a farmer’s reorganization plan?” Grassley asked.

“High taxes have caused farmers to lose their farms”. said Grassley, who believes that family farms are very important to the economic viability of rural  America. 

The policy reasons for this section of the farm bankruptcy law were that the farmers didn’t have enough money to pay everyone.  It would be better to allow them to sell some assets, which would generate cash and help them reorganize, keep farming and pay their creditors.  Congress, Grassley says, realized that someone would have to make a sacrifice and they decided to give farmers a break from government taxes in a very narrow set of circumstances.  The creditors that the IRS are trying to get ahead of are small businesses, suppliers and small local banks that extend credit and supplies to farmers according to Grassley. 

Grassley’s efforts on behalf of family farmers has made Chapter 12 the most debtor friendly chapter in the Bankruptcy Code.

Whether a tax refund will be taken by the Trustee in a Chapter 7 bankruptcy will depend on several factors.

As a general rule, the amount of taxes withheld from your pay are prorated over the entire year.  This means that the portion of the tax refund for the time before the bankruptcy filing is property of your bankruptcy estate and is available to be used to pay your unsecured creditors.

As an example, if you filed a bankruptcy petition on December 1, the withholding from January through November is part of the bankruptcy estate.

At the 341 Creditor’s Meeting, the Trustee will usually advise the Debtor as to whether or not he will “administer” the tax refund.  This decision will be based on a review of the tax return(s) provided to the Trustee.

For a tax refund to be worthy of administration, the Trustee will consider several factors:

• The amount of the refund.  Often if a refund is small, the Trustee will not take it simply because it is not cost effective to distribute it to the unsecured creditors.
• Exemptions.  Depending upon the state in which you live, the funds may be exempt under federal exemptions, state exemptions which permit a cash exemption or a “wild card” exemption, or an earned income tax credit exemption.  In Louisiana, where I practice, we have a specific earned income credit exemption.
• Prior year(s) unpaid taxes.   Taxes are normally a priority debt.  If the refund is going to pay past due taxes, then the trustee will not take it since the priority debt must be paid before an unsecured debt is paid.

When possible, the easiest way to avoid having to give up a tax refund is to file the return, receive the money and spend it before the bankruptcy is filed.  Paying for things such as pre-filing legal fees as well as the day to day necessities of life are permissible uses of a tax refund.

The receipt of a refund is only one issue in determining when to file a bankruptcy.  Other issues like a pending foreclosure, repossession, or the expected receipt of a bonus can all affect the timing.  Also, local practice in the court where you file will be a factor.

Everyone knows that you can’t discharge income taxes in bankruptcy.  Right?  No, not right at all.  This misconception about bankruptcy law illustrates just why you shouldn’t substitute cocktail party gossip for the advice of a good lawyer.  Especially when the question involves discharging income taxes in a consumer bankruptcy case.

Generally, income taxes are discharged in a chapter 7 or chapter 13 bankruptcy case when the tax is four years old or more.  (For those readers who owe substantial income taxes and who are learning this here for the first time, kindly place your eyeballs back into their sockets and read on for some additional qualifications.)

It’s not accomplished through special legal wizardry; in fact it’s routine and it happens automatically in most cases where the legal tests are met.

How is this possible?  Because of bankruptcy code section 523(a)(1), which lays out the tests for determining whether your income taxes can be discharged.

First, the tax must be owed for a year where three years have passed since the tax return was due.  Most of the time, the return was due on April 15.

Second, the return must have been filed more than two years ago.  Obviously, this rule applies only to late filers.

Third, the tax must not have been assessed with the last 240 days.  This rule applies where the return didn’t accurately show all the tax that was owed, and the IRS just finished assessing additional taxes after discovering your mistake.

Fourth, if you wilfully attempted to evade or defeat payment, it can’t be discharged.  Courts have ruled that simple non-payment, without anything more, is not enough to show that you tried to evade or defeat payment of the tax.

Sections 523 and 507 of the bankruptcy code do impose some additional requirements, but what has been written above is enough for most people to know.  If you filed your tax return on time, and if the return was accurate, and if it’s been more than three years since the return was due at the latest (usually April 15 of a given year), then your taxes are going to be discharged if you file for bankruptcy, unless a specific exception in the law applies to you.  It’s that simple.

If you owe income tax that you can’t pay, here is what you now know you should do: first, try to avoid listening to legal advice about bankruptcy from well-meaning friends at cocktail parties, and second, get yourself to a bankruptcy lawyer to find out for sure if your income taxes are dischargeable in bankruptcy.

Tax returns can be a trap for the unwary in Chapter 13 bankruptcy. Often, bankruptcy debtors do not have their tax returns squared away and filed before filing for bankruptcy. When non-tax creditors are pursuing you, and you need quick relief, often tax returns are the last thing on your mind. However, the need to file recent tax returns is enshrined in the updates to the bankruptcy code that went into effect in 2005.

Section 1308 of the Bankruptcy Code provides:

(a) Not later than the day before the date on which the meeting of the creditors is first scheduled to be held under section 341(a), if the debtor was required to file a tax return under applicable nonbankruptcy law, the debtor shall file with appropriate tax authorities all tax returns for all taxable periods ending during the 4-year period ending on the date of the filing of the petition.

This means that you must file all of your state and federal tax returns due within the past four years before your meeting of creditors. If you can’t do this, however, the law provides some help. At her discretion, the bankruptcy trustee can hold open the meeting for a period not exceed 120 days. It is the job of your lawyer to request this if your tax returns are not filed as of the date of your meeting. If the returns are not filed, and the meeting is not held open, your case will be dismissed if someone asks the Court to dismiss it. The reason for this is Section 1307(e) of the Bankruptcy Code, which provides:

Upon the failure of the debtor to file a tax return under section 1308, on request of a party in interest or the United States trustee and after notice and a hearing, the court shall dismiss a case or convert a case under this chapter to a case under chapter 7 of this title, whichever is in the best interest of the creditors and the estate.

If you owe federal tax and fail to pay, the IRS has a federal tax lien on all of your assets. The lien can be a secret and exists even if the IRS has failed to file a Notice of Federal Tax Lien in the public records. This secret lien can take your retirement funds to pay a tax debt even after the tax has been discharged in bankruptcy.

Bankruptcy can discharge some types of tax liability. However, a properly recorded lien generally survives bankruptcy discharge. This is true for recorded tax liens as well as liens that are recorded voluntarily against property of the debtor in bankruptcy. The code specifically provides protection for assets of the bankruptcy estate that the debtor has claimed exempt unless the assets are encumbered by a properly recorded tax lien. However, to qualify for exemption, the property must have actually been part of the estate in the first place.

The US Supreme Court in the 1992 case of Patterson v. Shumate, 504 U.S. 573, decided that assets protected by The Employment Retirement Security Act (ERISA) are not automatically part of the bankruptcy estate and can be altogether excluded from the estate. This protects ERISA covered retirement funds from claims of trustees and creditors. Unfortunately, excluding the asset does not allow the bankruptcy court to remove a secret federal tax lien. In order to protect retirement funds from the IRS secret lien, they must first be included and then claimed as exempt.

The 9^th Circuit Court of Appeals in Raines v. Flinn, 428 F.3d 893 explains that exclusion of ERISA assets is optional and that they can be voluntarily included in the estate. Once the assets have been included in the estate, code section 11 USC §522 permits them to be exempted and freed from the IRS secret lien. This must be done clearly and specifically or the IRS will retain their lien and can take the funds covered by their lien as shown by the 2010 US Tax Court case of Wadleigh v. Commissioner, 134 T.C. No. 10. In the Wadleigh case, the tax court agreed that the IRS retained the power to seize retirement funds, even after discharge, if the funds were excluded from the estate rather than exempted under the code.

Image credit: Audric Leperdi/Flickr

As April 15 approaches, many people are receiving forms 1099 C from their banks.  It’s one last parting shot after bankruptcy and foreclosure.  It’s causing panic throughout the nation.  Why? My friend Dan Press wrote a nice article about this a few months ago.  But now that tax time is approaching, it is not a bad idea to mention a few cogent points.

How can it be that you have “made money” and have to pay income tax even though you just filed bankruptcy?

That’s because from the bank’s standpoint, it forgave debt to you.  The bank didn’t want to.  You  made them do so when you filed your bankruptcy case.  But since you don’t owe them money any more, and they can write off their loss, the Internal Revenue Service would ordinarily treat the bank’s loss as your gain.

Fortunately, you almost certainly won’t owe any taxes on account of the 1099C.  You’ll have to point your accountant in the right direction since far too many have no idea about this topic.

Here’s what you need to know.

• Section 108 of the Internal Revenue Code protects you
• Your accountant will have to fill out a form IRS 982 along with your income tax return. Make sure your accountant looks at the February 2011 revision.
• Information is available in 2009-37, 2009-36 I.R.B. 309 available with IRS Publication 908. 
• Cancellation of debt in connection with your residence should be excluded from income until 2012.

At Bankruptcy Law Network, we are bankruptcy attorneys and not tax attorneys.  But we have to know and understand tax consequences of bankruptcy and we want you to understand them too. So now you have the information you need to give to your accountants and I’m confident that you’ll have very little difficulty with this seemingly challenging problem.

According  to the 4th Circuit Court of Appeals, if you fail to tell your state taxing authorities after the IRS adjusts your taxable income, it may prevent you from discharging your state taxes in bankruptcy.

Most states with personal income taxes base their determination of taxable income on federal taxable income, subject to some additions and subtractions. As a result, they also mostly defer to the IRS on auditing individual taxpayers. When the IRS conducts an audit and makes changes to a taxpayer’s taxable income as a result, it will assess the resulting taxes and will also notify the state taxing authorities.

Despite being notified by the IRS, most states also require a taxpayer subject to a federal audit adjustment to either file an amended return or otherwise notify the state taxing authorities of the audit adjustment. The state will then make the necessary adjustments, if any, in the amount of tax owed. There is often a very short deadline after the federal audit adjustment to notify the state.

In bankruptcy, an income tax is dischargeable (absent certain tolling events, and assuming no fraud or evasion) if (a) the due date of the tax return, including any extensions, was at least 3 years before filing; (b) the return was timely filed or, if late, was filed at least 2 years pre-petition; and (c) the tax was assessed at least 240 days pre-petition. All three must be met. If the IRS assesses additional taxes after an audit, a taxpayer may only need to wait 240 days (about 8 months) after the assessment to discharge those taxes in bankruptcy, provided the 3-year and 2-year rules have by then also been met.

If the debtor timely notifies the state (in the proper manner), then it will also assess, and 8 months from that assessment (again, assuming the 2-year and 3-year rules are met as to the original return) the state taxes will also be dischargeable in bankruptcy. But if the notification or amended state return is late, or not made at all, then watch out!

Once a state filing is late, it will likely trigger its own 2-year waiting period, because, as the 4th Circuit held, even a requirement to simply report to the state (without a requirement for an actual return) is the “equivalent” of a return, triggering the 2-year rule if it is not timely filed. Even worse, if the report or amended return is late and the state assesses the taxes based on the IRS notice, then it has an argument that even if the taxpayer files the return or report later, it is simply too late to be considered a return, meaning the taxes will never be dischargeable.

While there are good arguments that the 4th Circuit got it wrong, and that a required report is not the equivalent of a return where, as is the case in many states, there is no return form, it is not required to be under penalty of perjury or even signed, and may not contain enough information for state taxes to be assessed, it is far better to avoid the issue completely and simply file a timely return or report with the state.