What happens if you need to file a Chapter 13, you have not yet filed your tax return for last year, but you know that a refund will be coming your way.  The simple answer is that unless you are paying back your creditors at 100%, your Chapter 13 will demand that you turn over your tax refund check, and will use that money to pay your creditors.  If you know that a refund is headed your way, make sure to tell your lawyer before you file – there are some steps you can take to preserve some or all of your tax refund money.

Your Chapter 13 trustee will also want future refunds paid to the trustee.  This situation is easier to handle – you will want to adjust your payroll withholdings so that you do not have any refund coming.  As far as the Chapter 13 trustee is concerned, your tax refund is kind of like a savings account that artificially reduces your net pay amount.

All of the Chapter 13 trustees in the Northern District of Georgia require debtors who are paying less than 100% to creditors to include in their Chapter 13 plans a provision that authorizes the IRS to intercept any refund payable during the years that your plan is in effect and send this money to the Chapter 13 trustee.  And until now, the IRS has cooperated with the Chapter 13 trustees in redirecting refund money.

In January, 2010, however, a federal district court in Michigan has rules that the Chapter 13 trustee does not have the power to compel the IRS to serve as its collection agent.  In the case of United States v. Carroll, a judge in the Eastern District of Michigan ruled that there is no legal basis for the IRS to withhold money and deliver it to the trustee because Congress has not waived the IRS’ “sovereign immunity” that would otherwise leave the IRS vulnerable to contempt actions and other enforcement actions by the trustee (in other words, if the IRS failed to withhold a debtor’s refund, the trustee would not have the right to sue the IRS for damages or for remedial action).  The Michigan judge issued an order forbidding the bankruptcy courts there from confirming any Chapter 13 plan that has the income tax refund seizure language.

I would not be surprised if bankruptcy courts elsewhere in the nation begin to follow the path set by the Michigan judge.  We’ll know soon enough, but I suspect that the trustees in the Northern District may discontinue their demand for an income tax provision involving the IRS in Chapter 13 plans.

I do not expect, however that Chapter 13 trustees here or elsewhere in the country will permit Chapter 13 debtors from keeping large tax refunds.  I suspect that trustees will still demand provisions that obligate debtors to tender their tax refunds but they will expect the debtors to send in the money, rather than having it withheld by the IRS.  I will continue to advise my clients to minimize their refunds to avoid the problem entirely.

Needless to say, losing this automatic tax refund payment mechanism will make enforcement of tax refund plan provisions much more difficult.  It will be interesting to what if anything Chapter 13 trustees do to address this potential administrative nightmare.

First, it does make a difference whether the small business is incorporated.  If your small business is a proprietorship (i.e. “Tom Smith d/b/a Tom’s Lawncare”) then there is no way to separate personal assets and debts from business assets and debts.  In this situation, all debts are “personal” because the proprietorship does not have a separate identity from the individual.  All debts would have to be listed – for bankruptcy purposes in this situation, there is no difference between your personal credit card debt that arises from gasoline and grocery purchases and a credit card that you use for business purchases.

Assets of the proprietorship would be considered personal assets – assets that do not fit within the Georgia exemption statute would be at risk.

In a Chapter 7, if you have non-exempt assets you would have to surrender those assets to the trustee or offer to buy the “estate’s interest” from the trustee (usually at a discount from fair market value).

Note that any receivables of the business or any other property with potential resale value (i.e. customer lists, pending contracts) could be claimed as estate assets.

In rare instances a Chapter 7 trustee could object to your small business bankruptcy using an “income suppression” argument.  This argument asserts that you should not be eligible for bankruptcy relief because you have intentionally suppressed your income by leaving a highly paid job or intentionally refused to maximize income opportunities.

If you are incorporated, the shares of your business are assets and you may very well be asked to justify a de minimus (i.e. $500) valuation that you put on those shares.   I see this issue frequently when clients own service businesses.  For example, I recently represented a client in an incorporated service business that had about $75,000 worth of equipment, but also had around $80,000 of credit card debt, $2,000 of tax debt and was behind on rent and facing a possible eviction.  What is the value of the shares in this case?   Is it $75,000 under the theory that the equipment was not subject to any lien and could be liquidated?  Is it zero under the theory that the business (and my client as personal guarantor) could be liable for a fraudulent transfer if it liquidated the equipment when the business was insolvent?  Or is the value somewhere in between zero and $75,000 using a compromise argument?

The income suppression argument described above also applies when the individual debtor’s business is incorporated.  I have seen trustees take the position that a debtor with a certain level of education and training should make a reasonable effort to monitize that education rather than chase an entrepreneurial dream at the expense of creditors.

In the case of an incorporated business where the debtor has partners, the Chapter 7 trustee may become a replacement partner by virtue of his trustee powers and thereafter force a liquidation or a buyout.

I usually advise my clients who own small business clients that there is a possibility that the trustee may demand that the business close its doors and that they may have to find a new line of work.  This possibility is less likely if the business is a service business that does not involve hard assets or inventory, and more likely if there are business assets with value or receivables.

Needless to say there are a myriad of potential issues for small business owners who are thinking about filing a personal bankruptcy.  As always, you will benefit greatly by seeking counsel before your situation becomes critical.

In this video, Darrin discusses how bankruptcy can be used to discharge tax debts. He was nice enough to mention this blog in his video and I am reproducing it below:

Recently, I have had to deal with problems arising from "estimated liability claims" filed by either the IRS or Georgia in Chapter 13 cases.

The problem arises in the case of a debtor who did not file a tax return in a prior year because of very low or non-existent income.  I have had a number of clients tell me that their accountants or tax preparers advise them that the debtor did not need to file a tax return for years in which the debtor earned little or no income.

I do not know if this advice about not filing returns is correct or not as I am not a CPA or a tax preparer.  What I do know, however, is that if you did not file a return in a prior year, there is a good chance that the IRS or Georgia will file an estimated liability claim for those tax years in your Chapter 13 case.

This estimated liability claim will often be calculated based on your earnings for recent years.  In other words if you earned zero in 2003, but earned $50,000 in 2004, 2005 and 2006, then the IRS will assume that you earned around $50,000 in 2003 and they will estimate your liability for that period as well.  Their estimated liability claim will include tax liability, interest and penalties.

If the IRS files an estimated liabilty claim based on unfiled returns, your Chapter 13 case will include unanticipated priority tax debt and there is a good chance that the Chapter 13 trustee will not agree to recommend confirmation of your case because your tax debt is actually unknown.

I am currently working on several cases where we have had to ask for reset after reset to give the debtor time to file a return showing zero earnings and for the IRS to amend its claim.

If there are any years in which you did not file tax returns, I think it would be wise for you to consult with your tax preparer prior to filing Chapter 13.  I am now recommending to my clients that they advise their tax preparers about this estimated liability problem and file a return showing zero income so that their Chapter 13 plans will not be in jeopardy.

Technorati Tags: chapter 13 and taxes, estimated tax liability claims in bankruptcy, proof of claim, Georgia Department of Revenue, IRS claims

Darrin has an informative and easy to follow blog/podcast called the IRS Problem Solver blog.  His blog posts include text and video, which I suppose technically makes his blog a "vodcast."  In any event, his June 12, 2007 post deals with the discharge of taxes in bankruptcy, and I recommend it to you.  In this short video blog post, Darrin sets out the basic rules of discharging taxes in bankruptcy. 

In the post, Darrin notes that one of the services he offers is to analyze your tax situation to determine whether your taxes are discharged in bankruptcy.  If you have any significant amount of tax debt and are considering bankruptcy, you should strongly consider retaining a knowledgeable tax lawyer like Darrin to do this analysis.   If you want to speak with Darrin, you can reach him toll free at (888) 438-6474. 

I have done this type of analysis but I spend my time representing bankruptcy and Social Security disability clients.  Most bankruptcy lawyers – myself included – do not have the time to keep up with changes in the rules relating to the discharge of tax debts and I am far more confortable filing a "tax bankrutpcy" with the analysis and input of a tax problem consultant.

Around the first of February, 2007, my client received a 1099 from the mortgage company showing that $599,000 of debt was forgiven.  I checked with my colleague, CPA Scott Rittenberg, who advised me that in a non-bankruptcy context, a homeowner who sells or loses a home to foreclosure could be liable for taxes on the difference between his basis in the home (in this case around $500,000) and the forgiveness ($599,000).  Would my client be looking at an income event in the amount of $99,000?

Scott did note that if my client had been in his home for two years or longer there was a $250,000 exclusion that applied, but absent a two year stay, there could be a tax problem.  Scott advised me to look further to research the rules about how a bankruptcy might change things.

I did a quick search on the BankruptcyLawNetwork blog and I found this post that answered by question about the tax treatment of a forgiveness of debt in bankruptcy by my colleague, attorney Cathy Moran of Mt. View, California.  Cathy publishes a very comprehensive and informative California bankruptcy law web site that speaks to many consumer bankruptcy issues.

Cathy advises that if you get a 1099, you should file a Form 982 to advise the IRS that the debt forgiveness occurred in bankruptcy and has no tax consequences.

2008 Update: you can read another informative post about the tax treatment of debt forgiveness in a bankruptcy on Taxgirl’s blog in a post entitled “Foreclosures, Debt Forgiveness and Mortgage Losses Explained.”  Click on the link to read this post.

Needless to say, my client is much relieved by the answer to his question.  Tax consequences arising from a deed in lieu of foreclosure in a non-bankruptcy setting could have significant and unintended consequences.  If you have option of executing a deed in lieu vs. a bankruptcy, keep the tax issues in mind.

My clients are self employed real estate agents, both in their 60′s.  Residential real estate sales can be a good business, but it can also be cyclical – with some months yielding a nice income and other months completely dry.   In this case my clients had close to $100,000 in credit card debt and close to $200,000 in income tax debt.

As an aside, real estate agents often have income tax problems because of the nature of their income.  Funds are not always there when it comes time to pay quarterly estimates – the estimated payments are based on the previous  year’s income.  In addition, the sales cycle of listing to closing may be four to six months, which means that cash flow can be a problem.

In this particular case, we had to file earlier than I would have preferred because we were trying to beat the filing of a tax lien.  Most of the tax debt in this case was "stale" for bankruptcy purposes, meaning that we could treat it as unsecured debt.  Once a lien was filed, we would be stuck paying the entire amount as secured debt.

The problem we faced arose from my clients’ income in the six months prior to filing.  The spring and summer months were realtively good for income purposes, resulting in an average monthly income that had no basis in current reality.  This fall and winter had been very poor months for home sales, perhaps because of the rise in interest rates and tightening of mortgage underwriting standards.

When we ran a "means test," the calculations showed that my clients had close to $2,000 per month in disposable income.   The problem – in November, my clients’ gross income was just short of $2,000.

I suggested that we consider a "step" plan that provided for a lower payment during "lean" months and a higher payment during spring and summer, which are traditionally better for real estate agents.  At this point, my clients were wary about agreeing to this because of their concern that they could be digging a deeper hole for themselves.

We also discussed taking the case to the judge, but I really have no basis to argue that my clients’ income will not match that of 2005.  I suspect that in this case, my clients are spending money for products and services that they are not completely documenting.  I do not suspect any wrongdoing, but I do think that $20 here and $25 there are adding up, leaving them with no money at the end of the month.

We decided to leave the plan at the $2,000 per month figure for now.  In six months, if the income situation has not improved, we will amend the plan and go for a reduction based on real life numbers.  I have no doubt that this strategy will result in a great deal of hardship for my clients, but I don’t have any other ideas.

My conclusion – Chapter 13 has become even more unfriendly to self-employed and commision sales debtors.

Technorati Tags: Chapter 13, bankruptcy and commissioned sales debtor, real estate agents and bankruptcy, discharge tax in Chapter 13 bankruptcy, means test 

Darrin recently wrote about a case where he used the "bankruptcy card" in his negotiations with the IRS to negotiate favorable terms in an Offer in Compromise.  The case involved a debtor who had not filed tax returns for ten years and owed an estimated $145,000.  Darrin was able to negotiate a Offer in Compromise in the amount of $24,000 with the IRS Appeals Division by pointing out that the Internal Revenue Manual says that if a taxpayer threatens bankruptcy, then the IRS must calculate what the IRS would likely receive after the bankruptcy was over.

Obviously, not every $145,000 tax liability will settle for 17 cents on the dollar, but this is an example of how even the threat of bankruptcy can make a difference.

Technorati Tags: tax issues in bankruptcy, offer in compromise, darren t. mish, discharge of tax liability in bankruptcy

In this case, my client was both delinquent in his payment of county property taxes and his taxes were not being escrowed by the mortgage company.  Because of the delinquency, I included the county tax commissioner as a creditor in the case.  Because my client's county property taxes were not being escrowed, I allocated approximately $300 per month as a monthly tax escrow so that he would be able to pay the tax bill later this year.

The county tax commissioner filed a proof of claim that included the delinquent tax debt for 2005 as well as anticipated property tax debt for 2006.  I filed a Motion to Disallow Claim on the grounds that the 2006 tax debt had not yet come due and because we were already allocating for this tax obligation in the budget. 

The county attorney called me and explained that under Georgia law, your county property tax debt comes due on January 1 in the exact amount of the previous year's tax.  This tax obligation is subject to change based on updated tax rolls but it exists as of January 1.  So, in my case, his position is that the county acted correctly in filing a proof of claim for both 2005 and 2006.

I discussed this issue with my client and we decided to withdraw our objection to the county's proof of claim, and we will amend our budget to get rid of the 2006 monthly allocation.  On January 1, 2007, however, I will need to re-amend the budget to add a monthly tax escrow allocation as he will have to pay 2007 directly.

Interestingly, this issue would not have arisen if there had been no delinquency for 2005 as I would not have listed the county as a creditor, although arguably every property owner is automatically delinquent as of January 1.  My sense is that the mortgage company escrow departments as well as county tax commissioner's offices are probably fine with the existing escrow system as it would be a logistical nightmare to convince escrow departments not to escrow for the current calendar year.  However, if you pay your property taxes directly or if you do list the county tax commissioner as a creditor be aware of this proof of claim issue so that you do not double pay.

Technorati Tags: county property tax, chapter 13, proof of claim, chapter 13 trustee, jonathan ginsberg, objection to proof of claim, motion to disallow claim, withdrawal of motion to disallow claim