Most tax practitioners are vaguely aware of bankruptcy law. Today we learn something more.
Bankruptcy can have significant benefits for taxpayers. First, it can stop IRS collection action. Second, it can shake off a tax liability sooner than the 10 year time period Congress gives the IRS to collect. Third, it can be a pre-payment forum, an alternative to the Tax Court, where the taxpayer can contest an unassessed liability.
Along with benefits, however, come costs. The biggest cost is tolling. Bankruptcy tolls various time periods for the IRS to assess or collect. Two recent cases teach us just how costly bankruptcy tolling bad can be for taxpayers. Dave Andrew Lufkin Sr., v. Commissioner, T.C. Memo. 2021-71 (June 8, 2021) (Judge Greaves), teaches how bankruptcy tolls tax collection. Marc. S. Barnes and Anne M. Barnes v. Commissioner, T.C. Memo. 2021-49 (May 4, 2021) (Judge Lauber), teaches how bankruptcy can also toll assessment: it illustrates the confusing exception to discharge for tax debts that are unassessed but assessable as of the petition date. Details below the fold.
Law: Bankruptcy Benefits
The Bankruptcy Code (BC) is found in title 11 of the U.S. Code. The three basic bankruptcy protections that are generally most useful to taxpayers are as follows:
(1) The Automatic Stay. When a taxpayer files for bankruptcy protection, BC §362(a) creates what is called the automatic stay. The stay arises by operation of law and does not require a court order. It starts the day of the bankruptcy petition. The automatic stay generally prohibits any act to obtain possession of property of the bankruptcy estate or to collect or recover a claim against the debtor taxpayer that arose before the bankruptcy petition was filed. As to tax matters, BC §362(a)(8) specifically stays any proceeding before the Tax Court involving a tax period that ended before the petition date. But the stay does not prohibit the continuation of an audit up to and through the issuance of a Notice of Deficiency. BC §362(b)(9). Nor does it prohibit assessment of a tax when there is no right to commence a Tax Court proceeding. Id.
(2) The Discharge. The biggest benefit taxpayers seek from bankruptcy is discharge of their tax liabilities. The specific discharge rules vary, depending on whether the taxpayer filed for protection under Chapter 7, 11, 12, or 13. See generally BC §727, §1141, §1192, §1228, §1328. But as to taxes all of those specific rules are subject to the same set of exceptions, found in BC §523(a)(1).
BC §523(a)(1) does not permit discharge of three kinds of tax debts:
- taxes that result from a fraudulent return or willful evasion of tax. BC §523(a)(1)(C);
- taxes that were supposed to be reported on a return but the return was either unfiled as of the bankruptcy petition date or was filed within the two year period looking back from the bankruptcy petition date. BC §523(a)(1)(B); and
- taxes that are described in BC §507(a)(8) “whether or not a claim for such tax was filed or allowed.” BC §523(a)(1)(A). These are called “priority taxes” because BC §507 is titled “Priorities” and gives the general rules for which claims against the debtor get priority over which other claims. So to understand which taxes are either discharged or excepted from discharge, one must also understand which taxes get priority.
BC §507(a)(8) describes seven kinds of taxes that get priority. For our lesson today, we just need to look at this one: an income tax “not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case.” BC §507(a)(8)(A)(iii). In addition, any type of penalty that is “in compensation for actual pecuniary loss” is also entitled to priority, but non-pecuniary loss penalties are not. So the penalties listed in §6662 are not entitled to priority just because they are related to a priority tax claim. Their priority status (and, hence, dischargeability status) must be analyzed separately.
Remember, priority and discharge are different. To get priority, BC §507(a)(8) requires that the claim be filed and allowed. The discharge rules, however, contain no such requirement; they just piggyback off of the description, not off of any claim actually filed or allowed.
(3) The Prepayment Forum. BC §505(a)(1) permits the Bankruptcy court to “determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.” So if a taxpayer is facing the collection of a really big assessment and cannot pay the assessed tax, bankruptcy provides a forum to get a judicial review of the merits of the tax liability.
BC §505(a)(1) is broad and permissive. That means that if the taxpayer files for bankruptcy after filing a Tax Court petition, the bankruptcy court can exercise its discretion to adjudicate the same liability as is before the Tax Court. See In re Hunt, 95 B.R. 442 (Bankr. N.D. Tex. 1989) (explaining both the §505(a) power and factors to balance in deciding whether to exercise that power); see also In re: Yerushalmi, 123 A.F.T.R.2d 2019-2087 (Bankr. E.D. New York (June 5, 2019).
However, BC §505(a)(2) limits the discretion. Thus, the bankruptcy court cannot determine any tax liability when the Tax Court has actually issued a decision. See BC §505(a)(2)(A). The flip rule is that if a bankruptcy court decides the merits of a tax claim, that decision is res judicata and bars relitigation of the deficiency in the Tax Court, even if the bankruptcy case is subsequently dismissed. See Florida Peach Corp. v. Commissioner, 90 T.C. 678 (1988).
Law: Bankruptcy Tolling
The biggest downside for taxpayers is that when they emerge from bankruptcy, the IRS can resume assessing or collecting non-discharged tax liabilities as if the bankruptcy had never happened.
Generally, §6501(a) provides that the IRS has three years to assess a tax liability one the taxpayer has filed the required return. Similarly §6502(a) provides that once the IRS has made an assessment, it has 10 years to collect it. However, §6503(h) provides that when the taxpayer is the subject of a bankruptcy case, then both time periods are “suspended for the period during which the Secretary is prohibited by reason of such case from making the assessment or from collecting and—(1) for assessment, 60 days thereafter, and (2) for collection, 6 months thereafter.” That reference to “prohibited by reason of such case” is a reference to the BC §362 automatic stay discussed above.
That means if the IRS was about to assess a tax when the bankruptcy case commenced, and the tax liability was not discharged, the IRS’s ability to assess is tolled. Similarly, if the IRS was attempting to collect a tax when the bankruptcy case commenced, and the tax liability was not discharged, that means the IRS’s ability to collect is tolled.
That’s what we will learn in these two cases: ask not for whom the bankruptcy tolls, it tolls for the IRS.
Lesson 1: Tolling Under The “Not Assessed Before, But Assessable” Exception
Facts in Barnes. Mr. and Ms. Barnes untimely filed their tax return for 2003. The IRS audited the return and sent out an NOD in 2008 proposing to assess a deficiency of $54,486, a §6662(a)(1) penalty of $10,897, and a §6651(a)(1) late-filing addition to tax of $5,691, all for the tax year 2003. See Barnes v. Commissioner, T.C. Memo. 2012-80.
The taxpayers filed a timely petition in Tax Court in 2008 and the case went to trial in 2009. On July 26, 2010, before the Tax Court had issued its decision, the taxpayer filed a bankruptcy petition. The IRS did not file a claim in the bankruptcy proceeding for any tax liability for 2003. Neither did the taxpayers’ Chapter 11 plan include any provision for payment of 2003 tax liabilities.
On July 15, 2011, the taxpayers’ Chapter 11 plan was confirmed, resulting in a discharge of all liabilities not excepted from discharge. BC §1141(d). The Tax Court case resumed with the Tax Court issuing an opinion in March 2012. The taxpayers appealed and for reasons unclear to me, the IRS was allowed to assess their 2003 liability in 2012, pending the appeal, because they did not post an appeal bond. The D.C. Circuit affirmed the Tax Court decision in 2013.
In November 2017 the IRS filed a Notice of Federal Tax Lien for the 2003 tax liabilities (and others) and sent Mr. and Ms. Barnes the required Collection Due Process (CDP) notice. They timely asked for a hearing. The IRS Office Appeals issued an adverse Notice of Determination in 2019 and the taxpayers timely asked for Tax Court review.
Lesson From Barnes: In both the CDP and Tax Court proceedings, the taxpayers pressed two arguments. First, they said the statute of limitations to collect their 2003 liability had expired. Second, they argued that the 2003 liability had been discharged because the IRS had failed to “preserve” the liability by filing a proof of claim. During the Tax Court proceeding, the taxpayers also ran back to the Bankruptcy court and asked for a ruling that the 2003 liability had been discharged.
Each argument failed. The first argument was nonsensical. The collection statute of limitations did not start until after the IRS assessed the liability, sometime in 2013. Nor did the taxpayers have any grounds to assert that the assessment period of limitations had expired. The assessment period of limitations was still open when they filed bankruptcy, having been tolled by the timely Notice of Deficiency. Once the taxpayers timely petitioned Tax Court to redetermine the proposed deficiency, §6213(a) then tolled the assessment period until the Tax Court decision became final (although apparently that provision is trumped by §7485, see Coda, below).
Since commencement of the bankruptcy case during the pendency of the Tax Court proceeding stayed the Tax Court proceeding, BC §362(a), the assessment period of limitations remained tolled. §6503(h).
The second argument was no more availing, at least as to the amount of tax liability and associated interest. That is because as of the bankruptcy petition date, the 2003 liabilities had not yet been assessed, but they were still assessable, per the analysis in the above paragraph. Therefore, as Judge Lauber explains, the tax liabilities fit right into the BC §507(a)(8) description of priority tax debts. Since the liabilities fit the description, that made them non dischargeable per the plain language of BC §523, even though the IRS never submitted a claim in the bankruptcy proceeding. Op. at 10.
Bottom line: The 2003 assessment limitation period was tolled even though the IRS did not file a proof of claim for the 2003 taxes in bankruptcy and the Chapter 11 plan did not provide for the liabilities. However, both the §6651 additions to tax and the §6662 penalties were indeed discharged because they are non-pecuniary loss penalties not included in the BC §507(8)(a) description of priority claims. Thus, it was not enough for those to have been assessable but not assessed as of the bankruptcy commencement date.
Lesson 2: Automatic Stay Tolls Collection – For As Long As It Takes
Facts of Lufkin. The taxes owed in Lufkin are even older than in Barnes. The IRS assessed employment tax liabilities against Mr. Lufkin in 1998 and 1999. If nothing had happened to toll the collection period, the IRS would have needed to complete collection by 2008 and 2009.
But something did happen. Mr. Lufkin filed “multiple chapter 7 bankruptcy proceedings between 2000 and 2011.” Op. at 3. By the time the IRS figured out that the bankruptcy dust had cleared, it was October 2014. The IRS sent Mr. Lufkin a levy CDP notice and he timely requested a CDP hearing. For some reason, the CDP hearing did not take place until December 2016 at which time Mr. Lufkin contested the merits of the employment tax liabilities (which he could do b/c the IRS does not send out NODs before assessing employment taxes and Mr. Lufkin did not otherwise have an opportunity to dispute them). In the alternative, he argued that the collection limitations period had expired.
Lesson from Lufkin. Mr. Lufkin’s attack on the merits could not overcome the presumption of correctness. Judge Greaves finds that he “failed to satisfy his burden to show how respondent’s determination...was made in error....” Op. at 8.
Mr. Lufkin’s limitations period argument was equally futile because he had spent almost all of the years after the 1998 assessment futzing around in Bankruptcy. Judge Greaves writes: “even under a conservative calculation, more than 10 years had not elapsed on the applicable periods of limitations for the Form 941 liabilities when respondent issued the CDP notice in 2014.” Op. at 9-10. And then, of course, he invoked his CDP rights, which also toll the collection period.
Bottom line: Bankruptcy can be a taxpayer’s friend, but it also takes a toll.
Coda: Recall that the IRS assessed the Barnes’ tax liabilities while their appeal was pending. I confess a confusion about that and suspect others may share it. So let’s work it through. Section 6213(a) prohibits assessment until the decision of the Tax Court “becomes final” and §7481 says that when a Tax Court decision is timely appealed, it does not become final until “the expiration of the time allowed for filing a petition for certiorari, if the decision of the Tax Court has been affirmed or the appeal dismissed by the United States Court of Appeals and no petition for certiorari has been duly filed.” §7481(a)(2)(A). But...§7485 also provides that assessment is stayed by any appeal taken under §7483. The §7485 stay, however, is conditioned on the taxpayer posting a bond, which Mr. and Ms. Barnes did not do. It turns out that courts read §7485 as supplanting §6213 or, in the words of the Tax Court “The rule in section 6213(a) is subject to an exception found in section 7485.” Plotkin v. Commissioner, T.C. Memo 2019-27 (reviewing case law on the subject). Bottom line: if you want the stay on assessment to continue, post a bond. But if you want the collection limitations period to start earlier, don’t post a bond.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday to TaxProf Blog for another Lesson From The Tax Court.