Taxes & Timing: Calculating Outcomes for Bankruptcy Debtors

Bankruptcy lawyers regularly evaluate the dischargeability of taxes when deciding when to file a client’s bankruptcy case.

At base, the 3 year rule, the 2 year rule, and the 240 day rule routinely drive timing of a bankruptcy.

But as we approach the end of the tax year, a client’s current year tax situation becomes another moving part in the “when do we file” analysis, unrelated to tax dischargeability.

In the simplest situation, the client owes no back taxes and is appropriately withheld for the current year. No timing issue.

But suppose the situation is not so simple. Several fact patterns cry out for careful timing of the commencement of the case.

Client expects to owe taxes for current year

Unlike a Chapter 7 case, filing Chapter 13 does not create a separate taxable entity in the bankruptcy estate. Nor does it offer the debtor the opportunity to elect a short tax year.

Instead, the start and end of the debtor’s tax year is unaltered by an intervening Chapter 13 filing.

A Chapter 13 filed in January can include and pay the taxes associated with the tax year ending in December. As the taxing folk see it, the tax is owed just as soon as the tax year ends, regardless of whether the return is yet filed or even due.

So, file before year end and you forfeit the ability to pay the current year’s taxes through the plan without interest. (Bankruptcy Code § 1305 provides for treatment of post petition taxes; courts and the IRS seem to vary on their acceptance of the practice.)

Client owes old taxes and expects refund

But let’s look at the converse of those facts: your client owes back taxes and expects this year to get a nice refund.

Or would get a nice refund if it wasn’t for those old taxes that entitle the IRS to set off the old tax debt against the refund.

Unless, of course, you fiddle with mutuality. And that’s where timing comes in.

Mutuality essential for offset

The principle of set off allows one party to reduce what that person owes another by the amount the other owes him. In our practice, that means the IRS can reduce the amount it owes you for this year’s refund by the amount you owe them for an earlier year.

Section 553 of the Bankruptcy Code preserves the right of offset:

… this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case…

The key concept is that the debts have to be mutual.

Mutuality requires that the debts be held by the same parties, in the same capacity, and that the off-setting debts both be prepetition or post petition. Meyer. Med. Physicians, 385 F.3d 1039.

Destroy the mutuality in the taxpayer/tax collector equation, and set off is not available.

Timing the filing

File before the end of this tax year and the right to a refund becomes a post petition debt of the IRS to the debtor, since the refund isn’t owed til the tax year closes.

Bingo: there is no mutuality. The client owes a prepetition tax debt; come January, the IRS owes the client a post petition refund. And the IRS can’t offset the refund against prepetition taxes.

You may care less about this strategy if the only taxes your client owes are priority. Those priority taxes have to be paid in any event.

In fact, it may be to your client’s advantage to have them paid by offset, avoiding the trustee’s commission on payments made through the plan. Put another way, pay the tax via offset with 100 cents dollars as opposed to paying with 110 cent dollars via the trustee.

And if you practice in a district where tax refunds are paid to the trustee, your client can reduce his withholding such that there is no refund come next year.