Legal Options in Kansas for IRS Tax Debts, Notices and Liens
This writing is intended to highlight potential legal options available to taxpayers facing collection of a tax debt. Most of the legal options available to a taxpayer unable to pay his or her debt to the IRS are found in the Internal Revenue Code (“IRC”) and will be discussed at length herein.
IntroductionThe intersection of bankruptcy law and tax law create multiple legal issues that should be carefully considered anytime that a taxpayer also owes tax debt to the IRS or a state taxing authority. In some circumstances, filing bankruptcy can be an effective tool to address a tax debt. Under other circumstances, filing bankruptcy is unnecessary and will cause other unintended consequences to the taxpayer. This guide is intended to analyze these issues and with an emphasis on recent case law addressing these issues. This is a general summary of the law, not intended as legal advice for any specific circumstance as every situation is different.
Offers in CompromiseThe IRS is required under IRC 6159(c) to enter into installment agreements with taxpayers where the tax liability without regard to interest and penalties is $10,000.00 or less and other eligibility requirements are met. To qualify, the taxpayer must have filed tax returns and paid the amounts due on those returns for the five years prior to entering the installment agreement, be unable to pay the tax liability in full and pay the full amount of the installment agreement over three years. The IRS also offers installment agreements for tax debts up to $50,000.00 provided the full amount of the installment agreement is paid over six years. Installment agreements are appropriate where the taxpayer can afford to pay the tax debt.
The IRS is required by IRC § 6301 to collect tax debts in full. However, IRC § 7122(a) provides the IRS with discretion to compromise an unpaid liability consistent with grounds established in Treasury Regulations. One such ground is doubt as to collectability. In situations where a taxpayer lacks the income and resources to pay the tax debt in full or where there is a genuine doubt that the amount of the tax debt is correct, an offer in compromise is a potential solution. The IRS is authorized to settle a tax debt for less than the full amount owed in either a lump sum or installment payments provided the offer meets or exceeds what the IRS determines to be the reasonable collection potential (“RCP”). RCP is calculated using IRS FORM 433-A and generally equals the net equity of all of a taxpayer’s assets (including exempt assets) plus the net discretionary monthly income available to a taxpayer based on the taxpayer’s income less a standardized allowance of expenses published by the IRS and multiplied by 12 to 24 months depending upon the duration of the settlement payment term. The IRS will not accept an offer in compromise if the taxpayer qualifies for and has the ability to pay the tax debt in full under an installment agreement. Furthermore, the IRS will not consider an offer in compromise until the taxpayer has filed all prior year tax returns that he or she was legally required to file.
In some situations, an offer in compromise and filing bankruptcy are mutually exclusive options. An offer in compromise can be submitted prior to filing a bankruptcy but it is important to note than an offer in compromise submitted prior to filing a bankruptcy will toll the running of the 240 day rule . It is unclear whether submitting an offer in compromise will toll the running of the three year rule. The IRS will consider an offer in compromise following the conclusion of a Chapter 7 bankruptcy but it will not accept an offer in compromise during the pendency of an active Chapter 11, 12 or 13 bankruptcy.
Property Exempt from Collection of a Federal Tax DebtIRC § 6334 protects certain property of a taxpayer from being levied against to satisfy a federal tax debt and further clarifies that no other state law shall exempt property from federal tax collections. Notable exceptions include wearing apparel; fuel, furniture and personal effects not to exceed $9,080 in value; tools of the trade not to exceed $4,540 in value; and unemployment benefits. In small deficiency cases where the levy does not exceed $5,000, real property used as a residence by the taxpayer cannot be levied. In the case of levies larger than $5,000, the IRS may only levy a personal residence if a federal magistrate or district court judge approves the levy upon a finding that the taxpayer’s other assets are insufficient to pay the tax. Wages, salary and other income are exempt from garnishment in a weekly amount equal to the taxpayer’s standard deduction plus the total number of personal exemptions that the taxpayer would be entitled to include on a return under IRC § 151 during the year of the levy divided by 52.
Collection Due Process RightsIRC § 6320 provides that the IRS must notify a person that a federal tax lien has been filed within 5 business days after the filing. The notice must be severed personally, left at the taxpayer’s residence or sent by certified or registered mail to such person’s last known address. The notice, must among other items, inform the taxpayer of the right to request a collection due process hearing within 30 days. IRC § 6330 similarly provides that the IRS may not levy property to satisfy a tax debt unless the taxpayer has been notified of the right to request collection due process hearing within 30 days of the notice. If a collection due process hearing is requested, the IRS must consider collection alternatives to a levy such as an installment agreement or offer in compromise. The underlying liability of the tax can only be raised in the collection due process hearing if the taxpayer did not receive an appropriate notice of deficiency or otherwise have an opportunity to challenge the assessment. The results of a collection due process hearing can be appealed for a judicial review by the United States Tax Court. Upon a timely request for a collection due process hearing, the IRS must suspend collection activity until the conclusion of the hearing or any judicial appeals following the hearing. Applicable statutes of limitations are also suspended during this time. If a collection due process hearing is not timely requested, the IRS offers an equivalent hearing but the results of the equivalent hearing are not subject to judicial review.
Judicial Review in a Collection Due Process HearingIn Pierson v. Commissioner , the IRS issued and correctly mailed a notice of deficiency to the taxpayer indicating a deficiency of $5,944 in income taxes plus interest and penalties. The taxpayer had 90 days to file a petition for review in tax court pursuant to IRC § 6213(a). Shortly thereafter the IRS mailed the taxpayer a final notice of intent to levy pursuant to IRC 6331 which indicated that the taxpayer would be afforded 30 days to request a collection due process hearing. The taxpayer’s petition for review of the collection due process hearing sought to challenge the income tax assessment by alleging that assessing income against individuals rather than corporations was illegal. In rejecting the taxpayer’s argument, the Tax Court stated:
"[S]ection 6330(c) provides for an Appeals Office hearing to address collection issues such as spousal defenses, the appropriateness of the Commissioner's intended collection action, and possible alternative means of collection. Under section 6330(c)(2)(B), neither the existence nor the amount of the underlying tax liability can be contested at an Appeals Office hearing unless the taxpayer did not receive a notice of deficiency for the taxes in question or did not otherwise have an earlier opportunity to dispute such tax liability."
The Tax Court went on to find that the taxpayer failed to propose a less intrusive means for collection of the tax and therefore had failed to state a claim for relief. Likewise, in Kanofsky v. Comm’r , the Tax Court sanctioned a taxpayer for improperly arguing the merits of an assessment during a collection due process hearing where the assessment was previously adjudicated in a prior case before the Tax Court.
In reviewing a determination following a collection due process hearing, the Tax Court places significant emphasis on whether the IRS deviated from the provisions of the Internal Revenue Manual (“IRM”). In the case of Eichler v. Comm’r , the taxpayer was assessed trust fund recovery penalties against him pursuant to IRC § 6672. The taxpayer submitted a request for an installment agreement as well as Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals. Additional documentation revealed that the taxpayer and his spouse were age 76 and 71 respectively. They had become heavily indebted trying to promote a non-profit educational corporation for which both the taxpayer and spouse worked. The non-profit was eventually shut down in a foreclosure. Following an in person hearing, the IRS determination concluded that an installment agreement could only be approved with a down payment of $8,520.00 despite representations from the taxpayer that he qualified for currently not collectible status.
The Tax Court began its analysis by noting that the standard of review on appeal of a notice of determination is abuse of discretion. The appropriate inquiry is whether the determination was “arbitrary, capricious, or without sound basis in fact or law.” Compliance with or deviations from the IRM is relevant to the inquiry, however, the “provisions of the IRM do not carry the force and effect of law or confer rights on taxpayers
Tax Penalties and InterestThe penalty provisions most likely to apply to an insolvent taxpayer include the following: (1) failure to fil return penalty; (2) failure to pay tax penalty; (3) accuracy-related penalty; and fraud penalty. The failure to file return penalty is 5% of the tax due per month but limited to a maximum interest rate of 25% annually. The failure to file penalty can be assessed without providing a notice of deficiency. There is an additional penalty for failing to pay the tax due as shown on a return. This failure to pay tax penalty is in the monthly amount of ½% but not to exceed 25% annually. For tax that was not shown on a return, but later required to be shown following an assessment, if the assessed tax is not paid within 21 days following a demand, a penalty of ½ % per month up to a maximum of 25% annually.
Accuracy-related and fraud penalties are found in IRC §§ 6662 to 6664. IRC § 6662 authorizes imposition of a penalty equal to 20% of the portion of an underpayment of tax attributable to, among other reasons, negligence ; disregard of regulations; a substantial understatement of tax; or a transaction that lacks economic substance. A “substantial understatement of income tax” generally occurs if the amount of the understatement “exceeds the greater of -- (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000.” The 20% underpayment penalty is reduced or eliminated with regard to the portion of the understatement that is supported by “substantial authority” or if “the relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return” and there is a reasonable basis for the position.
The IRS publishes on its website a list of transactions considered to be abusive and lacking reasonable basis. Positions appearing on this list are referred to as “listed transactions.” Understatements attributable to nondisclosed listed transactions and certain reportable transactions are subject to a 30% penalty. The portion of any underpayment attributable to fraud is subject to a 75% penalty under IRC § 6663. IRC § 6664(c) and regulations thereunder provide exceptions to the imposition of underpayment penalties for reasonable cause if the taxpayer otherwise acted in good faith.
In addition to penalties, interest accrues on underpayment of both tax and on penalties. IRC § 6621 provides that interest shall accrue at the published federal short term rate plus 3%. The federal short term rate is published in Rev. Rul. 2015-1 and is presently .41%. As a result, in 2015, interest accrues for purposes of underpayment of tax and penalties at 3.41% annually.
Changes in Tax Basis Following Cancellation of DebtGross income includes under IRC § 61(a)(12) income from the discharge of a debt. However, IRC § 108 (a)(1) excludes from gross income that results from a discharge occurring in a bankruptcy case or when the taxpayer is insolvent. When the income exclusion applies, IRC § 108(b) provides that the taxpayer shall reduce certain tax attributes including the basis of the property of the taxpayer. IRC § 1017(b)(2) provides that where a basis reduction is applicable pursuant to a discharge occurring in bankruptcy or while the taxpayer is insolvent, then the reduction in basis is limited as follows:
[T]he reduction in basis under subsection (a) of this section shall not exceed the excess of –
(A) The aggregate of the bases of the property held by the taxpayer immediately after the discharge, over
(B) The aggregate of the liabilities of the taxpayer immediately after the discharge.
Property that was claimed as exempt in bankruptcy is not subject to the basis reduction rules. It is also important to keep in mind that a sale or repossession by a creditor is treated as a sale of the property at the fair market value at the time of the sale. If a deficiency balance is forgiven by the creditor following the sale, the forgiveness of debt constitutes cancellation of indebtedness income under IRC § 61(a)(12).
Dischargeability of Taxes in BankruptcyBankruptcy can be an attractive option for a person with significant debt owed to the IRS because of the options afforded by the Bankruptcy Code, 11 U.S.C. § 101, et seq., for discharging certain tax liabilities. While certain tax debts are nondischargeable in bankruptcy, filing a bankruptcy can in some instances stop the accrual of interest on those debts for as long as five years. The provisions of the Bankruptcy Code relating to discharge of tax debt are found in 11 U.S.C. §§ 523 and 507.
Dischargeability of Income Taxes in Bankruptcy11 U.S.C. 523 is the starting point for determining dischargeability of income taxes in bankruptcy. 523(a)(1) provides in relevant part that a discharge granted in Chapter 7, 11, 12 or 13 of the Bankruptcy Code (“the code”), does not discharge an individual debtor from any debt for a tax:
(A) of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title or 507(a)(2) or 507(a)(8), whether or not a claim for such tax was filed or allowed:
(B) with respect to which a return, or equivalent report or notice, if required--
(i) was not filed or given: or
(ii) was filed or given after the date on which such return, report or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition; or
(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.
Subparagraph A to § 523(a)(1) governs the dischargeability of income taxes arising from timely filed tax returns by incorporation of § 507(a)(8) of the Code. § 507(a)(8) bars dischargeability for three categories of tax debts arising from taxable years ending prior to the date the bankruptcy was filed. The first category is for tax debts arising from a taxable year for which the extended due date for filing the tax return falls within the three years preceding the bankruptcy filing date. The second category is for tax debts that were assessed by the IRS within the 240 days prior to the bankruptcy filing date. A tax debt is “assessed” for nondischargeability purposes at the time the assessment becomes final rather than when the notice of assessment is filed. The third category is for those taxes that have not yet been assessed, but that are assessable after the petition date. A tax is “assessable” if the IRS is permitted to assess the tax under the Internal Revenue Code. It is important to note that the three year look-back period and the 240 day look-back period are tolled under certain circumstances by virtue of the unnumbered hanging paragraph found at 11 U.S.C. 507(a)(8). That paragraph provides:
An otherwise applicable time period specified in this paragraph shall be suspended for any period during which a governmental unit is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior case under this title or during which collection was precluded by the existence of 1 or more confirmed plans under this title, plus 90 days.
Where multiple bankruptcies were filed during the look-back period, only one 90-day extension is added to the tolling period.
Dischargeability of Income Taxes in Bankruptcy Part IIIn addition to those tax debts incorporated by reference to § 507(a)(8), subparagraph B to § 523(a)(1) provides that tax debts arising from unfiled tax returns cannot be discharged and also imposes a two year waiting period after the filing of a late tax return before that tax debt can be discharged in bankruptcy. Finally, subparagraph C to § 523(a)(1) makes clear that tax debts upon which debtor made a fraudulent return or willfully attempted to evade the tax are nondischargeable. The test for fraudulent evasion of tax under 523(a)(1)(C) requires proof that (1) the debtor acted in some manner to attempt to evade the tax and (2) that the attempt was done willfully. There mere failure to pay the tax alone is insufficient. Rather, the totality of circumstances is considered including the following indicia of fraud: (1) understatement of income; (2) extensive dealings in cash; (3) inadequate record keeping; (4) intra-family transfers for insufficient consideration; (5) failure to acquire significant assets relative to earnings; and (6) a lavish and extravagant lifestyle. In Kansas, the elements required to prove that a return was fraudulent are: (1) knowledge of the falsehood of the return; (2) an intent to evade taxes; and (3) an underpayment of the taxes.
Willful attempt may be inferred from conduct such as keeping a double set of books, making false entries or alterations, or false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling of one’s affairs to avoid making the records usual in transactions of the kind, and any conduct, the likely effect of which would be to mislead or to conceal.
Dischargeability of Income Taxes in Bankruptcy Part IIIIn combination, §§ 523(a)(1) and 507(a)(8) generally provide five categories of taxes that cannot be discharged in bankruptcy. A tax debt is nondischargeable if it arose by virture of:
(1) a taxable year for which the extended due date for filing the tax return falls within the three years preceding the bankruptcy filing date (“the 3 year rule”);
(2) an IRS assessment made after the bankruptcy filing date or during the 240 days preceding the bankruptcy filing date (“the 240 day rule”);
(3) an unfiled tax return;
(4) a late filed tax return that is late-filed during the two years prior to the bankruptcy filing date (“the two year rule”) or
(5) a fraudulent tax return or willful attempt to avoid the tax.
From these rules, a few general themes result. First, tax returns must be filed in order for tax debts to qualify as dischargeable. If a tax return is filed late and otherwise is a dischargeable tax debt, then the taxpayer must wait two years after filing the late return before he or she files bankruptcy in order to discharge the taxes owed with regard to the late filed return. Second, tax debts arising with regard to the three taxable years preceding the bankruptcy filing date are non-dischargeable. Third, if the IRS assesses a tax that would otherwise be dischargeable, the tax payer must delay the bankruptcy filing 240 days after the assessment to discharge the assessed debt. If a deficiency is properly assed after the bankruptcy filing date, the assessed tax is nondischargeable. Third, debts arising from fraudulent tax returns or willful attempts to avoid tax are nondischargeable. Fourth and finally, it is necessary to keep in mind that these rules apply to dischargeability of the bankruptcy debtor's personal obligation to pay the tax. However, the filing of a bankruptcy generally leaves undisturbed a creditor's lien that arose pre-petition. This is also true with regard to IRS tax liens arising under IRC § 6321.
Tax LiensIf an IRS tax lien came into existence prior to the bankruptcy filing and attached onto the personal and real property of the taxpayer, that lien survives bankruptcy and can be foreclosed by the IRS even if the taxpayer is no longer personally liable for the tax obligation. Furthermore, federal tax liens take priority over state and federal exemption laws including the unlimited homestead exemption available to Kansas residents. However, the IRS has procedures under which a lien can be released. IRC § 6325 provides that the IRS shall issue a certificate of release of any federal tax lien not later than 30 days after the IRS finds that the liability has been satisfied or become legally unenforceable. In addition, the IRS may discharge the lien in exchange for a payment equal to the value of the lien or upon a showing that the lien in favor of the IRS lacks any value.
Trust Fund Tax Liability11 U.S.C. 507(a)(8)(C) also excepts from discharge “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” This code section includes the imposition of a penalty on an individual for failure to remit trust fund taxes such as withholding and payroll taxes pursuant to 26 U.S.C. 6672. Section 6672 permits a penalty assessment for the amount of unpaid taxes that any person is “required to collect, truthfully account for, and pay over any tax imposed by this title.” Whether a person is liable for the nonpayment of trust fund taxes takes into consideration such persons authority over decision making in the company, responsibility for disbursing funds and control over the financial affairs of the company.
Bankruptcy Automatic Stay and Assessment ProceduresThe nondischargeable nature of post-petition assessments found in § 507(a)(8)(iii) dovetails with 11 U.S.C. § 362(b)(9) which creates an exception in favor of the IRS to the bankruptcy automatic stay against collections. Normally, the filing of a bankruptcy petition imposes an automatic stay against all actions to collect a pre-petition debt. However, § 362(b)(9) provides that the automatic stay shall not deter an audit, the issuance of a notice of tax deficiency, a demand for tax returns or the making of an assessment for and issuance of a notice and demand for payment of such an assessment.
IRC 6201 authorizes the IRS to impose an assessment of additional tax where such tax is found to be owed after an appropriate inquiry. An assessment is officially assessed “by recording the liability of the taxpayer in the office of the Secretary” in accordance with applicable rules. Treasury Regulations state that “the assessment shall be made by an assessment officer signing the summary record of assessment.” IRS Form 4340 contains a listing of the assessments made against a taxpayer and the date that that each summary record of assessment was executed. Prior to assessing a deficiency, with regard to income, estate and gift tax, the IRS must send by certified mail a notice of deficiency to the taxpayer. The taxpayer has 90 days from the date the notice is mailed to file a petition in the United States Tax Court for a redetermination of the deficiency. The assessment cannot be imposed until the 90 day period expires or a decision from the United States Tax Court becomes final. The 90-day period is jurisdictional and cannot be extended by agreement or by the Tax Court. However, once the notice of deficiency has issued and the time to petition the Tax Court has passed, the IRS is required to assess the amount set forth in the notice and is under no duty to accept a return prepared in response to the notice of deficiency. The correct response to a notice of deficiency is to challenge the assessment in the Tax Court. Merely filing a return in response to the notice of deficiency has the potential to result in an assessment based on the amount of the deficiency. If a taxpayer has filed bankruptcy, the 90-day period is suspended by virtue of IRC 6213(f). That subsection suspends the 90 day period during the time that a debtor is prohibited by virtue of 11 U.S.C. § 362(a)(8) from filing a petition in the tax court and also for an additional 60 days thereafter. Proceedings in the Tax Court are de novo. The IRS notice of deficiency and method of calculation performed administratively cannot be considered as evidence in Tax Court and has no relevancy. Representation of a client requires admission to practice before the Tax Court.
Bankruptcy Automatic Stay and Assessment Procedures Part IIThe statute of limitations during which the IRS is permitted to make an assessment generally includes the three years following the date a tax return is filed or the due date for filing the return if later. The statute of limitations is six years where there is an omission of gross income exceeding 25% of the amount shown on the return. The statute of limitations does not start running until a return is filed. Also, if the IRS prepares its own return for the taxpayer as allowed by IRC 6020(b), that return is not considered a filed return for purposes of the statute of limitations. Furthermore, there is no statute of limitations with regard to a fraudulently prepared return or where there is will intent to evade tax. Filing a legitimate amended return subsequent to filing a fraudulent return does not start the running of a statute of limitations with regard to the fraudulently prepared return. There is also a separate statute of limitations limiting the time during which the IRS can start collections after an assessment. Pursuant to IRC § 6502, the IRS must begin the levy within 10 years of making the assessment. Certain penalties can be imposed statutory by the IRS without the necessity of following the assessment procedures. Judicial review of statutorily imposed penalties is only available in federal district courts or federal claims court after the penalty has been paid in full and a request for refund has been denied.