Litigating Tax Problems in Bankruptcy Court

Litigating Tax Issues in Bankruptcy Court: Tax issues often intersect with bankruptcy proceedings, creating complex challenges that require careful navigation by tax and bankruptcy lawyers. Litigating tax disputes in bankruptcy court involves unique procedural and substantive considerations, as the Bankruptcy Code interacts with federal and state tax laws in several intricate ways not commonly seen in regular tax court or bankruptcy court proceedings.

Jurisdiction of Tax Problems in Bankruptcy Court:

Bankruptcy courts have jurisdiction to resolve tax disputes under 11 U.S.C. § 505, which grants authority to determine the amount or legality of any tax, fine, or penalty, whether assessed or unassessed, unless the tax was adjudicated prior to the bankruptcy filing. This jurisdiction extends to federal, state, and local tax problems, making bankruptcy courts an all inclusive forum for resolving disputes over tax liabilities. However, a bankruptcy court may abstain from hearing certain tax disputes if they involve unusual tax issues of state tax law better suited for state courts. Additionally, disputed tax claims must be timely raised in the bankruptcy case to avoid procedural bars, such as deadlines for filing proofs of claim or objections.

Priority of Tax Claims

The Bankruptcy Code categorizes most tax problems based on their nature and timing, which significantly impacts their treatment in bankruptcy:

1. Priority Tax Claims: Under 11 U.S.C. § 507(a)(8), certain unsecured tax claims receive priority status, including income taxes assessed within three years before the bankruptcy filing, taxes required to be withheld (e.g., payroll taxes), and certain property taxes. These claims are typically non-dischargeable and must be paid in full in Chapter 13 plans or through a Chapter 11 plan over time.
2. Secured Tax Claims: Tax liens, such as those imposed by the IRS or state taxing authorities, are treated as secured claims to the extent of the debtor’s property value subject to the lien. Secured tax claims can complicate asset distribution and may require negotiation to resolve competing liens or interests.
3. General Unsecured Claims: Older tax claims (e.g., income taxes outside the three-year lookback period) may be classified as general unsecured claims, receiving lower priority and potentially subject to discharge.

Understanding the priority status of tax claims is the single most important legal issue for both debtors and creditors in litigating tax issues through the bankruptcy court. Debtors must account for priority claims in their repayment plans, while taxing authorities must ensure proper classification to maximize recovery.

Dischargeability of Tax Debts

One of the most contested issues in bankruptcy tax litigation is whether a tax debt is dischargeable. The Bankruptcy Code imposes strict requirements for discharging tax liabilities:

• Income Taxes: Under 11 U.S.C. § 523(a)(1), income taxes may be dischargeable if they meet the “three-year, two-year, 240-day rule”:
  • The tax return was due more than three years before the bankruptcy filing.
  • The return was filed more than two years before the filing (or not filed at all, in some cases).
  • The tax was assessed more than 240 days before the filing, unless a formal offer-in-compromise is pending.
• Trust Fund Taxes: Taxes such as payroll or sales taxes (may depend on your state definition of sales tax) withheld by the debtor but not remitted to the government (known as “trust fund” taxes) are non-dischargeable, and responsible individuals may face personal liability under 26 U.S.C. § 6672.
• Fraud or Willful Evasion: Taxes associated with fraudulent returns or willful attempts to evade payment are non-dischargeable, often leading to disputes over the debtor’s intent.

Litigating tax dischargeability often involves factual disputes, such as whether a debtor’s failure to file a return or pay taxes constitutes willful evasion. Bankruptcy courts may require evidentiary hearings to resolve these issues, and practitioners should be prepared to present detailed financial records and testimony.

Contact Us:

Litigating tax issues in bankruptcy court requires a deep understanding of both bankruptcy and tax law, as well as strategic planning to address the unique challenges of each case. By carefully navigating jurisdictional issues, claim priorities, and tax dischargeability rules debtors can achieve favorable outcomes for their tax problems. Call us to discuss your case: 310 788 9820.