Taxes in Bankruptcy: Their Priorities and Dischargeability

Key Facts:

A major debt for many people is taxes, including back taxes, penalties, and interest. Filing for bankruptcy protection does not protect the debtor from paying current or recent taxes. Furthermore, the bankruptcy estate, as a separate legal entity, may also have to pay taxes. Outside of bankruptcy, taxes have a top priority in a collective proceeding against the debtor. Hence, tax claims are paid before any other unsecured claims. However, in bankruptcy, tax claims have a lower priority. Sometimes creditors will even file an involuntary bankruptcy petition to force the debtor into bankruptcy so that less will go for taxes before the creditors are paid.

The priority treatment for taxes requires that a tax claim is actually for a tax, which is money collected for the support of a government. Even if a payment, such as a penalty or fine, is called a tax outside of bankruptcy law, it will not necessarily be considered a tax under bankruptcy.

Current and recent taxes not only have priority status in a bankruptcy, but they are nondischargeable for an individual debtor. However, the priority status of a tax claim depends on whether the liability for the tax was incurred before the filing of the bankruptcy petition or after it. When the liability for the tax was incurred is determined by non-bankruptcy law, usually tax law.

Postpetition Taxes

How taxes are treated under bankruptcy depends on when the liability for the taxes was incurred, and when they were due. Taxes have 2 different priority levels. If the taxes were incurred and were due during the pendency of the bankruptcy case, then they are paid out of the bankruptcy estate as an administrative expense, and therefore have 2nd priority over other claims against the estate. Only domestic support obligations rank higher. For instance, if estate property is sold at a profit, then the capital gains tax on the sale is treated as an administrative expense. Interest, fines, penalties, or reduction in credit on taxes classified as an administrative expense is also treated as an administrative expense.

Taxes authorities do not have to submit a request for an administrative priority for a tax claim, so the trustee or the debtor in possession must be sure to pay the taxes.

Prepetition Taxes

If the liability for the tax was incurred before the bankruptcy filing date, even if the tax is only due after the filing date, then they have only an 8th priority. Congress set the priority for tax claims lower than other priority payments, so that taxes would not consume most of the bankruptcy estate, leaving some money for the other priorities.

If part of the liability for a tax is incurred prepetition while the other part is incurred postpetition, then the postpetition liability will be treated as a 2nd priority administrative expense while the prepetition claim will have only 8th priority.

Eighth Priority Tax Claims

There are 7 types of tax claims that enjoy 8th priority under bankruptcy, and are listed in §507(a)(8) in the Bankruptcy Code:

  1. income and gross receipt taxes;
  2. property taxes;
  3. payroll withholding taxes;
  4. employment taxes;
  5. excise taxes;
  6. custom duties;
  7. penalties resulting from a priority tax claim.

The tax claims listed above have the same priority inter se, and, with certain exceptions, are limited to taxes due within 3 years of the bankruptcy filing date. Note, however, that tax penalties do not have priority, and, therefore, are dischargeable. For instance, the Fifth Circuit, in U.S. v. Chesteen, No. 19-30195 (5th Cir. Feb. 20, 2020), ruled that the ACA shared responsibility payment is a tax penalty rather than a tax and is therefore dischargeable under bankruptcy.

Income Taxes

For income tax liabilities incurred before the filing date, only taxes that became due within 3 years before the bankruptcy filing date have 8th priority and are nondischargeable. Taxes due more than 3 years before the filing date are treated as unsecured claims with no priority, and they are discharged at the successful close of the bankruptcy case. However, the 3-year time period is extended by any extensions granted to pay the tax.

The time period for priority taxes is also extended by any suspension in collections because of the automatic stay in a previous bankruptcy or because the debtor requested a hearing or appealed a decision involving the tax. The time period for priority is extended by the time of suspension + 90 days.

For instance, assume a debtor files for bankruptcy on January, 2020, but the case is dismissed after 100 days. During this time, any tax collection effort is stayed by the pending bankruptcy. Then the debtor files another petition on April, 2022. The applicable 3-year period for this bankruptcy will be extended by the 100 days that collection activity was stayed in the previous bankruptcy + 90 days. So any tax due within 3 years and 190 days of the commencement of the current bankruptcy will have priority status.

A tax claim also has priority if the government has assessed the tax within 240 days before the filing date, even if the tax was due more than 3 years before the filing date, or if the tax is assessable after the filing date. Whether a tax is assessable is determined by the applicable non-bankruptcy law. However, the 240-day period is extended by the time when an offer in compromise was pending + 30 days.

Employment taxes and excise taxes have the same applicable periods as income taxes.

Other Priority Taxes

Property taxes have priority if the tax was incurred prior to bankruptcy and was payable without penalty within 1 year of the filing date.

Custom duties have priority status for 1 year after the merchandise enters the market or is liquidated.

Trust fund taxes, which are taxes such as Social Security and Medicare taxes that must be collected by the employer for its employees, not only enjoys priority status, but there is no time limit for the priority. Generally, these taxes are assessed by the IRS against individuals who were responsible for collecting the tax, even if the employer was a corporation, but only if the corporation is unable to pay the tax.

The IRS is using Private Debt Collectors

6/12/17 - The IRS has started to use private debt collectors to collect tax debt more than 2 years old, but only if the taxpayers were previously contacted about the debt by the IRS. Taxpayers placed in this program will receive 2 letters from the IRS. The 1st letter will identify the private debt collection company that will be managing the account, then the 2nd letter will come from the private debt collection company so assigned. Both letters will include the name of the private debt collection company, the tax owed, and a taxpayer authentication number unique to the taxpayer.

Any communication from the debt collector will include the authentication number and they will never use robocalls or prerecorded messages, only a live operator. Payments are not made to these debt collection companies themselves, but instead, the collectors will ask that the payment be made to the IRS, either electronically or by check, to the U.S. Treasury. Anyone asking for direct payment to them is a scammer and should be avoided and reported. Likewise, for any debt collector that threatens criminal charges, refuses to give information about your debt, tries to collect a debt not recognized by you, refuses to give their mailing address or phone number, or asks for personal sensitive financial information.

The debt collectors must provide a validation notice upon request, stating how much is owed and to whom.

With any debt collector, ask for the name, company, street address, telephone number, and professional license number, if your state requires that debt collectors be licensed. Do not discuss any debt until you get the written validation notice that must include the debt amount, the name of the creditor and a description of certain rights under the federal Fair Debt Collection Practices Act. Never give personal financial or other sensitive information, since scammers can use this information to open new credit card accounts and checking accounts, and they can get loans based on your information. You can contact your original creditor to verify the debt collector assigned to your debt.