All posts in Taxes

Statutes of Limitation, the IRS, and the FTB

A potential client called me last week for help in dealing with the IRS.

It seems he owed a lot of taxes for tax years from 1992 to 1996.  Had he filed the returns on time?  Yes.  Had he filed bankruptcy in the meantime?  No.  Had he filed an offer in compromise?  No.  Has he heard anything from the IRS in the last three years?  No, but he thought that was because he had moved and not written to the IRS collection department to tell them about the move.  Has he filed a tax return from his new address?  Yes.

I told him not to worry, that he probably didn’t owe the taxes anymore because it took more than 10 years for the IRS to collect those taxes.  And it occurred to me that I should explain how statutes of limitation can work to the taxpayer’s advantage.

Audit and Assessment – Three Years IRS, Four Years FTB

The IRS has a three-year limitation period on assessment from the time of the return’s filing.  That means that if three years pass from the time you, the taxpayer, filed your return, the IRS can no longer audit you for that tax year.

Sounds simple, right?  But when did you actually “file the return?”  Let’s take a return for the 2011 tax year.  If you filed it before April 15, 2012, the law says that the return was filed on April 15.  If you had an extension until October 15 and filed the return on September 1, the limitation period starts on October 15.

If you filed the return late, the law says that it was filed on the day the IRS received it.

In California, the Franchise Tax Board generally enjoys more liberal state laws than the federal IRS.  The FTB has four years to assess more taxes on a filed return.

There is a big difference between how the IRS and the FTB go about “assessing” a tax, and how their audit procedures work.  For the IRS, assessment occurs at the end of the audit process.  Thus, the IRS generally tries to reach potential audit targets within a one-to-two-year window after the return is filed.  If the three-year clock has been ticking for two years and ten months, and you haven’t heard from the IRS, you are unlikely to get audited for that year – although there are relatively uncommon exceptions.  The IRS has to start its audit soon enough that it can complete the process and issue a Statutory Notice of Deficiency more than four months before the end of the limitation period, for reasons that are too complicated to mention here.

The relatively uncommon exceptions?  The IRS gets six years to audit you if it can show a large understatement of income, and if it can show that your return is fraudulent, it can open the audit and assess at any time; there is no statute of limitations on a fraudulent return.

The FTB, on the other hand, assesses the increased tax as soon as it smells a problem.  Like a deputized posse member who shoots first and asks questions later, the FTB starts its process with a Notice of Proposed Assessment; this counts as the “assessment” for purposes of the statute of limitations.  This notice can be mailed on the last day of the four-year clock, and it’s still effective.

If the taxpayer gets audited by the IRS and agrees to a higher assessment, the taxpayer has a duty to inform the FTB within six months.  The FTB then has two years to make its assessment.  If the taxpayer doesn’t make the six-month deadline, there is no limitation period – the FTB has an infinite amount of time to make the assessment.

These assessment clocks can be tolled (and often are) by agreement between the taxpayer and the taxing authority.  Sometimes this is a good idea, especially if the taxpayer just needs a bit more time to gather records to show to the auditor.  Sometimes it’s a bad idea, if the tax authority’s case is not very strong.

Obviously, the laws strongly favor the taxing authorities: our legislatures want to make sure that people do not get out of taxes owed by skillful procedural.  And while the FTB’s laws sound even more tilted against the taxpayer, there is a counterbalance: the FTB is generally less effective at opening and closing audits, and investigating a taxpayer’s affairs, than the IRS.  “Generally,” of course, doesn’t mean that it can’t be extraordinarily effective if it wants to be.

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The Notice of Federal Tax Lien on Personal Property and Bankruptcy

Debtor’s often have Notices of Federal Tax Liens outstanding at the time they file bankruptcy.  How are these handled?

First, a properly-noticed lien survives bankruptcy.  It continues to attach to any property owned at the time of the bankruptcy.  It does not attach to any property acquired after the petition date.

  1. Lien on real property.  If the bankrupt debtor owns a house and the IRS has filed a Notice of Federal Tax Lien against the debtor’s real property (in the county records), the IRS will generally keep that notice in place after bankruptcy.  The house may be underwater and the IRS lien thus worthless, but if the house appreciates in value, the IRS is entitled to the new value.

If, however, the debtor acquires a new piece of land after filing bankruptcy and discharging his taxes, the IRS lien won’t attach to the new piece of land.

  1. Personal property.  If there is a Notice of Federal Tax Lien filed against personal property, it attaches to everything the debtor owns on the day of the bankruptcy petition.  Once the debtor discharges the underlying tax, the IRS still has the right to seize all your personal assets (even those exempted) to satisfy its lien, but it just won’t.  Imagine: you, as a debtor, file for bankruptcy, go through the entire process, get your debts including your tax debts discharged, and then they send the Asset Recovery Team to your house to seize your car and sofas – for which it could get how much at auction?  Also, the lien doesn’t attach to newly-acquired property, so it would need to investigate whether the bracelet it proposes to seize and sell came from Aunt Tammy as a birthday gift after the bankruptcy petition was filed.  The IRS long ago figured out that the PR and legal problems here are huge, so they’ll go ahead and release the lien.

Relevance of Amending Tax Returns to Dischargeability of Taxes; John Fauchet to the Rescue Again

Question:

My PC filed his timely 2007 tax returns.  Seven months ago, the returns were amended reducing the tax owed.  Does the amendment restart the three year statute of limitations for dischargeability?

Stella Havkin

Stella, The three year statute runs from the date the return was first due.  Filing a late return, no matter how late, cannot change the date the return was first due.   Maybe John can comment, but when I’m working a tax case with  tax attorneys, they will file late, late, late amended returns if they believe the first return was wrong and overstated the liability.  The IRS can say, sorry, too late, but in appeals, it is my understanding, the IRS can actually consider them.  John?

Dennis McGoldrick

Stella and Dennis, I’m unaware of any statute that prevents a taxpayer from amending an already-filed tax return at any time.  See, for instance, this section of the IRM, which posits an amended return filed six years late:

The complications usually arise from the date of payment.  You can’t amend a tax return that’s already five years old and get back your original withholdings.  But you can file that return and affect the amount you owed on that return; if your five-year-old return says you owed $20,000, you never paid it, and you amend to show that you actually owe $10, your assessment will change and you’ll owe $10 – assuming the IRS doesn’t use that as the opportunity to audit you and find out that you really owed the $20,000 all along.

In Stella’s case below: the amended return shows an amount owed.  That’s what he owes; the date of assessment is the date that the IRS receives his amended return.  Count 240 days from that date, and it’s dischargeable under that rule.  But that’s not the only dischargeability rule.

The amended return doesn’t change the three-year statute all over again; the return was originally due on either 4/15/2008 or 10/15/2008, dates long since past.

But this amended return does implicate the two-year rule at 523(a)(1)(B)(ii).  You’ll have to wait another 17 months to discharge the tax showing on it, even though it decreases the assessment.

John D. Faucher

Discharging tax debts when the debtor has evaded collection

Section 523(a)(1) of the bankruptcy code distinguishes the nondischargeable taxes from those that may be discharged in bankruptcy.

In most cases, the analysis is pretty simple. Generally, nondischargeable taxes are those where the return was due less than three years ago, where the return was actually filed less than two years ago, or where the tax was actually assessed less than 240 days ago (assuming the debtor is filing a bankruptcy petition today). This is, in the end, numerical.

If the debtor made a “fraudulent return,” the taxes are not dischargeable. This is also very easy to determine: did the IRS assert the fraud penalty and win? It’s a rare case when a debtor files a bankruptcy petition and the first allegation of fraud comes when the debtor wants to discharge taxes.

But there is one phrase that invites interpretation, and that can trip up the most conscientious practitioner: 523(a)(1)(C) says that “A discharge . . . does not discharge an individual debtor from any debt for a tax with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

There are two main functions to the IRS: audit and collection. Audit determines how much tax you owe; collection ensures that you actually pay it. This subsection implicates both functions, and they have very different standards of bad behavior.

Because the subsection starts with the “fraudulent return” element, it’s a reasonable assumption to believe that fraudulent intent extends to the element of “willful attempt to evade or defeat tax.” Not so.

“Willful evasion” includes both a conduct element (an attempt “in any manner”) and a mental state element (“willful” means “voluntary, conscious, and intentional”). The conduct may be an affirmative act, such as transferring property to another family member for no consideration while tax debts hang over the owner’s head, or an omission, such as failure by a law partner’s failure to tell the accounting gal to withhold taxes.

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Penalties on Non-Dischargeable Taxes are Discharged in Chapter 7 (Sometimes)

I saw on another bulletin board recently a blanket statement that penalties on non-dischargeable taxes are discharged in chapter 7.  I spent a little time trying to confirm this as it is surprising to me.   As is common, the statement is sort of true but not completely.  The conundrum is set forth in Section 523(a)(7)(A) and (B).  (a)(7) states that penalties are not discharged “except (certain tax penalties).”  In re McKay v. United States, 957 F.2d 689 (9th Cir. 1992) takes a good stab at explaining that section.  In McKay, the taxpayer was found guilty of filing fraudulent tax returns.  That may be, he said, but the penalites are nevertheless discharged.  The district court agreed.  The Court of Appeals agreed saying:

Carefully parsed, [523(a)(7)] initially makes nondischargeable a “debt that is for a fine, penalty or forfeiture payable to and for the benefit of a governmental unit.”  Withdrawn from this class, however, are any such fines, penalties, or forfeitures that are “compensation for actual pecuniary loss.”  These are dischargeable.  The double negative, “does not discharge” and “not compensation for actual pecuniary loss,” accomplishes this end.  Another group of penalties are withdrawn from the nondischargeable group.  These appear in parts (A) and (B) of § 523(a)(7).  Part (A) withdraws tax penalties attributable to taxes which are not nondischargeable.  That is, part (A) makes dischargeable tax penalties attributable to dischargeable taxes.  This follows because part (A) relates “to a tax of a kind not specified in paragraph (1) of this subsection.”  Those types specified in paragraph (1) are not dischargeable taxes.  In relevant part “paragraph (1) of this subsection” makes not dischargeable “any debt” that is “for a tax … with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

Taxes and Discharge – A New Horror Story

I was chatting with an attorney at the recent Inn of the Court Meeting and heard a new horror story on discharging taxes.  Seems this debtor met the three year rule, the two year rule etc. etc.  Post closing, the IRS sends a letter saying “You still owe.”  The attorney tracks down the right guy at the IRS who promises to investigate.  Some time later he calls back and advises the attorney that the debtor was a resident of some county in Texas some time ago when the IRS unilaterally gave everyone an eight (or ten or whatever) month extension on filing their tax returns because of a disaster that had hit the area.  Therefore the due date of the tax return was not what they thought it was and was not more than three years before the filing.  Pay up!

How does the IRS determine how to attach liens to property?

The tax lien secures payment of a specific year or account. That year or account is either priority or general.
The POC may report $5,000 of secured debt, and this secured debt will relate to a specific year. The POC will always assume that the IRS is going to get paid the secured amount.

IRS always applies payments in the way that is in its best interest. Remember that rule, and you understand a great deal about the taxing authority.  Let’s say that the taxpayer-debtor has $5,000 of personal property (all exempt, but the IRS doesn’t care, because exemptions don’t apply to it).  The debtor owes $15,000 in general tax debts, $25,000 in priority tax debts.

Assuming that the tax lien covers both the general and the priority years, the IRS will take $5,000 of the general unsecured liability and make it secured, and leave the rest the way it is, because it would rather have the security use up general unsecured debt than priority debt, which will still be owed at the end of the day anyway.

Form 1099 in Chapter 13 cases

A reader asks: If a second lien is stripped in a chapter 13, and the mortgage lender issues a 1099 before the discharge is entered, is the cancellation of debt income still excluded from gross income under IRC Section 108?

Answer: The debt is not uncollectible until there is a discharge that gets rid of  it.  The lender can’t issue the 1099, even if there is a confirmed plan that  hoses it on 70% of the debt, because the debtor may flake out and never  complete the plan, win the lottery, and HELOC lender can collect.  But lenders aren’t always rational about their issuance of 1099s.  If the  debtor gets a 1099 during or after a year when he was in bankruptcy, the  debtor should file Form 982 with his return explaining why the 1099 doesn’t  represent taxable income.

IRS can’t assess the tax on COD income until either the taxpayer reports it  on his return, or it goes through the deficiency process ­ audit, Tax Court,  the whole enchilada.  FTB can assess as soon as it thinks it’s being abused,  but it would just about never open an audit on this issue before the IRS would.

The Silent Tax Lien and the Bankruptcy Trustee

A colleague writes:
PC has $150k of equity in her home. Taxes owed are dischargeable. I know if the IRS filed a Notice of Lien, the lien remains but what if no Notice of Lien was filed – is the unrecorded lien still attached to the equity?

Gentle lawyer:
The IRS does indeed have a silent lien against the equity in the house, but it disappears in bankruptcy. Because the bankruptcy trustee takes over the property with the powers of a judgment creditor, and because there was no Notice of Federal Tax Lien on file, the trustee’s interest trumps the IRS’s interest. The debtor gets to keep the equity in the house. After the discharge is entered, the taxes are discharged, and the IRS can no longer attach the house.

Why can the IRS use a refund to pay off dischargeable taxes?

The client owes $15,000 in taxes for the 2004 tax year, and you’ve done the analysis and determined that this is a dischargeable debt.  He also owes $10,000 for the 2009 tax year, and this isn’t dischargeable.  For some reason, no notices of federal tax lien are on file, so there is no question of a secured debt (or so you think).  After filing his 2011 tax return, he gets a $12,000 refund.  You’re filing his chapter 7 petition tomorrow.  What happens to the refund?

Answer: it pays off $12,000 of the dischargeable tax from 2004, and none of the 2009 liability.
Why, you ask?  And then, depending on your temperament, you may even add the phrase “that ain’t fair” after your question.  After all, the IRS didn’t have a Notice of Federal Tax Lien, so why does it get to pay itself on a tax debt that is going to be discharged?

The reason is that the 2004 tax debt, while dischargeable, is also secured, specially if the person gets to know the Different Types Of Loans. IRC Section 6321 puts a silent lien on all property of a tax debtor to secure the payment of tax. When the taxpayer gives the IRS money in the form of excess withholding of tax, the IRS has a lien on that money to pay the delinquent tax.  Because this is not a voluntary payment, the IRS, not the taxpayer, gets to determine where the tax refund will be applied.

So, as of December 31, 2011, the taxpayer-debtor had a credit of $12,000 on his 2011 tax account (even if this computation did not take place until a few months later). He also owed $15,000 on the 2004 tax year, which we assume is the oldest collectible tax delinquency. When he files his bankruptcy petition on February 15, 2012, the IRS is in possession of his tax refund, and it may use it as an offset against the 2004 debt – prepetition asset against prepetition liability. So what if the 2004 liability was going to be wiped out in the bankruptcy? At the end of the 2011 tax year, when the IRS had full possession of the tax refund, the liability existed.

The good news for your debtor: the IRS won’t apply his 2012 refund against the 2004 liability, because the 2004 liability will have been discharged.