Collecting Unpaid Taxes from a Bankrupt Taxpayer: Is There Still Hope?

When a creditor hears that a debtor has filed for bankruptcy protection, the tendency is to expect that the debt owed will not be repaid. However, for our municipal and state clients, special rules apply that may warrant a closer look to determine whether the tax can still be collected. In today’s economic climate, every dollar of revenue for a political subdivision will help save jobs and programs for residents.

As of the first quarter of 2011 state’s revenues remained at roughly 9% below pre-recession levels. States and municipalities are addressing very large budget shortfalls. Forty-two states and the District of Columbia are projecting a combined shortfall for the 2012 fiscal year of over $103 billion dollars. Temporary aid to states as a result of the 2009 Federal Recovery Act will largely be gone by the end of the 2011 fiscal year, and states and municipalities are facing deficits that threaten jobs and social programs. The National League of Cities annual survey in October of 2010 found that almost 9 in 10 cities were feeling the economic crunch.

States and municipalities need to examine every source of revenue possible, including taking a second look at bankrupt tax payers to determine if the tax may still be collected. First, certain taxes are not dischargeable by way of a Chapter 7 or Chapter 13 bankruptcy including:

• Taxes for which a return was not filed;
• Taxes for which a return was filed late and filed less than two years before the bankruptcy filing;
• Taxes relating to a fraudulent return or relating to the debtor willfully attempting to evade or defeat the taxes; and
• Withholding taxes for which the debtor is personally liable.

In a Chapter 7 bankruptcy, the following are also non-dischargeable:

• Income tax due for the tax year ending on or before the bankruptcy filing date, where return was due within 3 years of the bankruptcy filing date;
• Income tax for the tax year ending on or before the bankruptcy filing date, where the tax was assessed within 240 days before the bankruptcy filing date;
• Income tax not assessed before, but assessable after the bankruptcy filing date;
• Property tax incurred before the bankruptcy filing date that was last payable without penalty less than one year before the date of the bankruptcy filing;
• Employment taxes earned from the debtor prior to the bankruptcy filing date for which a return was last due less than three years before the bankruptcy filing date;
• Excise taxes where a transaction occurred prior to the bankruptcy filing date for which a return was last due less than three years before the bankruptcy filing date, or if a return was not required, where the transaction occurred in the three years proceeding the bankruptcy; and
• Certain customs duties.

While pre-petition and post-petition interest on a non-dischargeable tax is also non-dischargeable, penalties must provide for an actual pecuniary loss in order to be considered non-dischargeable when assessed on an otherwise non-dischargeable tax.

States and municipalities should also look at filing liens on property timely. Tax liens placed prior to a bankruptcy are considered a valid lien against the property that survives the bankruptcy, provided that they attach to actual equity in the property. Liens for property taxes attach automatically to property on January 1 of each year, but are property specific. Liens may be placed by a municipality on specific property for costs expended by a municipality to remove or repair or secure an unsafe, abandoned or open property; to abate a nuisance; or to make emergency repairs to hazardous conditions on that property. When this cost is certified by the legislative authority for the municipality, and provided to the county auditor with the description of the property affected, the lien is recorded in the tax duplicates. Finally, liens for unpaid income tax and other taxes may be filed once judgment is rendered for that tax amount. Unlike the above taxes, a judgment lien is valid against all property held by the debtor in the specific county in which the lien is filed, not just the particular affected property. Where these liens attached to equity in property prior to the bankruptcy filing, and survived the bankruptcy, the debtor may be required to pay the lien when transferring the property, and the lien must be considered in any foreclosure proceeding.

The Weltman Governmental Collections Practice Group and Bankruptcy Practice Group can help you determine whether a certain taxpayer’s taxes are dischargeable in bankruptcy and whether any further action is needed.

Cited Works

McNichol, Phil Oliff and Nicholas Johnson. “States Continue to Feel Recession’s Impact.” Center for Budgeting and Policy Priorities. June 17, 2011. www.cbpp.org Popovec.

“Hungry for Tax Revenue, Municipalities Serve Up Tax Incentives to Lure Retailers and Developers.” May 2, 2011. www.retailtrafficmag.com v. Home State Bank, 501 U.S. 78, 111 S.Ct. 2150 (1991).