Bankruptcy can be one of the best methods for resolving tax debts. This is particularly true if the taxpayer’s primary assets only consist of retirement accounts and equity in a personal residence. The recent In re Moore, No. 15-42046 (Bankr. E.D. Tex. Jul. 7, 2016), case presents an opportunity to consider the results if the taxpayer tried to settle unpaid taxes in bankruptcy or by settling the tax debt with the IRS.
Facts & Procedural History
Moore filed for Chapter 7 bankruptcy and included her individual retirement account (IRA) in the bankruptcy petition. The IRA had a balance of $125,000 at the time. She subsequently withdrew $28,000 from her IRA during the bankruptcy proceeding. A portion of the $28,000 was withheld to pay Federal income taxes and Moore received the balance. Moore deposited the funds into her bank account. She used the funds to pay living expenses over the next three months.
The bankruptcy court confirmed that the withdrawals from the IRA during the bankruptcy proceeding continued to be exempt even though the funds were not rolled over to another IRA. The court rejected the argument that IRA withdrawals are like the proceeds from the sale of a personal residence, which are only protected from creditors for six months after the date of the sale under Texas law.
Discharging Taxes in Bankruptcy
The court opinion does not explain what debts Moore was seeking to discharge in bankruptcy. If we assume that it included unpaid taxes, the question is whether the taxes were dischargeable in bankruptcy.
The general rule that taxes are dischargeable in bankruptcy. There are exceptions. These exceptions prevent taxpayers from discharging:
- Taxes due for a year within three years of the date the bankruptcy petition was filed,
- Taxes due for a year for which no return was filed,
- Taxes attributable to a fraudulent return or an attempt to evade or defeat the tax,
- Taxes for a year for which a delinquent return was filed within two years of the bankruptcy petition date, or
- Taxes assessed within 240 days of the date of filing the bankruptcy petition, plus any time plus thirty days during which an offer in compromise was made within 240 days after the assessment was pending.
If Moore included unpaid taxes that were dischargeable, the tax debt would have been discharged and Moore would have been able to keep her full retirement account and all equity she had in her home. This would be a pretty good result given the circumstances.
Settling Unpaid Taxes with the IRS
This result would have been starkly different if Moore had pursued an offer in compromise based on collectibility or tried to obtain an installment agreement with the IRS rather than filing bankruptcy.
The IRS considers the taxpayer’s reasonable collection potential to determine whether to accept an offer in compromise based on collectability and to set the amount of an installment agreement. Reasonable collection potential considers the taxpayer’s income less certain very minimal living expense allowances and the discounted net value of the taxpayer’s assets.
Here, the IRS would have included the value of the full IRA less the sales costs and any early withdrawal penalty in determining how much the taxpayer could pay. Any tax withholding and penalty payment would not be considered as part of the amount of the offer. Worse yet, if Moore was retired at the time of her offer, the IRS would also count the IRA distributions as income in making this calculation. The IRS would also include the full value of equity in a personal residence less the sales costs.
This would result in the IRS not accepting anything less than this equity value. To the extent these amounts exceed the unpaid taxes, the IRS would expect the taxpayer to full pay her tax liability. This means that Moore would have to liquidate her retirement account, borrow against her house, or find some other way to full pay the tax liability.
One only has to consider the underlying policies to understand the disparate results in bankruptcy and in settling with the IRS. Bankruptcy is about a fresh start. It balances the interests between the debtor and the debtor’s creditors. The IRS offer in compromise program also has an element of the fresh start concept, but it is primarily intended to benefit the IRS. The offer in compromise encourages taxpayers to come forward (and wait in line) to resolve their unpaid taxes. It is a second chance at voluntary compliance. This allows the IRS to process and eventually collect taxes that the IRS would simply never get to without this program. The policies for the installment agreement program are similar.