For the most part the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 comes into full force on October 17, 2005. The Act contains a number of tax-related provisions, almost all of which are controversial. I will focus on a few of the tax-related provisions.

The Bankruptcy Code & How It Works

The Bankruptcy Code now requires all debtors file either tax returns or tax transcripts shortly after seeking the protection of bankruptcy and to make those returns or transcripts available to the United States Trustee and, upon request, to the creditors (the tax returns are then a matter of public record). The provision is mandatory. No exceptions are permitted. The penalty is dismissal of the bankruptcy case. That appears to make sense, unless you consider that not all taxpayers are required to file tax returns (in which case there would be no tax returns or tax transcripts).

Example 

Taxpayers are not required to file tax returns if their taxable income is less than the standard deduction plus the allowable exemption. Similarly, individuals and businesses located in certain territories and possessions, such as the Virgin Islands, are not required to file federal tax returns.

The IRS & Taxpayer Time Frames

The timing will probably also pose problems. It can take the IRS over a month to provide taxpayers with copies of their tax returns or with tax transcripts. Yet, Congress required that the taxpayer present these documents in less than 30 days after commencing the bankruptcy case. How are taxpayers to do this, especially since more taxpayers are now going to be requesting tax returns and transcripts from the IRS? The IRS will no doubt have to step up its transcript delivery process. It seems like this should be possible with the use of technology.

This rule raises the question as to what will happen in the cases where the IRS has lost the tax returns, there are no tax records entered in the IRS records sufficient to produce a tax transcript, but the IRS IMF file indicates that returns were filed? This scenario comes up occasionally. For now, it appears that taxpayers in this situation will not be entitled to seek the relief of bankruptcy.

Bankruptcy Tax Opportunities 

Congress also did not close several large bankruptcy-tax opportunities. For example, Congress failed to shutdown the ability of taxpayers to take out loans (which are dischargeable in bankruptcy) to pay off tax liabilities (that are not dischargeable in bankruptcy), with the intent of using the loan proceeds to pay off the tax liability. Taxpayers often do this to minimize the amount of debt that they will owe after they emerge from bankruptcy.

Congress did provide that a “debt relief agency” (FYI most bankruptcy attorneys will now be considered “debt relief agencies” when they are working with lower income taxpayers) can not now advise taxpayers about this option. Congress did not prevent non-debt relief agencies (such as bankruptcy attorneys, who are individuals who help higher income taxpayers) from advising clients as to this. So attorneys working with higher income taxpayers are still free to make this recommendation to higher income taxpayers (this even undermines the infamous means test that Congress devised to prevent higher income taxpayers from qualifying for bankruptcy relief).

Moreover, attorneys and “debt relief agencies” are under a duty to provide taxpayers with copies of the law and in this instance handing the taxpayer a copy of the law would clearly tip off the client that they would benefit from taking the action that is proscribed in the rule. In essence the legislation points out the opportunity to taxpayers. So Congress has done for debt relief agencies what the agencies could not do for themselves.

The Act requires all taxpayers undergo and pay for budgeting and counseling in order to qualify for bankruptcy relief. The idea is that this will present the potential-bankrupt business or individual with an opportunity to hear non-bankruptcy options for dealing with debt. This is of little to no value in cases where the primary debt is a dischargeable tax liability, yet it is still mandatory.

How Is Setting A Budget Going To Help The Taxpayer Pay For An Unpaid Tax Debt?

Even if the counseling points out ways to avoid bankruptcy, why would the taxpayer want to pursue those options if the tax debt is fully dischargeable? This will create a new stream of income for credit counseling agencies, at the expense of the legitimate creditors.

The Act also changed the priority rules with respect to tax liabilities. In essence, the Bankruptcy Code provides that all of the taxpayers assets are to be added up and then applied to debts according to a priority list provided in the Bankruptcy Code. Federal tax liabilities are next to last on that list, which makes them payable before general unsecured creditors. This priority allows the IRS to collect most of all tax liabilities that are not otherwise dischargeable.

Tax liabilities are not dischargeable if they are due to taxes for more recent tax years. Congress changed the Bankruptcy Code to extend this time period in accordance with any time period in which the IRS was not lawfully able to collect the tax debt, such as times during which a collection due process hearing request is pending or the case is before the Appeals Office pending placement on the Tax Court docket. So in essence this new provision now allows IRS delays in processing such requests to make tax debts priority claims, rather than non-priority general unsecured claims.

The Act also prohibits debt relief agencies (i.e., bankruptcy attorneys who work with lower income taxpayers) from hiring a tax attorney to advise taxpayers on their tax obligations. The idea appears to be that attorneys should not be able to dissipate the bankruptcy assets unnecessarily by hiring other attorneys to work for the taxpayer (this is contradictory to Congresses requiring taxpayers dissipate assets to pay for unnecessary credit counseling and tax transcript fees).

There are situations where hiring an attorney would increase the assets available to creditors, such as where the taxpayer needs to know whether they are required to pay tax on certain transactions. Thus, bankruptcy attorneys are no longer able to advise taxpayers to bring in a tax attorney when there is a tax issue that the bankruptcy attorney cannot answer, regardless of whether it is necessary and warranted. This rule can be detrimental to taxpayers given that tax returns now must be filed (including some prior year tax returns) in order to qualify for bankruptcy relief. So the taxpayer will now have to tax positions on tax returns and taxable transactions without counsel and then they will be subject to non-dischargeable penalties and interest if they are incorrect.

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