Tax Aspect of the Bankruptcy Abuse Prevention & Consumer Protection Act

The Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) was enacted by Congress to address the perceived bankruptcy abuses. The law made significant changes to the bankruptcy code, including new eligibility requirements, mandatory credit counseling, and the creation of the means test.

While BAPCPA was primarily aimed at addressing bankruptcy-related issues, it also had significant tax provisions. I will focus on a few of the bankruptcy-tax-related provisions.

The Tax Provisions

The BAPCPA introduced several tax provisions that individuals and businesses need to be aware of when filing for bankruptcy. The most significant changes included the following:

1. New Tax Filing Requirements. Under the new law, individuals filing for bankruptcy are required to file all tax returns that are due for the previous four years. Failure to file these returns could result in the dismissal of the bankruptcy case. This can significantly impede the filing of bankruptcy cases as it can take time to get the IRS transcripts and other records needed to prepare and file unfiled tax returns.
2. Priority Claims. The BAPCPA made changes to the order in which creditors are paid during bankruptcy proceedings. Under the new law, certain tax debts are given priority over other unsecured debts. This means that tax debts must be paid before other unsecured debts, such as credit card debt or medical bills.
3. Tax Refunds. The BAPCPA also made changes to the treatment of tax refunds in bankruptcy proceedings. Under the new law, tax refunds are considered to be part of the bankruptcy estate and can be seized by the trustee. This means that debtors cannot receive their tax refunds until the bankruptcy case is resolved.
4. Discharge of Tax Debt. The BAPCPA made it more difficult for individuals to discharge tax debts in bankruptcy. Under the new law, tax debts can only be discharged if they meet specific criteria. For example, the tax debt must be at least three years old, and the tax return must have been filed at least two years before the bankruptcy case is filed.
5. Trust Fund Recovery Penalty. The trust fund recovery penalty is a payroll tax issue. The BAPCPA also strengthened the Trust Fund Recovery Penalty (“TFRP”). This penalty applies to individuals who are responsible for collecting and remitting payroll taxes to the IRS but fail to do so. Under the new law, the TFRP cannot be discharged in bankruptcy.

The Elephant in the Room

Congress did not address or close one of the largest bankruptcy-tax opportunities and, arguably, bankruptcy abuses. Specifically, the BAPCPA does not address the situation where taxpayers 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 Takeaway

The BAPCPA had a significant impact on individuals filing for bankruptcy. The new law made it more difficult for individuals to file for bankruptcy and made it harder for them to discharge tax debts. The new tax filing requirements and the priority given to tax debts also meant that individuals needed to be more diligent in managing their tax affairs.

The BAPCPA also had significant implications for businesses filing for bankruptcy. The changes to the treatment of tax debts meant that businesses needed to be more diligent in managing their tax affairs. The new law also made it more difficult for businesses to discharge tax debts, which could have significant financial implications.