Bankruptcy laws provide filers with protection from many kinds of creditors, but tax collectors generally are not among them.
It has long been the case that tax debts per se are not dischargeable in a Chapter 7 bankruptcy, unless a tough series of conditions are met. And even then, if the Internal Revenue Service or other tax authority has placed a lien on your property, that lien will remain.
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The bankruptcy bill pending in Congress would toughen things up even further. A relatively recent strategy of using a credit card to pay state taxes and then getting the credit card debt discharged would be cut off. Also under the bill, Chapter 13 filers would have to show that they have filed all their tax returns due during the previous four years.
Chapter 7 is basically a liquidation, in which most of the filer's debts are wiped out, while Chapter 13 is a workout, in which the debtor repays some or all of his debts over three to five years.
All of this doesn't mean that bankruptcy is useless if you're behind on your taxes. In fact, the IRS, like other creditors, is stayed from taking collection action against you while your case is before the bankruptcy court. This stay can be helpful, but the rules are so complicated that they can create pitfalls for both the debtor and the IRS, as two recent cases in the U.S. Tax Court show.
The rulings of the Tax Court make clear that the IRS cannot ignore a stay of collection, even when there is little likelihood it will accomplish anything more than a delay, and that if the debtor is offered a chance to dispute his tax liability by the bankruptcy court, he had better make the most of it. It may be the only chance he'll get.
In the first case, an Illinois woman named Catherine Beverly filed a petition for relief under Chapter 13, which generally allows individuals to pay some or all of their debts over time. She filed her petition on Nov. 2, 2001. On Nov. 26, 2001, the IRS issued her a notice that it intended to seize her assets because of several years of unpaid income taxes in the 1980s and 1990s. On Nov. 27, 2001, the bankruptcy court issued an order dismissing her case for failure to file required schedules.
Beverly refiled for bankruptcy on Dec. 5, 2001; on Dec. 19, she filed a form with the IRS seeking what is called a due process hearing, to challenge the levy; on May 17, 2002, the bankruptcy court again dismissed her case; on June 5, 2003, the IRS notified her that it intended to proceed with collection; and on July 7, she took her case to the Tax Court.
Noting that bankruptcy law bars "the commencement or continuation of . . . a judicial, administrative or other action or proceeding against the debtor," the court concluded that the IRS "violated the automatic stay" when it issued the Nov. 26 notice of intent to collect.
The IRS argued that Beverly should have told it she had filed a bankruptcy proceeding, and because she didn't, she should not be able to argue that the agency violated the bankruptcy stay. But the Tax Court concluded that Beverly was acting in good faith and that the IRS, in effect, should have known better. It therefore declared the agency's collection action against Beverly void.