This is the fact situation: taxpayer and his spouse own a home with $30,000 in equity. They owe $40,000 in unsecure debt such as Visa, MasterCard, J.C. Penny Co. and personal loans. They have a judgment against them in the amount of $50,000 from a civil lawsuit. The taxpayers have approximately $20,000 non-exempt assets.
The taxpayer was self-employed and his spouse is a homemaker. However he gave up his
self-employment to find a “real job” with a W-2 because his business income is so erratic. No quarterly estimated taxes have been paid for the current year.
For purposes of this article, let’s assume that all the above occurred during the 2011 tax year and the taxpayer sought the assistance of a bankruptcy attorney. Also assume the taxpayer closed down his self-employed business on June 30, 2011 and proceeded to become a W-2 employee on July 1, 2011.
The bankruptcy attorney could possibly advise the taxpayer and his wife to go to a consumer credit company to set up long term repayment on the debt that is owed.
Additionally the practitioner may advise the taxpayer to negotiate with the civil judgment creditor to reduce the amount of the obligation. Usually all of this would fail miserably. If the taxpayer was successful in reducing the debt owed to a lesser amount he may face the
possibility of the creditor issuing a 1099-C (cancellation of debt) which may become income in that tax year.
At this juncture the taxpayer/debtor would usually ask the bankruptcy attorney how a Chapter 7 bankruptcy would be of benefit to them. The practitioner would probably
indicate to the taxpayer/debtor that the unsecured creditors would be eliminated
in the Chapter 7 bankruptcy however the $20,000 in non-exempt assets would be
sold by the trustee then given to the creditors on a pro-rata basis. Therefore, the remainder of the balance owed to the creditors would be extinguished, a 1099-C would not be issued, and the non-exempt assets of course would no longer be available to the creditors as they were liquidated in the bankruptcy.
The taxpayer/debtor would naturally assume (with a sigh of relief) that everything was taken care of. The husband would then continue his W-2 job thinking all is well. However, in February 2012 the taxpayer meets with his tax preparer and receives “bad
news.” The taxpayer is informed that because he was self-employed for the first several months of 2011 and no estimated taxes were paid to the IRS his self-employment tax plus income tax is approximately $15,000. When the taxpayer files his 2011 taxes on or before April 15, 2012 the IRS will now asses additional penalties and interest and file a lien against the taxpayers residence. Although the equity in the home was protected with certain exemptions in the Chapter 7 bankruptcy, those exemptions do not apply to the IRS and if they chose to do so they could sell the house resulting in the taxpayer and his family not having a place to live. This usually is not the case, however it could happen.
Since the taxpayer has a wife and three children in the home and a moderate amount of income he is unable to immediately pay the tax debt for the year 2011 which is growing on a daily basis with interest and penalties. All of this could have been averted if the bankruptcy practitioner had knowledge of IRC 1398(d). Section 1398(d) allows the taxpayer to file a “short year” for purposes of filing a tax return. This can be accomplished without asking for permission from the Department of Treasury. What does the filing of this “short year” do for the taxpayer in conjunction with his Chapter 7 bankruptcy?
Remember that for several months in 2011 the tax obligation equaled around $15,000 and the taxpayer did not find out about it until 2012. However if the practitioner had the 1040 tax return prepared prior to the commencement of the bankruptcy that obligation then existed at that moment. When the Chapter 7 bankruptcy is filed the practitioner files a claim for the IRS for the $15,000 plus small amounts for penalties and interest. That tax obligation becomes a “priority debt” in the bankruptcy scenario. The general unsecured creditors still remain general unsecured and when the trustee in the bankruptcy sells the assets, which were approximately $20,000, the priority tax debts gets paid first and if there is nothing left over for the general unsecured creditors then they receive nothing
and are discharged. So, in this case the trustee would see there is a claim for the $15,000 plus interest and penalties on a tax obligation for a short year 2011. The trustee also notes that it is a priority claim and when the trustee liquidates the non-exempt assets the taxes are paid off first.
In the month of February 2012 the taxpayer now goes to his tax preparer and explains that there was a 1040 filed for short year 2011 and the tax preparer can prepare another 1040 for the balance of the year 2011. The difference now is that the taxes have been paid for the self-employment for 2011 and the W-2 withholdings have covered the tax liability for the balance of the year with the second 1040. There will be no tax obligation and no tax liens put on the taxpayers home. This allows him that “fresh start” that the bankruptcy court has available for a taxpayer/debtor.
Usually when taxpayers/debtors are interviewed the issue of good credit vs. bad credit really does not exist. They already have bad credit or are going to have bad credit anyway. How do I get control back in my life and how does that control give me a future? The answer in this scenario is: utilization of section 1398(d) of the IRC to give you that control and that future.
