The Discharge of Taxes and Tax Liens: A Study in Complexity

When two sections of the laws are Code-oriented (the Bankruptcy Code and the Internal Revenue Code), the interaction of those laws can create complexity for an individual or their adviser. As many of you are aware, at Shenwick & Associates we do many bankruptcy filings for individuals to discharge personal income taxes. In a prior e-mail, we discussed what taxes qualify for discharge in personal bankruptcy. A gloss or complexity, however, is when an individual who files for bankruptcy to discharge taxes (which are dischargeable in bankruptcy) and the Internal Revenue Service has filed a Notice of Federal Tax Lien prior to the bankruptcy filing.

First, some background information on tax liens. Section 6321 of the Internal Revenue Code provides that:

"If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person."

One of the consequences of a tax lien is that the IRS obtains an interest in the taxpayer's property, whether it be a condominium, a house or a car, and that property cannot be sold or refinanced (since the lien applies also applies to the taxpayer's credit) without paying the IRS. Additionally, if the IRS is so inclined, they can foreclose on the property (via a tax levy) to obtain title to the property. In fact, Section 522(c)(2)(B) of the Bankruptcy Code provides that if a tax authority has an outstanding tax lien, the tax authority can still collect on the lien, even if the tax is dischargeable in bankruptcy. This provision provides that property exempt under the Bankruptcy Code is not liable during or after the case for any debt that arose before the commencement of the case except "a tax lien, notice of which is properly filed." Unfortunately for the taxpayer, Section 6502 of the Internal Revenue Code provides that a tax lien is collectible for ten years after the date of assessment. And even worse, the Supreme Court case of Glass City Bank v. United States, 326 U.S. 265 (1945), held that tax liens attach to all property owned by the taxpayer during the ten years in which the lien is collectible.

So what are the consequences of the discharge of a tax where the IRS has filed a tax lien prior to the bankruptcy filing? To understand this issue, one must go back to a painful time in most lawyers' lives, the first year of law school, when we learned the distinction between an in personam obligation and an in rem obligation. An in personam obligation or liability means that an individual is liable for the debt, and an in rem liability or obligation means that only the property is liable for the payment of the debt.

Accordingly, if an individual files bankruptcy to discharge income taxes, and based on the statutory requirements of the Bankruptcy Code those taxes are in fact discharged, but the IRS had filed a Notice of Federal Tax Lien, then while the individual is not personally liable for the debt, any assets owned by the individual during the ten years after the date of filing of the tax lien are subject to being seized by the Internal Revenue Service.

Accordingly, if an individual files bankruptcy and discharges taxes, and a tax lien has been filed by the Internal Revenue Service, then the individual must make sure not to acquire property after they receive their discharge of debts during the pendency of the ten year statute of collections. And in fact, the taxpayer must make themselves "judgment proof."

Let us clarify this analysis by a recent example. An individual recently contacted us who wanted to file bankruptcy to discharge taxes. Our analysis indicated that many of her taxes for the early tax years were dischargeable. We did the bankruptcy filing and commenced an adversary proceeding (bankruptcy litigation) to determine whether her taxes were dischargeable. The Internal Revenue Service then contacted us and indicated that they had filed a Notice of Federal Tax Lien in 2003 and that, while they agreed the taxes were dischargeable, the tax lien was in effect through 2013. The debtor received her discharge of debts in 2011, and she agreed that she would not acquire property until 2013 to make herself "judgment proof." In 2013, after the tax lien expires, she will then be able to acquire property. In the interim, since the debtor is married, she will put property in her husband's name, if necessary.

In conclusion, a couple of rules:

1. If an individual is considering filing bankruptcy, they should file bankruptcy prior to the Internal Revenue Service filing a tax lien. The automatic stay that goes into effect upon filing for bankruptcy will prevent the Internal Revenue Service from filing a tax lien.

2. If an individual files bankruptcy and they are subject to a tax lien, they must determine when the tax lien expires and they cannot put property in their name until the tax lien expires.

3. A tax lien, by statute, is good for ten years. While the IRS can renew tax liens, in our experience, they rarely do.

Anyone with questions concerning tax liens and the discharge of taxes should contact Jim Shenwick.