Good representation of business clients, both large and small, requires solutions through all of a businesses’ life-cycle including financial distress. It is not unusual for counsel (or other business advisors) to deal with liquidity challenges resulting in an inability to make tax payments that may ultimately culminate in a visit from the Internal Revenue Service (“IRS”). This article provides guidance on how to identify and address tax issues regularly confronted by vulnerable businesses.
Resolving Tax Issues with the Internal Revenue Service
As the revenue collection arm of the United States government, the IRS possesses many powerful tools to secure payment for taxes owed. The IRS has established procedures to assist taxpayers in paying their unpaid taxes in arrears in recognition that voluntary compliance maximizes revenue collection.
To collect a tax debt, the IRS must first establish a payment right – known as an “assessment.” Pursuant to 26 U.S.C. § 6201 (Title 26 of the United States Code is hereinafter referred to as the “IRC”) the IRS is “authorized and required to make the inquiries, determinations, and assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)….” Taxes are generally assessed through two methods (a) deficiency procedures under IRC § 6212 (concerning generally, income taxes and estate and gift taxes) or (b) automatic assessment (otherwise referred to as a non-deficiency assessment). The primary difference between a deficiency and non-deficiency assessment is the taxpayer's right to petition the United States Tax Court (“Tax Court”) for redetermination of deficiency assessments without prepaying the tax that is due.
Under the deficiency assessment process, the IRS must send a Statutory Notice of Deficiency (“SND”) to the taxpayer. The SND provides the taxpayer 90 days to petition the Tax Court for redetermination of the tax. If the taxpayer does not file a timely petition with the Tax Court, the assessment becomes final and the IRS then moves the case to collect from the delinquent taxpayer. A timely Tax Court petition, however, suspends collection only for the tax periods under protest until the case is resolved.
Where an assessment is not subject to deficiency procedures (such as a payroll or excise taxes), the tax is due when assessed. IRC § 7421(a), known as the “Anti-Injunction Act,” requires that, except for certain statutory exceptions, the taxpayer must pay the tax and file a lawsuit seeking a refund in order to obtain redetermination of the assessment. Such refund lawsuits must be brought in U.S. District Court or the Court of Federal Claims. Once the assessment becomes final and all appeals are exhausted, the IRS Collections Division will use whatever means available to procure payment.
Collection Alternatives for Taxpayers
The IRS divides unpaid tax payers into three broad categories of “collection alternatives,” for taxpayers to resolve their debts: (a) offers in compromise (“OIC”), (b) installment agreements (“IA”) and (c) currently not collectible status (“CNC”). An offer in compromise is an agreement by the government to accept less than full payment on a tax debt. An installment agreement permits the taxpayer to pay its tax debt over time. Currently not collectible status means the taxpayer cannot pay his or her debt and collection activities will be suspended, but the government may seek to collect the debt if the taxpayer’s situation changes. Each collection alternative is available to business and individual taxpayers.
Whether a taxpayer will qualify for a collection alternative depends on the reasonable collection potential of that taxpayer “RCP”. RCP is a defined formula that looks at the taxpayer’s current assets and future income to assess reasonable collection potential. The principal way in which the IRS obtains the taxpayer’s information is through a financial statement— Form 433A for individuals, and Form 433B for businesses. The financial statement provides the IRS with detailed information concerning the taxpayer’s income, expenses, assets and liabilities. Income producing assets may be retained by the taxpayer, but the IRS will ordinarily require the liquidation of non-income producing assets.
Offer in Compromise: The government will enter into an offer in compromise on a tax debt if the RCP demonstrates doubt about the collectability of the taxes . If the RCP provides that the taxpayer has sufficient income to satisfy in full the tax debt over the 10-year statute-of-limitations for collection, then the IRS will not enter into an offer in compromise with the taxpayer.
With regard to a business and evaluation of its assets, the IRS will consider whether it can extract greater collection if the business continues operations (resulting in an “in-business Offer in Compromise”); or whether the IRS can obtain more immediate recovery from shutting down the business and liquidating its assets. Before proceeding, a business taxpayer considering the propriety of an Offer in Compromise must first determine the value of its income producing assets,.
A taxpayer may elect to pay the amount due on the OIC in two ways; either a lump sum where the taxpayer pays 20% of the settlement amount at the time of filing the OIC and the remainder in no more than five installments following acceptance of the OIC, or in monthly deferred payments over two years, starting when the OIC is filed, not upon acceptance. A taxpayer must remain in tax compliance during the pendency of the OIC and for five years thereafter, or the OIC will be retroactively rejected, and the IRS may collect the full (pre-OIC) debt owed. Upon completion of the OIC, any federal tax liens will be withdrawn. Also, assets liquidated in the three years prior to making an OIC (known as “dissipated assets”) can be included in the RCP, if not used for income producing purposes.
Installment Agreements: Installment agreements (“IA”) come in two forms: (a) full pay and (b) partial pay. Under a general installment agreement, the taxpayer must pay off in full its obligation within the permissible number of months based on the income portion of his or her financial statement. Thus, if the taxpayer owes $100,000 and the RCP shows the taxpayer can pay $5000 per month, the installment agreement must be completed within 20 months.
Where a business taxpayer owes less than $25,000, and the debt can be paid within 48 months, the IA will be automatically accepted without the need to submit a financial statement. These so-called “streamlined installment agreements” may be processed on-line. For individuals, the IRS will automatically accept IA’s to pay less than $50,000 over 72 months. The IRS has also extended a pilot program that allows most individual taxpayers with less than $100,000 of back taxes to pay the IRS over 96 months without submitting a financial statement.
The IRS is generally flexible in working out longer term installment agreements for good cause shown. However, a federal tax lien will be filed to protect the government’s position. The IRS will also accept installment agreements that increase the payments over time or where the main payment is deferred to allow for a specific event, such as the sale of property or the liquidation of assets.
Partial Pay Installment Agreements: Where the RCP calculation provides that a taxpayer is unable to pay in full the taxes prior to the expiration of the statute of limitations on collection (which is 10 years following the assessment becoming final) the IRS can accept an installment agreement for the RCP-specified amount even if the payments will not fully pay the tax. This “partial pay installment agreement” (“PPIA”) ends when the collection statute expires. PPIAs are of particular interest to taxpayers who are not OIC candidates because their monthly income renders an OIC beyond their means (due to the requirement that the OIC be completed in no more than 2 years). For example, the taxpayer who shows the ability to pay $500 per month would be required to offer $24,000 for a deferred payment OIC (48 months multiplied by $500). If the statute of limitation has only 2 years left, that same taxpayer may be a candidate for a PPIA because of his or her ability to pay the same $500 per month over the remaining life of the statute, but only have to pay $12,000.
Currently Not Collectible Status: If it would be a hardship for the taxpayer to make payments on their tax debt, the taxpayer (including businesses) may be placed in “currently not collectible” (“CNC”) status. This does not mean that the tax debt is discharged.
The taxpayer must request CNC status by submitting a financial statement. The IRS will ask for updated financial statements every six to twelve months to verify the tax payer’s financial condition. Further, the IRS can unilaterally reinstitute collections. Notice will be afforded prior to doing so and the taxpayer will be entitled to request a new collection alternative. One benefit of CNC status is that the statute of limitation on collections continues to run.
Employment Taxes
Payroll tax proceeds constitute a key component of federal revenue. The IRS Data Book states that more than 50% of federal revenue is derived from payroll deducted taxes. Because of the importance of this revenue stream, both the Department of Justice Tax Division and the IRS have repeatedly stated that payroll tax liabilities will be subject to stricter civil and criminal compliance and enforcement actions.
IRC § 6672 allows the IRS to recover “trust funds” withheld from an employee’s pay from “any person required to collect, truthfully account for, and pay over any tax imposed” and “who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof.”
The “trust fund” portion of employment taxes is comprised of 7.65% of the Social Security and Medicare tax withheld from an employee’s pay and any income tax withheld from the employee’s pay. The employer is deemed to be holding these funds in trust for the U.S. Government. The penalty is referred to as a “100% penalty” which means that the entire amount can be recovered against anyone determined to be a “responsible person” who willfully fails to collect and pay over such tax. Trust fund taxes do not include the employer’s matching obligations.
A “responsible person,” including owners, managers, lenders, and creditors, can be held liable for a business’ failure to remit trust fund taxes. The term “responsible person” is broad, encompassing anyone responsible for collecting, accounting and paying over taxes to the government. All responsible persons are jointly and severally liable for the unpaid tax. See McCray v. U.S., 910 F.2d 1289 (5th Cir. 1990).
To be personally responsible for a trust fund liability, a third-party must have willfully failed to collect and pay over the trust funds. Willfulness exists where “money withheld from employees as taxes, in lieu of being paid over to the Government, was knowingly and intentionally used to pay the operating expenses of the business, or for other purposes.” Revenue Ruling 54-158. Thus, if a corporate decision maker chooses to pay vendors instead of the IRS, he/she can be held liable for the unpaid trust fund taxes.
Cancellation of Debt Income Issues
Cancellation of debt (“COD”) income occurs when an asset is written down, foreclosed, surrendered, or a debt obligation is restructured. This is frequently a surprise to the taxpayer, who never considered the debt written off as “income.” When the taxpayer is unable to pay the tax on the debt forgiveness, it becomes an IRS collection case.
When dealing with COD income issues, taxpayer representatives should confirm that the creditor has in fact cancelled the debt. Unless the creditor has actually cancelled the debt, the taxpayer does not have COD income. Discharge of a personal guarantee of business debt does not generally trigger COD income to the guarantor.
There are a number of exceptions to the general rule that the cancellation of a debt gives rise to taxable income which provide relief for taxpayers and excuse them from realizing income. IRC § 108(a) lists five exceptions to the COD income rules. These include: the discharge occurs in a bankruptcy case, the discharge occurs when the taxpayer is insolvent, the indebtedness discharged is qualified farm indebtedness, the indebtedness discharged is qualified real property business indebtedness (for taxpayers other than a “C” corporation), or the indebtedness discharged is qualified principal residence indebtedness that is discharged on or after January 1, 2007 and before January 1, 2014.
One of the key elements to the Bankruptcy Code is the idea of granting honest debtors a “fresh start” free from the crushing debts they were carrying. A critical component of “fresh start” is not to have “income” recognized from the discharge of debts in a bankruptcy case. The avoidance of the COD income oftentimes makes a bankruptcy filing preferable to negotiating a reduction in a taxpayer’s debts with their creditors.
In analyzing the COD income issues, IRC § 108 tests bankruptcy at the shareholder level for corporations (both C and S corporations) and at the partner level for partnerships (including LLCs). Thus, even if an LLC is in bankruptcy, the COD income it recognizes flows through to the members and, unless the members are also in bankruptcy, the COD income must be recognized. Conversely, for S-corporations (which are pass-through entities), the S-corporation’s COD income will not flow through to the shareholders.
Under IRC § 108(a)(1)(B), taxpayers may avoid COD income to the extent the taxpayer was insolvent immediately before the discharge. To measure insolvency, the taxpayer’s total liabilities, just before the date the debt was discharged, are subtracted from the value of its assets (including exempt taxes), also valued on the date before the debt was discharged. The taxpayer can exclude from income the amount of the COD equal to the amount to which it is insolvent. This “insolvency exception” is important for parties that have not filed bankruptcy.
Where COD income is excluded from gross income by IRC § 108(a), the unrecognized COD income reduces tax attributes, such as net operating loss (“NOL”) carry forwards. A taxpayer may also make an election under IRC § 108(b)(5), to apply excluded COD to reduce basis in depreciable property; this election, however, cannot be used to reduce basis below zero.
Bankruptcy Specific Issues
Dischargeability: Income taxes owed by a business are dischargeable to the same extent as they are for individuals. Therefore, so long as the tax return was due more than three years prior to the petition date (including extensions), the tax return was in fact filed more than two years prior to the petition date, and there have been no additional assessments within the 240 days prior to the petition date, federal income taxes may be discharged. If tax returns have been belatedly filed for corporations, state income taxes may be determined to be nondischargeable under rulings in the First, Fifth and Tenth Circuits. It is important to remember, certain events may toll these period.
Under Chapter 11 of the Bankruptcy Code (Title 11 of the United States Code, hereafter the “Bankruptcy Code”), nondischargeable tax debts must be repaid within five years of the petition date. Any chapter 11 plan of reorganization must contain a provision ensuring that applicable tax debts are repaid within the applicable time frame, plus statutory interest. Therefore, businesses with significant tax debts should make immediate provisions to begin the repayment process or be faced with large plan obligations. Where a business is a pass-through entity (partnership, LLC or S-corporation) the income tax obligations will be recognized at the equity holder level.
Creditor Trusts: Trusts are frequently used as the vehicle to pursue any further recoveries for creditors under confirmed plans of reorganization or liquidation. Instead of finishing up the business of the debtor in possession through a confirmed plan using a trust vehicle, structured dismissals are becoming more prevalent as a “confirmation alternative.” Generally, a “structured dismissal” results in a sale of substantially all of the debtor’s assets, a settlement amongst the key players, and some claims resolution process followed by distributions. Where distributions to creditors will be deferred (i.e. due to payoff of a buyer’s note or resolution of litigation), it is necessary to establish a creditors’ trust to manage the post-dismissal assets. It is not possible to establish a liquidating trust in a dismissal scenario because Rev. Proc. 94-45 (the IRS ruling that establishes a safe harbor for liquidating trusts) requires that the trust be implemented through the plan and disclosure statement process. See Rev. Proc. 94-45.01.
Such “non-qualified creditors trusts” will be taxed as business trusts. If taxed as a corporation, the entity would have to pay taxes and file a tax return (Form 1120). If taxed as a partnership, the tax effects would continue to flow through to the creditor/owners, but the treatment would be different than under the trust rules. The entity would then file a tax return (Form 1065 – unless it is treated as a disregarded entity where there is only one creditor/owner). The arrangement may be taxed as a complex trust and would be responsible for taxes (IRC § 641) and must file a tax return (Form 1041). Bankruptcy lawyers crafting resolution alternatives that include trusts must consider these issues.
Conclusion
The IRS possesses powers no other creditors have. When a tax deficiency arises it can wreak havoc on a business’ ability to operate, or restructure. The IRS (and most state taxing authorities) can be flexible in resolving tax issues. However, practitioners must act early, know the correct questions to ask their clients, provide information in a manner that the governmental authorities can use, and understand the limitations of governmental tax resolution programs.