Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
INCOME TAX CLAIMS IN THE YEAR OF BANKRUPTCY:
A CONGRESSIONALLY CREATED QUAGMIRE
Gregory L. Germain
Assistant Professor of Law, Syracuse University College of Law; University of California, Santa Cruz, B.A., 1982; University of California, Hastings College of Law, J.D., 1985; University of Florida, College of Law, L.L.M. (Tax), 2001. The author benefitted greatly from the assistance of his research assistants at the Syracuse University College of Law, Richard Wallach, Rui O. Santos, and Kevin Roggow
Whenever a debtor files bankruptcy on a date other than the first or last day of the tax year, the debtor will potentially owe some taxes on income earned before bankruptcy and some taxes on income earned after bankruptcy. For example, suppose that a debtor filed a bankruptcy petition on November 1, 2005, and owed $12,000 in taxes for the entire 2005 calendar year. Suppose also that the income upon which the taxes were imposed was earned proportionally during the year. Eleven months of the tax liability was incurred on prepetition income, and one month of the tax liability was incurred on post-petition income. How will the government’s claims for the unpaid tax liability be treated in bankruptcy? The answer to this question was surprisingly complex and confusing prior to the new Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. 1 In such cases, the courts would reach different results depending on whether the debtor was an individual or a corporation, and whether the debtor filed for a liquidation under Chapter 7 of the Bankruptcy Code, or sought to reorganize under Chapters 11-13. 2 The 2005 Act made what appeared to be a minor change in the language of section 507(a)(8)(A) of the Bankruptcy Code: the words “for a taxable year ending on or before the date of the filing of the petition” were moved from subsection 507(a)(8)(A)(i) to the flush language in subsection 507(a)(8)(A). The Senate Committee Report makes no mention of the reason for moving the language. 3 Indeed, the change appears to have gone unnoticed by bankruptcy law experts discussing the new statute. 4 Yet, the change will affect virtually every debtor who files a bankruptcy petition, and may dramatically impair the government’s ability to collect taxes on prepetition income earned in the year of bankruptcy. In the example above, the debtor could make a strong argument that the change in the statute should allow it to convert what would have been an $11,000 claim that would be entitled to priority over most other general unsecured claims and excepted from discharge, into an $11,000 general unsecured claim that could be discharged without full payment. 5 This Article looks at the treatment of the government’s claims for taxes incurred in the year of bankruptcy by analyzing the complex state of the law before the change made by the 2005 Act. It then considers how those rulings may affect the law under the 2005 Act, which went into effect for cases filed on or after October 17, 2005.