On April 20, 2005, President Bush signed the largest bankruptcy reform bill since 1978. Many of the provisions in the bill protect consumers and their rights to privacy by restricting public access to personal information contained in a bankruptcy case file to the extent the court finds that disclosure of such information would create undue risk of identity theft or other unlawful injury to the individual or the individual’s property. Other provisions include protection for IRAs, having a set and uniform rate of interest due on tax liabilities, and quicker set-offs of refunds and liabilities.

There are basically four different types of bankruptcy. They are referred to by the Chapter under which they are covered under Title 11 of the Bankruptcy Code.

Chapter 7 is used primarily by individuals who wish to be absolved of all debt. Under Chapter 7, the individual is allowed to keep certain exempt property while all other assets are sold to repay creditors. A separate bankruptcy estate is created and the court appoints a trustee to oversee the disposition of assets and payments to creditors. With certain exceptions, all unsecured debt is cancelled.

Chapter 11 is primarily used by businesses that want to keep operating. It is similar to Chapter 7 in that a separate estate is created consisting of property owned by the debtor prior to filing bankruptcy. In Chapter 11, the debtor remains in control of the assets as a “debtor-in-possession,” although a trustee may be appointed. In that case, control is turned over to the trustee.

Chapter 12 is a special provision governing family farms that have regular income. A separate estate is not created, instead the debtor continues filing the same federal tax forms that they had been filing prior to bankruptcy.

Chapter 13 is similar to Chapter 12 where a separate estate is not created, and is commonly referred to as the “wage-earners” chapter. This resembles a reorganization that enables individuals to propose and carry out a repayment plan under which creditors are paid over a specified period.

Below is information about the bankruptcy reform bill dealing primarily with tax issues.

Priority of Tax Claims – Under current law, a tax claim is entitled to be treated as a priority claim if it arises within certain specified time periods. In the case of income taxes, a priority arises, among other time periods, if the tax return was due within three years of the filing of the bankruptcy petition or if the assessment of the tax was made within 240 days of the filing of the petition. The 240-day period is suspended during the time that an offer in compromise is pending (plus 30 days). Though the statute is silent, the Supreme Court in Young v. United States, 535 U.S. 93 (2002) held that the three-year period is suspended during the pendency of a previous bankruptcy case. Section 705 amends Section 507(a)(8) of the Bankruptcy Code to codify the rule suspending priority periods during the pendency of a previous bankruptcy case during that 3-year or 240-day period together with an additional 90 days. During any period in which the government is prohibited from collecting a tax as a result of a request by the debtor for a hearing, and an appeal of any collection action taken against the debtor, the priority is suspended, plus 90 days. Also, during any time in which there was a stay of proceedings in a prior bankruptcy case or collection of an income tax was precluded by a confirmed bankruptcy plan, the priority is suspended, plus 90 days.

Setoff of Tax Refunds – Under current law, the filing of a bankruptcy petition automatically stays the setoff of a prepetition tax refund against a prepetition tax obligation unless the bankruptcy court approves the setoff. Interest and penalties that may continue to accrue may also be nondischargeable pursuant to Section 523(a)(1) of the Bankruptcy Code and cause individual debtors undue hardship. Section 718 of the Act amends Section 362(b) of the Bankruptcy Code to create an exception to the automatic stay whereby such setoff could occur without court order unless it would not be permitted under applicable nonbankruptcy law because of a pending action to determine the amount or legality of the tax liability. In that circumstance, the governmental authority may hold the refund pending resolution of the action, unless the court, on motion of the trustee and after notice and a hearing, grants the taxing authority adequate protection.

Nondischargeability of Certain Educational Benefits and Loans – Section 220 of the Act amends Section 523(a)(8) of the Bankruptcy Code to provide that a debt for a qualified education loan (as defined in Section 221(d)(1) of the Internal Revenue Code) is nondischargeable, unless excepting such debt from discharge would impose an undue hardship on the debtor and the debtor’s dependents.

Dismissal for Failure to Timely File Tax Returns – Under existing law, there is no definitive rule with respect to whether a bankruptcy court may dismiss a bankruptcy case if the debtor fails to file returns for taxes incurred postpetition. Section 720 of the Act amends Section 521 of the Bankruptcy Code to allow a taxing authority to request that the court dismiss or convert a bankruptcy case if the debtor fails to file a postpetition tax return or obtain an extension. If the debtor does not file the required return or obtain the extension within 90 days from the time of the request by the taxing authority to file the return, the court must convert or dismiss the case, whichever is in the best interest of creditors and the estate.

Rate of Interest on Tax Claims – Under current law, there is no uniform rate of interest applicable to tax claims. As a result, varying standards have been used to determine the applicable rate. Section 704 of the Act amends the Bankruptcy Code to add Section 511 for the purpose of simplifying the interest rate calculation. It provides that for all tax claims (federal, state, and local), including administrative expense taxes, the interest rate shall be determined in accordance with applicable nonbankruptcy law for overpayments and underpayments of tax. With respect to taxes paid under a confirmed plan, the rate of interest is determined as of the calendar month in which the plan is confirmed.

Retirement Plan Exemptions – Debtors can exempt retirement funds from the bankruptcy estate to the extent they are in a fund or account that is exempt from tax. This generally includes all plans that fall under Section 401(a), including 401(k) plans, 403(b) annuities, SEPs, SIMPLEs, and 457 plans. The exemption also applies to traditional and Roth IRAs, however, those accounts are subject to an inflation adjusted $1 million cap, determined without regard to rollover contributions. The cap can be increased at the discretion of the bankruptcy judge.

Education IRAs and Section 529 Plans – Education accounts under Section 529 and 530 are exempt from the bankruptcy estate if the designated beneficiary of such account is a child, stepchild, grandchild, or step-grandchild of the debtor for the taxable year during which funds were placed in the account. A legally adopted child or a foster child, under certain circumstances, may also qualify as a designated beneficiary. Funds deposited between 720 days and 365 days before the filing date are protected to the extent they do not exceed $5,000. Similar criteria apply with respect to funds used to purchase a tuition credit or certificate or to funds contributed to a qualified state tuition plan under section 529(b)(1)(A) of the Internal Revenue Code.

Maintenance of Tax Returns – This section authorizes the AOUSC to receive and retain debtors’ tax returns for the year prior to the commencement of the bankruptcy for Chapter 7 and Chapter 13 filings. Such collection and storage of tax returns would commence only at the request of a creditor. In addition, a debtor is required to provide the bankruptcy trustee, not later than seven days before the date first set for the meeting of creditors, a copy of his or her Federal income tax return or transcript for the latest taxable period ending prior to the filing of the bankruptcy case for which a tax return was filed. Should the debtor fail to comply with this requirement, the case must be dismissed unless the debtor demonstrates that such failure was due to circumstances beyond the debtor's control. Upon request, the debtor must provide a copy of the tax return or transcript to the requesting creditor at the time the debtor supplies the return or transcript to the trustee.

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