Taxes incurred just prior to filing bankruptcy are not dischargeable in bankruptcy. The debtor will have to pay these taxes or work out a collection alternative with the IRS for these taxes.
This raises the question as to whether a debtor can basically pay the IRS estimated payments to satisfy their income taxes for the current year, even though the payments made prior to filing bankruptcy should be void and the assets pulled into the bankruptcy estate for creditors.
This pre-payment of estimated taxes puts the IRS ahead of other creditors.
The recent Rouguette vs. IRS, No. 21-51507-CAG (Bankr. W.D. Tex. 2022) case provides an opportunity to consider this situation.
Facts & Procedural History
This case involves a dispute between the bankruptcy trustee and the IRS. The parties are fighting over ownership of estimated payments the debtor made prior to filing bankruptcy.
In the six-month period leading up to the bankruptcy petition being filed, the debtor made five estimated payments to the IRS. The payments were made for the 2021 tax year. The bankruptcy petition was filed in December 2021.
The payments were not due at the time they were paid as the 2021 tax return did not have to be filed until April 2022. Moreover, at the time the payments were made, it was clear that the payments would exceed the amount of estimated payments that were required to have been paid. Taxpayers only have to make estimated tax payments equal to 90% of the current year tax liability or 100% of their prior year income tax liability. The debtor made estimated payments in excess of the 90% or 100% amounts.
Because of this, the bankruptcy trustee brought suit to recoup the payments to the IRS to pay other creditor claims. The trustee filed suit arguing that the payments were fraudulent transfers under Bankruptcy Code § 548(a)(1)(B).
Fraudulent Transfers and Bankruptcy
Section § 548 sets out the general rule that a bankruptcy trustee can avoid a transfer the debtor made within two years of the filing of the bankruptcy petition. The bankruptcy trustee has this power if (1) the transfer was incurred to commit bankruptcy fraud or (2) the debtor received less than the equivalent value for the transfer.
With respect to the second option, less than reasonably equivalent value usually means that the debtor gave up an asset and did not get anything back in return. These may be outright gifts. It may also be a situation where the debtor gives another party a good deal–i.e., selling assets for less than the fair market value.
The court summarized the rules for evaluating whether “reasonably equivalent value” was received:
First, a court determines whether the debtor received an economic benefit at the time of the transfers or obligations. See Butler Aviation Int’l, Inc. v. Whyte (In re Fairchild Aircraft Corp.), 6 F.3d 1119, 1127 (5th Cir.1993); Brandt v. Charter Airlines, LLC (In re Equipment Acquisition, Inc.), 511 B.R. 527, 534 (Bankr. N.D. Ill. 2014). Second, the value provided must be “reasonably equivalent” to what the debtor received. See Think3 Litigation Trust v. Zuccarello et al. (In re Think3, Inc.), 529 B.R. 147, 200 (Bankr. W.D. Tex. 2015); see also Abramoff v. Life Ins. Co. of Georgia (In re Abramoff), 92 B.R. 698, 703-04 (Bankr. W.D. Tex. 1988). This two-step inquiry considers the value of what was transferred and what was received at the time of the transfer. See Gutierrez v. Lomas Mortgage, et al. (In re Gutierrez), 160 B.R. 788, 790 (Bankr. W.D. Tex. 1993) (finding that value must be determined on the date of the transfer).
The bankruptcy trustee argued that the debtor did not make a Section 1398(d) election and, therefore, the taxes for which the estimated payments were made was a liability of the debtor and not of the bankruptcy estate.
This is important because if the estate did not have an obligation to pay the taxes, then the estate did not receive a “reasonably equivalent value” by making the payments.
The Section 1398(d) Short Year Election
The Section 1398(d) short-year election allows a debtor to split their tax year into two years for tax purposes. The first short-year is the time from January 1 of the year the bankruptcy petition is filed through to the date of the bankruptcy petition filing. The second short-year is from that date to December 31s of the same year.
If a debtor makes this election, the liability for the debtor’s first short-year is payable from the estate assets. If the debtor does not make this election, the liability for the debtor’s first short-year is payable by the debtor and not the estate.
The court considered prior precedent for a case where no Section 1398(d) election was made and noted the following from the prior case:
one way to determine reasonably equivalent value was to prorate the prior year’s tax liability on a quarterly basis and compare that amount to the amount of each estimated tax payment. If the estimated tax payment was roughly the same amount as the prorated amount of the prior year’s tax, then there would be a dollar-for-dollar payment and the estimated tax payments would be for reasonably equivalent value.
The trustee did this analysis and determined that the payments exceeded the amount of estimated tax payments to be made and, in doing so, concluded that the excess payments were for pre-bankruptcy liabilities that belonged to the debtor and not the estate.
The court in the present case reasoned that if these payments were not fraudulent transfers, “debtors would withhold paying their estimated tax liability, not make a short election, and deprive the estate of assets that would be liabilities of the estate as opposed to paying a tax claim that the estate would not be liable.”
The court cautions that “this case and should not be construed to hold that every estimated tax payment without a debtor making a 26 U.S.C. § 1398 election is a basis for a fraudulent transfer.”
Debtors should evaluate their prior estimated payments and options when it comes to bankruptcy. Tax planning can help save the debtor a considerable amount in taxes in this situation.
If the requirements are met, a Section 1398(d) election can make the pre-petition income taxes a debt that can be paid from estate assets. This can be particularly helpful if the debtor has assets that he is going to lose in bankruptcy anyway.
The debtor might as well have these assets used to pay his taxes as the taxes incurred just prior to bankruptcy are not dischargeable and the debtor would be stuck paying them after the bankruptcy case.