Bankruptcy Court -- An Alternative Way to Dispute Taxes

Bankruptcy is designed as a way for an insolvent debtor, one who cannot pay his or her creditors, to get a fresh start. Depending on the type of bankruptcy involved--Chapter 7, Chapter 11, or Chapter 13 for example--among the main functions of a bankruptcy court are to liquidate assets, discharge certain debts, or confirm a payment plan for non-dischargeable debts.

It can also serve as a way to dispute taxes, as illustrated in a recent Virginia bankruptcy court decision . In Harris v. Commonwealth, the debtor and his wife filed for Chapter 7 bankruptcy.

In Chapter 7, also known as a liquidation bankruptcy, a trustee takes control of the "nonexempt" assets of the debtor's and reduces them to cash from which creditors will be paid. (Note that before the case is filed you and your attorney will know if there are any nonexempt assets, and can plan accordingly.) While certain unsecured debts are discharged under Chapter 7, certain types of debt, like child support and income taxes less than three years old, are not dischargeable.

Like almost all Chapter 7 cases, this case was determined to be a "no-asset case," where there were no assets available for liquidation or to pay creditors. All of the dischargeable debts that the debtor had were discharged and the only reason for the Chapter 7 action was to contest an income tax assessment. The assessment was for nearly $613,000, and was disputed by the debtor.

Tax courts have broad discretion to determine tax liabilities assessed before or after the debtor filed for bankruptcy. However, in "no asset" cases, where there are no assets to distribute, courts have usually abstained from deciding disputed tax matters. In these cases, the only avenue for debtors who have been assessed an incorrect amount of taxes is to pay the full amount of the taxes and subsequently sue for a refund in state court.

The Commonwealth argued that the bankruptcy courts should abstain from deciding the amount of tax a debtor owes in no asset cases since the decision will not affect the debtor-creditor relationship. However, the debtor argued that he would be severely prejudiced since he would be forced to pay well over half a million dollars BEFORE he could litigate the incorrect assessment in state court. Due to the enormity of the debt, the debtor argued that he would be unable to litigate and therefore would be denied the fresh start guaranteed by Chapter 7.

The debtor further argued that while he would be extremely prejudiced by having to pay the tax first and litigate in state court later, the Commonwealth would suffer no prejudice either way because, in the end, the Commonwealth will only get the correct amount of tax due. The debtor argued that all that his case required was a substantiation of the amount of gross revenue he received and then calculate the correct tax due, which would not be a complex matter and not take up too much of the bankruptcy court's time. This outcome would be the same in either bankruptcy or state court, but the procedure in state court would severely prejudice the debtor. In the end, the court agreed with the debtor and allowed the case to move forward in bankruptcy court.

What is interesting about this case is that it illustrates the possibility for other debtors in similar situations to litigate their tax matters in bankruptcy court. This can prove very beneficial to many people who are already considering bankruptcy and also want to clear up a tax matter but have not been able to get the government's attention to resolve it. It also may eliminate the requirement of having to pay a mistaken tax assessment and sue for a refund later. Since most people are filing for bankruptcy precisely because they cannot pay their bills, being able to litigate tax matters before actually having to pay an incorrect amount of tax may make a huge difference in getting the "fresh start" promised by bankruptcy.