Category Archives: Bankruptcy

Can You Discharge Those Unpaid 1040 Taxes in Bankruptcy?

by Larry Goldsmith, CPA, JD, CFF, MAFF

Last week, I reviewed a new client’s IRS transcript. The client apparently filed his individual income tax returns late and wanted to file bankruptcy to discharge his 1040 tax obligations. I subsequently learned that the IRS filed substitute individual income tax returns on the client’s behalf and issued an income tax deficiency before the income tax returns were filed.

 The question was: if the Internal Revenue Service files a substitute tax return on behalf of the debtor/ taxpayer, before the taxpayer files their own income tax returns would that late tax return be considered eligible for a bankruptcy discharge under Section 523 tax return?

I have to admit that it was my belief at the time that if the late filed tax returns increased the income tax assessment, the late filed tax returns would be dischargeable if the tax returns qualified under the various timing constraints. However, after further research, examining several court cases, I have concluded that if the income tax returns were filed after the IRS had issued a substitute tax return, or issued a deficiency, a bankruptcy discharge is not attainable, even where the debtor subsequently filed an income tax return.

It appears that the bankruptcy courts have not consistently held on issues of discharge where the debtor filed a late tax return prior to the IRS issuing a notice of deficiency. From the Appellate court statements I doubt if the courts would favor the discharge of the late filed income tax returns.

Here are a couple of cases exemplifying the court’s consistency in this matter:

IN RE PAYNE 431 F.3D 1055 (7TH CIR 2005)

The taxpayer failed to file a 1986 tax return, and the IRS subsequently filed a substitute tax return for the debtor. In 1992 the taxpayer filed an offer in compromise that was rejected. The taxpayer filed a Chapter 7 in 1997. The bankruptcy court discharged the 1986 tax debt.

The 7th Circuit Court of Appeals stated that, the substitute tax return and an offer in compromise do not constitute a tax return and therefore the income taxes were not dischargeable.

MALLO V. INTERNAL REVENUE SERVICE

A married couple filing jointly, the Mallos filed their individual income taxes several years after the IRS issued notices of deficiency. Two years after filing the income tax returns the Mallos filed bankruptcy seeking to discharge the income tax obligations.

The Mallo bankruptcy court held that post assessment filings do not constitute tax returns and are therefore excepted from discharge under 523(a)(1).

The Court of Appeals held that tax debt was not dischargeable because, “the filing of a return after an assessment negates an honest and reasonable attempt to comply with tax law”.

The Court of Appeals held that, “if a Form 1040 is filed late, the tax debt is non-dischargeable under 523(a)(1)(b)(i). The court reasoned that a late tax return is not a return as defined by Section 523(a); it does not satisfy applicable filing requirements.

The Court observed that the definition of a filed tax return differs from the IRS’s definition.

The U.S. Supreme Court acknowledged the different interpretations and stated that further review was not warranted, thereby upholding the U.S. Court of Appeals for the Tenth Circuit findings.

My advice after researching this matter? Always file your tax returns in a timely manner.

Questions or comments? E-mail me at larry@cjbs.com if you have any questions about this posting or if I may be of assistance in any way.

Larry Goldsmith is an experienced Financial Forensic expert and CPA who investigates and verifies financial income and assets in matrimonial matters. CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies. 

My Perspective of Accountants and CPAs

Larry Goldsmith

by Larry Goldsmith, JD, CPA, MAFF, and Julieann Chaet, CPA, MAFF

I’ve always looked at accountants, CPAs or not, as instruments or tools to be used by the IRS or the banks, or buyers and sellers of businesses. What I mean by that is, accountants working in public accounting firms complete the tasks for the Internal Revenue Service to collect its taxes. We provide the measuring stick used by bankers to lend money. We are the instrument that verifies income and assets for the buyers and sellers of businesses. We are important because we produce the tax returns the IRS looks for and the financial statements the banks require. We provide the verification to business that the company is profitable.

To our clients, we become the trusted individuals they depend on to prepare their tax returns or to prepare their company’s financial statement. But all too many times clients will make financial decisions without asking for their accountant’s opinion. I have to say my favorite clients are the ones who call me up to say “Are you busy?” or “Do you have a minute?”  The truth is, I was busy, but that interruption when they ask for my opinion or ask me a question, can save them hundreds or even thousands of dollars.

It usually takes only minutes to answer a client’s question when they call or e-mail. It’s when clients don’t ask the questions, that it can cause problems that can cost more than money.

I prepared very few tax returns this tax season because I was thankfully busy with my forensics work. However, one of the tax returns that I did prepare was absolutely gut-wrenching. A month later, I still think about these particular clients who I’ve never personally met. As I was sorting through their data and inputting the numbers into our tax program, I became curious. I thought I must be missing something. I finished preparing the tax return. The couple owed what was for them a lot of money – thousands of dollars.

So I asked the partner whose name is on the return, “what’s the deal?” Apparently, this 62 year old couple was making over $100,000 a year for at least the last 5 years. Both husband and wife had their own careers. They owned a home. The husband had even gone back to school to further his professional degree while maintaining his career.

The problem started with a stroke – a stroke had debilitated the husband at the age of 59. The husband could no longer care for himself so a full-time nurse was brought in to care for him. After a couple years the wife could no longer afford the full-time nurse so she quit her job to care for her husband. They sold their house and moved into their daughter’s apartment.

By the time I was preparing the couple’s tax return, most of the couple’s savings including IRAs and proceeds from the house had been spent on living expenses and the husband’s medical care.

So what did I do?  I saw Larry Goldsmith, the head of CJBS’s Financial Group’s litigation, asset protection and tax practices team walking past my desk. “Larry, you need to do something!”, I said. I didn’t care that he was just walking in from the polar vortex that we were having outside, and that maybe he wanted to take off his hat and defrost. This woman was going to live probably for another decade or two. Her husband could live years in his current condition, and all their money was squandered on medical bills. Where would the money come from to pay the tax return?

Unfortunately, even with his vast experience and resources for this sort of thing, Larry wasn’t able to provide a solution. It was too late. The truth is the couple was financially bankrupt and didn’t know it. Their liabilities (the monies they owed) far exceeded the monies and assets they possessed. They spent their savings along with their IRA’s that she would one day need because she didn’t know that there were taxes to pay on the IRAs.

Thousands of dollars of her savings were spent caring for her husband that didn’t need to be. The wife did not know about different agencies that could’ve helped or the benefits of financial planning. She did not know that creditors cannot seize her IRAs from her.

You see she never asked the questions of her accountant so the accountant wasn’t aware of all that was happening.

We became aware the day we called her to try to make sense of the documents in front of me.  There is a solution, but it requires planning.

Julieann Chaet, CPA, MAFF

Julieann is the Manager of CJBS’ forensic accounting and litigation services practice.

Call Julieann at 847.580.5449, or e-mail: jc@cjbs.com

 

Larry Goldsmith, JD, CPA, MAFF

Call Larry at 847.580.5427, or e-mail: Larry@cjbs.com

Alternatives to Bankruptcy: Business Survival in Tough Times

By: Larry Goldsmith, J.D., C.P.A., C.F.F.A.
Partner at CJBS, LLC

In these difficult economic times, there will be many businesses that will no longer be able to meet their current obligations. Their lenders will refuse to advance additional capital and the financial pressures will force the closely held business owner into Chapter 7 bankruptcy. There are better alternatives than bankruptcy, but your lender and trusted advisors may not tell you about these options.

Bankruptcy is not always the answer for many business owners who have decided to liquidate their distressed businesses. Upon filing Chapter 7 bankruptcy, an overburdened bankruptcy court system appoints a Chapter 7 trustee to manage the case. The trustee’s duty is to investigate if the owner is guilty for the business’ failure. He also investigates whether preferred customers, or the owners, received fraudulent transfer payments or preferences during a period that in the State of Illinois may deem as long as four years from the date of the transfer.

The system is flawed because bankruptcy is a slow and costly process. The trustee often has many cases and is fortunate to close a case and sell the assets within a year or two. During such time, the business and its assets could have lost much of its value to potential purchasers. The bankruptcy process also invites litigation. Litigation is expensive and has a tendency to diminish the proceeds from the sale of the assets. Litigation against former owners is common.

An Assignment For The Benefit of Creditors, known as an ABC or an assignment, is a common law remedy governed by state law. An experienced professional, known as an ‘assignee,’ is appointed by the corporation’s board of directors to take charge of the business assets and to liquidate the business and its assets to pay the creditors of the failed business. The assignee’s goal is to quickly take complete control of the business and its assets and then determine the best means of selling the business, either as a going concern or sell the assets at auction. Then the assignee, as the fiduciary for the creditors, determines which creditors get paid and in what priority.

The assignee has a flexibility that the bankruptcy trustee does not have or may not be willing to assume either because of liability issues or because of the administrative problems associated with the Federal Bankruptcy Court. To maximize the return to creditors, an assignee may decide to employ former employees or owners to run the business in the short term because a going concern can be sold for greater dollars than an auction of unused machinery and inventory. The assignee will then try to collect all of the receivables and sell all of the assets within months of his appointment.

There are no back room deals or midnight sales in a properly administered assignment. The assignee is required to notify the creditors upon receiving the assignment. At the close of the assignment, the assignee will send out a final letter and accounting to all creditors. The assignee will then publish, with at least ten days advanced notice, where and when the assets are to be sold in the local newspaper. If there are related purchasers or initial bids for the assets, the assignee should disclose these matters to the public and creditors. The assignee is most productive if there is a working relationship with both the creditors and the former business owners.

AN ASSIGNMENT IS A BUSINESS SURVIVIAL OPTION
If the business is inundated with both secured and unsecured creditors and the lender is unable or unwilling to advance additional capital to permit the company to meet its current obligations, potential equity investors will not want their monies to be used for paying the old debts of the company. The equity investor will want their capital to be used to grow the company and grow its profits. The equity investor may recommend that the business be sold in an assignment for the benefit of creditors. The new equity investor forms NEWCO to purchase the assets of the old business in an advertised sale. In many cases, the assets of the company have a fair value which is less than the secured creditor’s security interest in the assets of the company. NEWCO may be able to acquire all of the business assets of the former company by working out a deal with the secured creditor. Newco has the assets of the old company without the old company’s obligations, creating a fresh start.

Now the equity investor’s actual capital can be used to grow the business and grow the profits in the new company. Former employees may be offered new positions with the new company, former owners may have an interest in the new company and the business will continue as a going concern benefiting both society and the local economy. The creditors of the old company receive just as much, if not more, than they would have received had there been a Chapter 7 bankruptcy.

For the closely held business owner, having a failing business is a nightmare. Business friends are calling the office and the owner’s residence demanding immediate payments. Threatening letters greet the owner at the office. Letters promising quick fixes are delivered daily. The business owner does not sleep. He prays that they will be able to cover the next payroll and hopes that there are sufficient funds for the payroll taxes. Sadly, too often the secured creditor has the business owner’s residence as additional collateral, compounding the owner’s fears.

The assignment brings greater peace to the business owner than a bankruptcy. The assignee communicates with creditors when the assignments begin and often the creditors will cease the harassing telephone calls. The speed of the assignment is able to put an end to an ugly chapter in the business owner’s life quickly, without protracted years in bankruptcy court with court appearances, depositions and creditor meetings. Since assignments are more cost efficient and can result in a greater return to the creditors, there is greater likelihood that secured creditors can be satisfied and personal assets can be saved from the demise of the business. The former owner can help the assignee to collect receivables and maximize the proceeds to the creditors, which is an additional advantage to why the assignment for the benefit of creditors has been a successful legal tool for so many informed business owners.

Larry Goldsmith is an attorney, Certified Public Accountant and a member of CJBS, an accounting and financial consulting firm in Northbrook, Illinois. Larry has been in active in performing Assignments for the Benefit of Creditors, as an assignee for over fifteen years. Larry can be contacted via email at LARRY@CJBS.COM, or by telephone at 847-580-5427.