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The Surprise Bill – Interest Due after Bankruptcy

Posted on Sep. 26, 2019

The case of In re Widick, No. 10-40187 (Bankr. D. Neb 2019) provides a reminder that bankruptcy does not discharge all debts even when the debtor pays all of the tax for the year through the bankruptcy plan.  Mr. and Mrs. Widick completed a chapter 13 plan.  To obtain the plan and to complete the plan, they paid all of the income taxes for two years and all of the trust fund recovery penalties for two quarters.  I suspect that their bankruptcy attorney did not mention to them that paying all of the taxes does not keep the IRS from coming back after the bankruptcy case to collect the interest.  They brought this action to hold the IRS in contempt for violating the discharge injunction due to its efforts to collect from them after the bankruptcy court granted the discharge in this case.  With relative ease, the bankruptcy court delivered to them the sad news that the IRS could continue to collect from them after the discharge and the authority for the IRS actions went back for three decades in the controlling circuit case of Hanna v. United States (In re Hanna), 872 F.3d 829 (8th Cir. 1989).

In bankruptcy creditors cannot generally collect post-petition interest from a debtor. An exception to this rule exists if the creditor has a secured claim with enough equity to pay the interest or if the debtor is in chapter 11 where the creditor can receive interest after the plan confirmation (but not for the period from the petition to confirmation.)

Although bankruptcy generally serves as an interest free zone, interest still runs. The difficult concept for debtors with tax debt comes where the IRS starts pursuing them after discharge to collect interest on a debt that they believe they have satisfied. Whether the IRS can come after this debt post-discharge depends on whether the debt itself qualified as non-dischargeable debt. In the case of the Widicks, it did. Because the debt satisfied the exception to discharge in 523, the IRS could pursue collection of the interest after the granting of the discharge.

The Widicks owed income taxes that were recently incurred. These income taxes received priority status under B.C. 507(a)(8)(A). The unpaid TFRP liabilities also attained priority status under B.C. 507(a)(8)(C) and due to their nature have priority status no matter how old they were. Because the income taxes and TFRP taxes had priority status, the debtors had to provide for payment in full of these taxes and all pre-petition interest in order to obtain confirmation of their plan. The chapter 13 plan did not require, and could not require, the Widicks to pay the interest that ran on these taxes over the 5 year life of the plan. Debtors might think that because the plan did not require payment of post-petition interest, they got a pass on this interest. Because debtors might easily reach this conclusion, their lawyer must carefully advise them of the interest rules with respect to taxes. Otherwise, they will become quite upset when the IRS offsets post-discharge refunds and takes other collection action.

A similar situation occurs in offers in compromise. The standard language of the offer in compromise developed by the IRS requires that the debtor forego any refund for the year in which the IRS accepts the offer (and any pre-offer years.) As with bankruptcy, the taxpayer’s representative must carefully explain to the individual obtaining the offer the consequence of this provision. The taking of the refund might occur 12 months or more after the offer acceptance. At that point the taxpayer can easily have forgotten the promise to forego the refund. For this reason, putting a discussion of the refund taking in the letter closing out the offer provides a good way for the representative to prepare the taxpayer for the future and protect themselves from criticism and anger that occurs when the IRS takes the refund.

Here, the debtors’ chapter 13 attorney did not prepare his clients for the consequence of the post-discharge interest liability. In its relatively short opinion the court points out that although the Hanna case cited above involved a chapter 7 debtor, case law existed with respect to chapter 11 and 13 cases in their district. The law here is well settled even if it is surprising. Clients may not like this aspect of the law, but if they know it’s coming, then they understand it’s part of the bargain of the discharge — just as the taking of the post-offer acceptance refund is part of the bargain of the offer in compromise.

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