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August 31, 2015
Indiana Bankruptcy Attorney Steven Taylor

By: Steven P. Taylor
Law Office of Steven P. Taylor, P.C.
August 31, 2015

Commonly, in consumer bankruptcy cases, Debtors have attempt resolve their financial issues by raiding their retirement accounts. For those debtors that are younger than 59 ½ years of age, this leads to the 10% additional tax (an “exaction”) of the withdrawn amount as part of their current tax bill in addition to the normal income tax. Bankruptcy may be an appropriate method to deal with tax debt and other times it’s not-and something like the Offer in Compromise program may be a much better option than bankruptcy tax relief.

In the bankruptcy world, whether the Internal Revenue Service has assessed a “tax” or “tax penalty” has different implications. The priority scheme treats income taxes and tax penalty claims differently. Income taxes that a debtor owes to the government are entitled to eighth priority distribution under § 507 of the Bankruptcy Code which are not dischargeable. In contrast, tax penalties that do not compensate for the government’s actual pecuniary loss are subordinated to general unsecured claims and are dischargeable in a Chapter 13 bankruptcy.  In a Chapter 13 bankruptcy (§523(a)(7) does not apply) there is  a Tenth Circuit opinion, In Re Cassidy 983 F.2d 161 (10th Cir. 1992), where the Court rejected contentions that the 10% amount was entitled to §507(a)(8) priority status either as income tax or a penalty in compensation for actual pecuniary loss. See also In Re Cespedes, 393 B.R. 403 (Bankr. E.D.N.C. 2008). Unfortunately, in a Chapter 7 bankruptcy, the exaction not entitled to priority status under §507(a)(8), but will not be dischargeable under §523(a)(7). In Re Mournier, 232 B.R. 186 (Bankr. S.D. Cal. 1998).

Recently, the Court, Bradford v. United States Department of Treasury – IRS, 14-11805, a case from the United States Bankruptcy Court, Middle District of Georgia, Albany Division, looked at the dischargeability of this 10% exaction again. In this Chapter 13 bankruptcy case, the Internal Revenue Service asserted a priority status for the 10% due to early withdrawal of the Debtors from a retirement account under 11 U.S.C. §507(a)(8), either as an income tax (§507(a)(8)(A) or, alternatively as a penalty compensating the government for actual pecuniary loss (§507(a)(8)(G)). The Debtors contended that the 10% exaction was a penalty and that the penalty was not in compensation for actual pecuniary loss and thus not entitled to priority. The parties agreed that if the 10% penalty did not fit into a subcategory of §507(a)(8), it was not entitled to priority treatment under the Debtors’ plan.  The Court, in a 36 page opinion, found that the classification by Congress of the 10% exaction as a “tax” was not determinative based upon Supreme Court precedent. The Court, following a functional analysis, found the 10% exaction was a penalty for purposes of §507(a). Furthermore, the Court found that the penalty was not to compensate the government for actual pecuniary loss and was not entitled to priority status.

The interaction between bankruptcy and tax laws can be extremely complicated. In some cases, simply waiting to file your bankruptcy can turn a priority tax debt into a nonpriority obligation. For these reasons, if you want to file for bankruptcy to eliminate or reorganize your tax debts, consider talking to a knowledgeable bankruptcy attorney in your area first to learn about your options.

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