Published: | Last Updated: February 8, 2024
Taxpayers, Bankruptcy, and the Statutory Notice of Deficiency
Although extended unemployment benefits, eviction moratoriums, stimulus payments, small business loans, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the Consolidated Appropriations Act, 2021, and other government programs may have stemmed the tide of anticipated COVID-related bankruptcy filings, seeking bankruptcy relief may still be the most appropriate option for some taxpayers experiencing financial difficulties in the wake of the COVID pandemic. Bankruptcy relief allows debtors to receive forgiveness of many of their debts, subject to complex rules. Further, upon filing a petition in bankruptcy court, debtors generally receive a reprieve from their creditors’ collection actions, and that includes the IRS.
The filing of a bankruptcy petition generally triggers an “automatic stay” that immediately stops current and future collection actions for pre-petition debts and property of the bankruptcy estate for the pendency of the bankruptcy case. Pre-petition debts include taxes incurred before the filing of the bankruptcy petition, even if they were not yet assessed. Income taxes are considered incurred on the last day of the income tax year. Generally, the automatic stay lifts upon conclusion of a bankruptcy case, either upon entry of an order discharging the debtor’s eligible debts or an order dismissing the case.
While the automatic stay does not prohibit the IRS from assessing deficiencies that have been agreed to by the taxpayer’s signature of consent or full payment of tax, it does limit certain IRS compliance activity for unagreed deficiencies covered by the bankruptcy.
The IRS is not prohibited from issuing statutory notices of deficiency to taxpayers in bankruptcy and will generally issue a notice of deficiency for an unagreed pre-petition deficiency. Notice 1421, How Bankruptcy Affects Your Right to File a Petition in Tax Court in Response to a Notice of Deficiency, is included with the notice of deficiency issued to taxpayers currently in bankruptcy. This notice explains how the taxpayer’s petition period is determined. Notice 1421 further explains that in most cases, the automatic stay prohibits the commencement or continuation of a tax court proceeding (unless the Bankruptcy Court lifts the automatic stay to allow the notice of deficiency to be challenged in the Tax Court). While the automatic stay is in effect, the Tax Court will generally dismiss attempts to petition a statutory notice issued for pre-petition liabilities, due to lack of jurisdiction.
Taxes and bankruptcy each are complex topics. Combining the two can be confusing and overwhelming for taxpayers, particularly when addressing the issue of tax assessment. In the 2018 National Taxpayer Advocate Annual Report to Congress, we discussed that the IRS’s failure to clearly convey critical information in statutory notices of deficiency made it difficult for taxpayers to understand and exercise their rights. Taxpayers receiving statutory notices while their cases are pending in bankruptcy court may also have difficulty understanding and exercising their rights. Although Notice 1421 provides taxpayers in bankruptcy with additional information about their rights and applicable procedures, it requires taxpayer comprehension of complex calculations.
Taxpayers receiving a notice of deficiency have 90 days to petition the Tax Court to challenge a proposed deficiency (150 days if the notice is sent to an address outside of the U.S.). If the taxpayer does not petition the Tax Court within the designated time frame, the IRS can assess the deficiency. In situations where the automatic stay prevents a taxpayer from petitioning the Tax Court, the time to petition is suspended, as are the legal timeframes in which the IRS may assess and collect the deficiency. During this time, the IRS holds the taxpayer’s case in “bankruptcy suspense,” awaiting the termination of the automatic stay. While interest and penalties continue to accrue during the pendency of the bankruptcy case, IRS procedures prevent the issuance of most IRS notifications while the automatic stay is in effect.
Currently, taxpayers who filed bankruptcy prior to their audit assessment spend about three years on average in IRS bankruptcy suspense. The lengthy and silent time period between the issuance of the taxpayer’s notice of deficiency and the subsequent assessment often creates confusion for taxpayers with tax liabilities that were not discharged, but were perhaps believed to be discharged due to the complexity of bankruptcy procedures. Although Notice 1421 provides information to assist taxpayers with the determination of their petition period, the computation is complex. The current procedure assumes that taxpayers understand a notice of deficiency and the significance of the petition period, and that taxpayers will retain the Notice 1421 for purposes of later computing the petition period upon the termination of their bankruptcy. Taxpayers unaware that the pending proposed deficiency exists or that the petition period has resumed could be deprived of the right to petition the Tax Court on these proposed deficiency determinations.
IRS Letter 6262, Yearly Reminder – Status of Bankruptcy Case, was finalized in August of 2020. It will be an annual letter that reminds the taxpayer that the proposed deficiency remains in bankruptcy suspense. It will also remind taxpayers that they must obtain permission from the Bankruptcy Court if they want to petition the Tax Court while the stay remains in effect in their bankruptcy case. Once in use, the IRS will issue this letter annually, and will include a copy of the notice of deficiency that the IRS previously issued, as well as Notice 1421. A notice of deficiency waiver will also be included if the taxpayer wants to consent to the assessment of the deficiency (already included in the IRS’s proof of claim), if a taxpayer has no intention of filing a Tax Court petition.
Relatedly, the IRS recently finalized Letter 6285, Stay Lifted. The IRS created this letter to alert taxpayers that the bankruptcy (automatic) stay has been lifted, and the taxpayer’s timeframe for challenging the proposed examination deficiency by filing a petition in Tax Court will reopen. Most important, this letter will provide taxpayers whose cases were held in bankruptcy suspense with the last date to file a petition — critical information the taxpayer previously had to keep track of on their own.
Although Internal Revenue Manuals have not yet incorporated procedures for issuance of Letters 6262 and 6285, the creation of these letters is a step in the right direction. I encourage the swift implementation and use of these letters. They provide taxpayers in bankruptcy proceedings much-needed clarity and may serve to reduce the volume of cases the IRS is required to suspend and monitor.
The pandemic has caused numerous financial burdens for individuals and businesses. Despite its negative stigma, filing for bankruptcy could provide benefits, such as eliminating certain debts, stopping creditors from garnishing wages, and helping taxpayers maintain possession of their homes. Before any taxpayer decides to move forward, I would strongly recommend seeking the advice of a qualified bankruptcy attorney, as the benefits of filing for bankruptcy come at a price. This affects more than just a taxpayer’s wallet. Everyone must look at their specific situation to determine whether bankruptcy is right for them. In the alternative, taxpayers should also familiarize themselves with the various payment options (e.g., installment agreements and offers in compromise) offered by the IRS. Taxpayers leaning towards bankruptcy need to understand the impact bankruptcy can have on their financial situations — including state and federal tax ramifications. We look forward to working with the IRS to continue improving its procedures in providing taxpayers with the information necessary to protect their rights once a bankruptcy petition is filed.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.