If tax liability is wrongly paid, the taxpayer file a refund lawsuit filed in federal district court. This lawsuit requests that the IRS pay back the tax that has been wrongly paid. A taxpayer must pay the contested liability to gain access to this relief. For low-income taxpayers, the tax may be paid by seizures of later refunds or with an installment plan. The rules for a refund lawsuit are complex. A client who has been denied a refund should be immediately referred to a tax lawyer.

Generally, a refund suit is barred unless filed within 2 years after the date of mailing of the IRS’s Notice of Disallowance of the claim.1 Absent a Notice of Disallowance, there is no time limitation for filing a refund lawsuit.2 However, a taxpayer should not delay filing a lawsuit. Several courts have ruled that the 6-year limitation in 28 U.S.C. § 2401 applies as an outer limit.3 Be aware that the taxpayer may have signed a waiver of the Notice of Disallowance when the IRS originally denied the refund. Many low-income taxpayers do not know if they signed such a waiver or may forget to tell you. The 2-year period for a refund lawsuit begins running on the date the waiver is filed. If you are faced with a waiver, you should determine whether it is valid.4

I.R.C. § 7422(a) and § 6511(a) allow the filing of a refund lawsuit within 2 years of the payment of taxes. This opens up potential rights to a refund lawsuit that are more than 3 years after the original tax return was due. One common situation may arise with payments under an installment agreement. When a taxpayer pays the last payment on an installment agreement with the IRS, the right to sue for a refund accrues and the 2-year time clock begins running.5 For instance, a taxpayer who finally pays off a 2013 tax obligation in 2022 will now be able to sue for a refund of the 2013 overpayment.6

Another situation that may extend the time for filing a refund lawsuit occurs if a taxpayer has obtained an Earned Income Credit for a recent tax year. The IRS will offset that refund against taxes owed for prior years, sometimes 5 to 10 years earlier. If that offset extinguishes the prior year tax liability, the taxpayer then has the right to sue for a refund. Ordinarily, withholdings and credits are deemed to have been paid on the April 15th return deadline per I.R.C. § 6513. However, this statute does not apply when the refund claim arises from the application of an overpayment from one tax year to an outstanding tax liability for another tax year.7 In this situation, I.R.C. § 7422(d) applies and the date of offset is considered the date of payment.8 Therefore, the taxpayer will have the right to seek refund for the taxes paid within 2 years of the IRS offset.9

• 1I.R.C. § 6532(a).
• 2Consol. Edison Co. of N.Y. v. United States, 135 F. Supp. 881 (Ct. Cl. 1955); IRS CN Chief Counsel-2012-012, 2012 WL 2029785.
• 3Finkelstein v. United States, 943 F. Supp. 425 (D.N.J. 1997).
• 4See 26 C.F.R. § 301.6532-1(c)(1)–(4); IRS Nat’l Office Serv. Ctr. Advice, Assistant Chief Counsel Memorandum, No. 200202069 (Jan. 11, 2002), https://www.irs.gov/pub/irs-sca/0202069.pdf.
• 5I.R.C. §§ 7422(d), 6511(a).
• 6See, e.g., Dresser Indus. v. United States, 73 F. Supp. 2d 682 (N.D. Tex. 1999), aff’d, 238 F.3d 603 (5th Cir. 2001).
• 7Favret v. United States, No. 03-2322, 2003 WL 22888792 (E.D. La. Dec. 5, 2003).
• 8Id.
• 9Payment of taxes by IRS offset can be determined from the offset notice or a transcript of the taxpayer’s account.

An “assessment” is the timely recording of a taxpayer’s liability in accordance with IRS rules.1  Generally, assessments must be made by the IRS within 3 years after the filing of a return.2 The period is extended to 6 years if a return omitted more than 25% of the taxpayer’s gross income.3 The 3- or 6-year limit on assessment is referred to as the Assessment Statute Expiration Date (ASED). This period may be waived by the taxpayer. The assessment period does not begin if a tax return was fraudulent or not filed.4 There is no statute of limitation for assessment of a fraudulent return, and the subsequent filing of a non-fraudulent return does not avoid the unlimited statute of limitation for the original return.5 However, when the original fraud consists of not filing a return, a subsequent return triggers the 3-year limit on assessment.6

The taxpayer has a right to the IRS’s record of assessment. Transcripts of a taxpayer’s records may be ordered by tax professionals from the Practitioner’s Priority Service at (866) 860-4259. These transcripts can also be obtained by tax attorneys with access to the IRS online database through E-services. 

There are three different types of transcripts that are useful to a tax attorney. The first is the “account” transcript which will state the amount of tax liability and provide a timeline of actions taken by the taxpayer and the IRS for that tax year; it will also enable you to determine the expiration date for collections.7 The second is the “wage and income” transcript which show all information reported by third parties, such as W-2 and 1099 information, mortgage interest payments, IRA withdrawals, and cancellation of debt. The third transcript is the “tax return” transcript which provides a summary of the original tax return filed by the taxpayer. If the return is amended by the taxpayer or changed by the IRS, however, the “tax return” transcript will not be updated to show those changes. You will need to get that information from the client or by calling the IRS. 

• 1I.R.C. § 6203.
• 2I.R.C. § 6501.
• 3I.R.C. § 6501(e)(1).
• 4I.R.C. § 6501(c).
• 5I.R.C. § 6501(c)(1)–(2); Badaracco v. Comm’r, 464 U.S. 386 (1984). A preparer’s fraud can extend the statute of limitations. See Allen v. Comm’r, 128 T.C. 37 (2007).
• 6I.R.C. § 6501(c)(3); IRS Nat’l Office Field Serv. Advice, Assistant Chief Counsel Memorandum, No. 200051040 (Dec. 22, 2000).
• 7For guidance in spotting statute of limitations issues, see Am. Bar Ass’n, Effectively Representing Your Client before the IRS ch. 17 (8th ed. 2021). The IRS account transcripts will use code 150 to designate the assessment date. See Transaction Codes, Pocket Guide, IRS Document 11734 (Rev. 5-2012).

Generally, the IRS has 10 years after a timely assessment to collect taxes.1 The date after which the IRS may no longer collect taxes is referred to as the Collection Statute Expiration Date (CSED). The IRS Practitioner Priority Service (866-860-4259) will tell you the CSED. It is common for the IRS to miscalculate the CSED. Therefore, do not rely on the IRS calculation. If the IRS collection employee won’t review and decide a CSED defense, request a Taxpayer Assistance Order by a Form 911 from your Taxpayer Advocate Service office.

The 10-year time limit can be tolled by deficiency notices, Tax Court proceedings, collection due process hearings, requests for innocent spouse relief, Offers in Compromise, bankruptcy, Taxpayer Assistance Orders, and appeals of wrongful levies or liens.2 If the 10-year period is close to expiration, be careful about taking action that may extend limitations period.

Being placed into Currently Not Collectable status does not toll the CSED. If the suspension action was taken by a separated spouse, determine whether that action also suspended the limitation period as to your client. 

If your client lived in a federally declared disaster area, the I.R.S. may have extended the limitation periods under its I.R.C. § 7508 (A) authority. For example, after Hurricane Katrina, the IRS deadlines for collection were extended for 1 year.3

• 1I.R.C. § 6502.
• 2I.R.M. 5.1.19.3. Note that some cases may involve several actions that suspend the statute of limitations. See, e.g., I.R.M. 5.1.19.3.6.3 (giving the IRS’s position on how to calculate the suspension periods that result from an innocent spouse claim made within a collection due process appeal).
• 3IRS Notice 2006-20 (extending limitation periods to August 28, 2006 for taxpayers affected by Hurricane Katrina).

Previously, the IRS required taxpayers that could pay a monthly amount towards their liability but could not pay off the entire amount before the CSED to waive the protections of the CSED. It is now possible to request a “partial installment agreement”, which allows taxpayers to pay what they can afford until the CSED extinguishes the rest of their debts. To obtain this kind of agreement, a taxpayer must be able to provide complete financial documentation to show that the monthly amount is the most the taxpayer can afford to pay after paying basic expenses. Documentation includes paycheck stubs, public benefits award letters, bills, leases, and current bank statements. A partial installment agreement is particularly advantageous if a taxpayer can afford to make some payments towards the tax liability and wants to forestall other possible IRS collection actions, such as levies and bank account seizures.

The taxpayer generally wants to delay or defeat the collection process. Potential strategies may include showing that the lien or levy is invalid (e.g., the taxpayer did not receive the required notices), avoiding or suspending the levy, or convincing the IRS to pursue alternatives to collection.

IRS seizure of income and assets may cause a taxpayer to default on other debt, suffer eviction or foreclosure, lose a business or the means to make a living, or find it impossible to pay basic expenses. If a taxpayer seeks your help after a levy is already in place, you should act quickly to resolve the seizure or levy.

The Taxpayer Advocate may issue Taxpayer Assistance Orders (TAO) to stop collection activity. A TAO may be issued if the taxpayer is suffering or about to suffer a significant hardship due to IRS action or inaction or for circumstances set forth in IRS regulations.1

TAOs are most often issued when an actual or threatened seizure of a tax refund, bank account, pension plan, car, or wages will leave a taxpayer without enough money for basic necessities or when the seizure will cause the taxpayer to lose a primary home (including through eviction), a car necessary for work, or access to medical care or education. A Form 911 is used to apply for a TAO. The Louisiana Taxpayer Advocate can be reached at 504-558-3001 (phone) and 504-558-3348 (fax).2 If the levy has not yet started, the attorney should request Currently Not Collectable (CNC) status for the taxpayer before the deadlines to respond.3 This will stop most collection actions.

• 1I.R.C. § 7811(a).
• 2For more information on TAOs, see IRS Publication 1546; I.R.M. 13.1.7.2; 26 C.F.R. § 301.7811.
• 3For discussion of CNC status, see Section 6.6.2.

The IRS may seize property or income through the levy process once proper notice is given. A levy reaches every species of property owned by the taxpayer unless exempted by federal law.1 Essentially, the IRS steps into the taxpayer’s shoes and can reach the taxpayer’s interest in the property. The IRS will seize tax refunds and apply them to prior tax debt. Homes and vested retirement accounts are not exempt from seizure. Unemployment benefits, worker’s compensation, a modest amount of wages, furniture, household effects, and tools of a trade are exempt from seizure.2

• 1Drye v. United States, 528 U.S. 49 (1999).
• 2I.R.C. § 6334; 26 C.F.R. § 301.6334-1.

The IRS must obtain a federal court order to sell a principal residence for tax debts. Such collection actions are rare. A taxpayer’s principal residence is exempt from seizure for tax debts less than $5,000. For debts greater than $5,000, possible defenses to seizure include IRS noncompliance with the laws and procedures applicable to levy and the existence of reasonable collection alternatives. There may be other defenses if the home is jointly owned and the co-owner is not liable for the tax debt.1

Seizure does not automatically require a taxpayer to move out. The IRS will not evict a taxpayer after the sale; eviction can only be accomplished by the buyer, who must bring an eviction action in state court. 

Purchasing the property at a tax sale also does not grant the buyer full title to the house. After the sale, the taxpayer has 180 days (not 6 months) to redeem the property by paying the full bid price plus interest at 20% per annum.2 If the taxpayer plans to redeem, it may be possible to rent from the purchaser until the taxpayer completes the redemption process.

• 1The district courts have some discretion under I.R.C. § 7403 to deny a foreclosure sale where the IRS holds a lien on only part of the house. See, e.g., United States v. Rodgers, 461 U.S. 677 (1983); United States v. Winsper, 3:08CV-631-H, 2010 WL 4638598 (W.D. Ky. Nov. 4, 2010) (finding that expectation of non-liable spouse was a factor weighing in favor of denying foreclosure), rev’d on other grounds, 680 F.3d 482 (6th Cir. 2012) (reversing denial of foreclosure due to district court’s abuse of discretion on other factors); United States v. Jensen, 785 F. Supp. 922 (D. Utah 1992) (harm to terminally ill nondebtor outweighed delay to IRS); United States v. Jones, 877 F. Supp. 907 (D.N.J. 1995) (nondebtor wife kept house in return for ½ rent payments to IRS); see also United States v. Craft, 535 U.S. 274 (2002) (holding that I.R.C. § 6321 federal tax lien attaches to taxpayer’s rights in “entireties property” even though state law exempts entireties property from creditors’ claims that are only against one spouse); IRS Chief Counsel Notice 2003-60, (IRS position on Craft).
• 2I.R.C. § 6337.

Generally, levy cannot be made on wages or property until the IRS has given the taxpayer the 30-day written notice of intent to levy required by I.R.C. § 6331(d).

The IRS uses a Form 668-W to levy wages. If the taxpayer has a levy notice, determine the current stage of the levy process. Generally, the taxpayer will receive 3 statutory notices before the actual levy:

• 10-day Notice and Demand for Payment1
• Final Notice Before Levy2
• Final Notice of Intent to Levy and Collection Due Process hearing opportunity at least 30 days before proposed levy3

The last notice is CP notice 90. However, if the IRS is going to levy Social Security benefits, it must issue a CP notice 91. The IRS can levy up to 15% of Social Security Retirement, Railroad Retirement, Spousal and Survivor, and Disability benefits. The IRS will not levy Supplemental Security Income (SSI). 

• 1I.R.C. § 6331(a).
• 2Id.
• 3See I.R.C. §§ 6330(a), 6331(d).

There are various strategies for responding to a wage levy:

• Claim the highest exemption possible. Generally, the IRS will levy based on 1 exemption and single-filing status. A taxpayer who is married or has children may claim a higher exemption amount and a more favorable filing status. The amount the taxpayer pays for support established by court order is exempt from levy. If the taxpayer or the taxpayer’s spouse is at least 65 years old or blind, an additional standard deduction is available. Use Form 668-W.1
• Ask for a reduction of the levy based on economic hardship. If the levy will cause economic hardship, but the taxpayer can afford to pay a lesser amount, file for a reduced levy. The IRS will require the taxpayer to complete and sign a Form 433-A and list income, expenses, and assets.
• File or call for “Currently Not Collectible” (CNC) status if the taxpayer cannot afford to make any payments toward the tax liability after paying basic expenses and does not have an asset that can easily be liquidated to pay the liability. Many low-income taxpayers can be placed in CNC status if collection would cause undue hardship by leaving them unable to meet necessary living expenses. Basic living expenses include food, household items, rent or mortgage payments, a car note, gas, homeowners or car insurance, and funds for medications. The IRS website contains the list of standard costs for each of these expenses, which may be based on the number of people in the household or the parish in which the taxpayer lives. These costs are known as Collection Financial Standards. If your client’s expenses are higher than these standard amounts, you will have to submit documentation of the expense and argue that it is justified. The IRS will usually not expect taxpayers to sell their residence. The agency also allows one vehicle per taxpayer, and so a married couple with joint liability can keep two vehicles. This analysis may change if the home or vehicle has a lot of equity. The IRS may then require the taxpayer to obtain a mortgage if the taxpayer can afford to make the monthly payments and pay the liability with the loan proceeds. If a vehicle is very valuable, the IRS may require the taxpayer to sell it for a cheaper vehicle and give the IRS the difference. If the tax liability is less than $10,000, the attorney can request CNC status by calling the number on the collection form and providing the financial information. You may be asked to fax supporting documentation to the IRS agent. This could be Social Security award letters, paycheck stubs, bills, or recent bank statements. If the taxpayer owes more than $10,000 for all years of liability, the IRS will require a Form 433-A or 433-F that is signed by the taxpayer. This can be faxed to the IRS agent when you call in. The IRS must release a levy upon a determination of CNC status.2 The IRS agent may say that the taxpayer needs to file missing tax returns before the request for CNC status can be processed, but this is not true. The IRS may not deny a release for hardship because the taxpayer has failed to file tax returns.3 If an agent makes this demand, you should ask to speak with a manager. You may need to enlist the help of the Taxpayer Advocate Service if the IRS refuses to release a levy on the ground of the taxpayer’s failure to file returns. Although CNC status will stop most collection actions, the IRS can still file liens after CNC status has been approved, and it often does, which may be a consideration when seeking this remedy. The IRS can also still seize tax refunds for past liability even if the taxpayer is in CNC status.
• File a collection due process appeal on Form 12153 if you need more time to gather information or financial documentation. A collection due process appeal will generally stop the IRS from making a levy while the appeal is pending. Collection alternatives and other defenses can be pursued in a collection due process appeal.4
• Ask for a brief suspension of the levy if the taxpayer can pay the liability. The IRS has authority to suspend collection activity for up to 120 days for individuals to allow the taxpayer to gather the funds to pay the liability.5 This is often referred to as the “Fresh Start” program. Interest and penalties will not accrue during the 120-day period. If the taxpayer fails to pay the liability in full by the requested deadline, however, all accrued interest and penalties will be added to the amount owed.
• Submit a proposal for an Installment Agreement or Offer in Compromise. Levies are suspended while an Installment Agreement or Offer in Compromise is under consideration or in effect. The suspension continues if denial of the Installment Agreement or Offer in Compromise is appealed to an IRS appeals officer.

• 1See IRS Pub. 1494.
• 2I.R.C. § 6343(e).
• 3Vinatieri v. Comm’r, 133 TC. 392 (2010); IRS Notice CC-2011-005; I.R.M. 5.11.2.2.1, .19.1.7.1.5.
• 4The taxpayer has 30 days to appeal a levy to an IRS Appeals Officer. I.R.C. § 6330(b); 26 C.F.R. § 301.6330-1(b)(1). If a taxpayer timely requests an appeal, the IRS may not levy while the appeal is pending. I.R.C. § 6330(e). Use Form 12153 to appeal.
• 5I.R.M. 5.14.5.5.

An employer who fires an employee because of an IRS wage levy may have violated 15 U.S.C § 1674.1 The taxpayer does not have a private cause of action to enforce this law.2 The U.S. Department of Labor polices employer violations and may seek reinstatement and back pay.3

• 1Martin v. Hawkeye Int’l Trade, Inc., 782 F. Supp. 1320 (S.D. Iowa 1991).
• 2Smith v. Cotton Bros. Bakery Co., 609 F.2d 738 (5th Cir. 1980).
• 3Martin, 782 F. Supp. 1320.

A bank levy is a one-time levy that reaches the deposits at the time of the levy. I.R.C. § 6332(c) only requires banks to hold funds subject to levy for 21 days. So, a taxpayer or a joint account holder must act quickly to prevent the levy from being executed. The IRS may ask the bank to hold the funds longer than 21 days if another person claims ownership of the funds.

The IRS may seize a taxpayer’s bank account even if it includes exempt wages or exempt Social Security benefits.1 The IRS may even seize an account that the taxpayer does not own but from which the taxpayer has the right to withdraw funds. When this happens, account owners must act quickly to convince the IRS that they—not the taxpayer—own the funds. 

If the bank transfers the levied funds to the IRS, non-liable account holders must use the wrongful levy procedures to recoup their funds from the IRS. To do so, they must file a Form 4528 within 9 months. If you can’t secure the returns of the funds within 9 months, you should file suit before the 9-month period elapses.2

• 126 C.F.R. § 301.6334-2(b); I.R.M. 5.11.4.5.
• 2I.R.C. § 7426(a)(1); EC Term of Years Tr. v. United States, 550 U.S. 429 (2007). There may be a due process exception to the 9-month rule in some circumstances. See Scheafnocker v. Comm’r, 642 F.3d 428 (3d Cir. 2011).

The IRS may issue a continuous levy which takes 15% of a taxpayer’s Social Security check on a monthly basis.1 The IRS has decided not to levy on SSI benefits even though the law allows this. Ask for release of the levy based on economic hardship or seek Currently Not Collectible status based on hardship.2 If the tax liability is $10,000 or more, the IRS will require Form 433-A collection information statement from the taxpayer and will conduct the analysis of hardship based on its financial standards. If the taxpayer’s only income is Social Security, a collection information statement may not be required for the hardship determination.3

• 1I.R.C. § 6331(h).
• 226 C.F.R. § 301.6343-1(b)(4); I.R.M. 5.11.2.2.1.2, .4.
• 3I.R.M. 5.16.1.2.9.

Circumstances under which a levy may be released include:

• The liability is satisfied or becomes unenforceable.
• The release will facilitate collection (i.e., the property will be sold and proceeds transferred directly to the IRS).
• The taxpayer enters an installment agreement.
• The levy causes economic hardship to the taxpayer (e.g., Currently Not Collectable status).
• The fair market value of the asset exceeds the liability and release will not hinder collection.1

• 1I.R.C. § 6343(a); I.R.M. 5.11.2.2.1.

A federal tax lien is the IRS’s legal claim to property as security or payment for a tax debt. The claim arises “automatically” under I.R.C. § 6321 and attaches to every interest in property and rights owned by a taxpayer without regard to their location.1 This statutory lien is often referred to as a “secret lien” because it arises even if not publicly recorded.2 The lien also attaches to after-acquired property other than property acquired after a bankruptcy in which taxes were discharged. Federal tax liens even attach to property exempt from seizure under state law.3 Exemption from levy under federal law does not bar a lien on the exempt property.4 The IRS may seek to enforce the lien against exempt property by a foreclosure lawsuit under I.R.C. § 7403, but this is unlikely.

If a taxpayer does not pay a bill, the IRS will generally send a Notice of Federal Tax Lien which demands payment within 10 days.5 The Notice will threaten the filing of a tax lien in the public records office if the bill is not paid.6 A tax lien is not self-enforcing. To enforce a tax lien, the IRS must administratively levy the property or income or bring a foreclosure suit under I.R.C. § 7403.

• 1Drye v. United States, 528 U.S. 49 (1999).
• 2IRS Chief Counsel Memorandum, No. 200634012 (June 23, 2006).
• 3Drye, 528 U.S. 49; Medaris v. United States, 884 F.2d 832 (5th Cir. 1989).
• 4Matter of Sills, 82 F.3d 111 (5th Cir. 1990).
• 5IRS personnel are directed to file liens for tax debts that are $10,000 or more and may file for lesser debts.
• 6Note that the filing of a lien on a taxpayer’s home may trigger a technical default if the mortgage has a “‘no lien” clause.

Because a lien attaches to inherited property, renunciation of an inheritance won’t defeat the lien. It will still attach to the property despite Louisiana succession law that allows for renunciation that defeats creditors’ claims.1 If the IRS has filed a lien in the parish conveyance records, attempts to evade payment by transferring the property with a donation or renunciation could be construed as fraud.

• 1Drye v. United States, 528 U.S. 49 (1999).

A taxpayer may appeal a Notice of Federal Tax Lien by filing a Form 12153 within 30 days.1 Grounds for appeal include:

• IRS noncompliance with law or administrative procedures2
• Spousal defenses, such as innocent spouse relief
• Challenges to the appropriateness of collection actions
• Collection alternatives such as an installment agreement or an Offer in Compromise (OIC)3
• Assessment of tax or filing of lien while a bankruptcy stay was in effect
• Expiration of the time to collect the tax prior to the lien
• Taxpayer’s opportunity to dispute the asserted liability
• Full payment of taxes before the lien was filed

Lien appeal decisions by the IRS Appeals Officer are reviewed by the Tax Court under an abuse of discretion standard. The petition for judicial review must be filed within 30 days.4

• 1See 26 C.F.R. § 301.6320-1.
• 2In a “CDP” appeal, check for compliance with all applicable I.R.M. procedures. See Murphy v. Comm’r, 125 T.C. 301, 307 (2005).
• 3If a taxpayer appealing a lien seeks an OIC, the IRS Appeals agent will then transfer the case to the IRS office that processes OICs. Unlike with a “standalone” OIC, the denial of an OIC as part of a lien appeal can be judicially reviewed by the Tax Court. For a complete discussion of Offers in Compromise, see Section 7.3.
• 4I.R.C. §§ 6320(c), 6330(c)–(e). Joint Comm. on Taxation, Summary of the Conference Agreement on H.R. 2676, No. JCX-50-98R, at 132 (June 24, 1998).

There are several ways to remove an IRS lien.

Release–I.R.C. § 6325(a). A recorded lien can be released if the tax liability is satisfied or becomes legally unenforceable.1 A lien becomes unenforceable upon expiration of the 10-year statute of limitations for collection unless the IRS brings timely suit and wins judgment, at which point the lien is extended indefinitely.2 Since the 1980s, the IRS has used “self-releasing” liens that contain the date that the lien is released due to the 10-year statute of limitations. This date may not be correct, however, as the taxpayer may take actions that toll the statute of limitations, such as filing a bankruptcy or submitting an Offer in Compromise. The tax attorney should calculate when the liability becomes legally unenforceable after reviewing the account transcript of all actions taken by the taxpayer. If needed, the IRS will issue a certificate of release within 30 days after the lien is paid or becomes legally unenforceable, but the taxpayer must request the certificate. Absent a request, the IRS will not take action to cancel or release a lien and will instead rely on the expiration date listed on each lien. IRS Publication 1450 explains how to request a certificate of release.

Surprisingly, taxpayers often don’t know whether the lien has been satisfied or has expired. You may be able to review the actual lien in the public records; in Louisiana, these records are maintained by the Clerk of Court for each parish. Information on the lien’s payment status can also be obtained from the IRS lien staff or from an IRS account transcript. Inquiries about routine lien releases and current payoff amounts can be made to IRS customer service unit, 800-913-6050.

Withdrawal–I.R.C. § 6323(j). A withdrawn lien is treated as if it never existed. The IRS may withdraw a lien if the filing was premature or made in violation of administrative procedures or if the liability is being paid through an installment agreement or an Offer in Compromise.3 If these conditions are met, a Certificate of Release of Lien (Form 668Z) may be obtained from the IRS and filed in the public records. If the lien was filed in error, the IRS Certificate of Release should so state to minimize damage to the taxpayer’s credit rating.4 Use Form 12227 to request a withdrawal of a lien.

Discharge–I.R.C. § 6325(b). A discharge may be sought by a taxpayer who wants to sell or refinance a specific property. The taxpayer will have to agree that the tax liability will be paid at the time of sale/refinancing, with a check going directly to the IRS. If the taxpayer owns property with co-owners, only the taxpayer’s share of the proceeds will be affected. A certificate of discharge can also be issued if the taxpayer’s other property has value double of unpaid balance secured by lien, the taxpayer pays the value of interest IRS has in the property, or the taxpayer agrees that proceeds of sale will be substituted for the property (while parties sort out priorities of their claims). Use Form 14235 to discharge a lien on a specific asset.

Subordination–I.R.C. § 6325(d). Liens may be subordinated to a lender or other creditor. Subordination is a process whereby the IRS allows a creditor to move ahead of the IRS’s lien position. For example, the IRS may consent if the property will be mortgaged, and the funds used to pay the tax liability. IRS Publication 784 sets forth the procedures for the subordination of federal tax liens. To obtain a certificate of subordination, contact the IRS Advisory Group Manager for your area. The addresses can be found in IRS Publication 4235. Request subordination by filing a Form 14134 along with supporting documents.

Non-attachment–I.R.C. § 6325(e). A certificate of non-attachment states that the lien does not attach to the property of a person. This procedure is used when your client is not the person who owes the taxes but is being hurt by the lien because that person has the same or a similar name.5

• 1I.R.C. § 6325.
• 2I.R.C. §§ 6322, 6502(a); Markham v. Fay, 74 F.3d 1347, 1353 (1st Cir. 1996).
• 3I.R.C. § 6323; Internal Revenue Serv., Pub. No. 1468, Guidelines for Processing Notices of Federal Tax Lien Documents (2014).
• 4I.R.C. § 6326(b).
• 5See Internal Revenue Serv., Pub. No. 1024, How to Apply for a Certificate of Non-Attachment of a Federal Tax Lien (2016).

Most legal aid clients will be candidates for “Currently Not Collectible” (CNC) status. A taxpayer may be placed in CNC status if collection would cause undue hardship by leaving the taxpayer unable to meet necessary living expenses.1 A levy on wages must be immediately lifted if the taxpayer is placed CNC status.2 A taxpayer may receive CNC status even if there are unfiled tax returns.3

• 1I.R.M. 5.16.1.1, .2.9.
• 2I.R.C. § 6343(e); I.R.M. 5.16.1.2.9(7).
• 3Vinatieri v. Comm’r, 133 T.C. 392 (2009); I.R.M. 5.16.1.2.9, 8.22.7.7(4).

A taxpayer is eligible for CNC if collection would make the taxpayer unable to meet necessary living expenses, thereby causing undue hardship. The individual taxpayer’s financial information generally must be compiled on a Form 433-A.1 If the taxpayer has assets that can easily be liquidated to pay the liability, the IRS may deny the request for CNC status. Such assets can include whole life insurance policies, retirement accounts, extra vehicles, boats, or campers.

To be “necessary” expenses must be “necessary to provide for a taxpayer’s and his or her family’s health and welfare or production of income.”2 The IRS uses various standards to determine the allowable amount of these expenses. Expenses for clothing, food, housekeeping, personal care, and out-of-pocket health care automatically use the national standard. A taxpayer who claims more than the amount set in the national standard must substantiate and justify each separate expense of the total national standard.3 For housing and transportation, taxpayers are allowed the lesser of the local standard or the amount actually paid.4 The current national and local standards can be found on the IRS website and in I.R.M. 5.15.1.2. “Other expenses” may be considered if they meet the necessary-expense test.5 Examples of “other expenses” found necessary by the IRS include taxes, secured debt, and court-ordered payments.6

It is generally a good practice tip to ask your client to give you at least 3 months of complete bank statements to support your request for CNC status. These statements can usually be accessed online. Modern electronic banking has resulted in most income being deposited into, and expenses directly paid from, bank accounts. These statements can give you a clear picture of your client’s current financial situation. If there are any unexplained deposits or withdrawals, you should consult with your client about these items. You may find that a low-income client is sharing an account with children or other family members or is receiving one-time gifts to pay bills. 

• 1I.R.M. 5.16.1.2.9.
• 2I.R.M. 5.15.1.8.
• 3Id.
• 4I.R.M. 5.15.1.9.
• 5I.R.M. 5.15.1.10.
• 6Id.

CNC status suspends collection but does not forgive or compromise the tax or release liens. As a result, interest and penalties continue to accrue. The IRS will also continue to offset future tax refunds. However, because CNC status does not toll the collection limitation period, the 10-year statute of limitation for collection continues to run.

A taxpayer who is not financially able to pay a tax debt immediately may make monthly payments through an installment agreement. The IRS generally will not take collection actions while an installment agreement is being considered, in effect, or on appeal.

The minimum monthly payment on an installment agreement is $25. The time period for installment agreements varies. Generally, the installment agreement should not extend beyond the time remaining on the collection statute of limitation. Low-income taxpayers who pay a small monthly payment may not be reducing their principal tax debt given the interest rates charged on the taxes owed. The fees for setting up installment agreements also vary. Most low-income taxpayers will qualify for a reduced $43 set-up fee; apply for this reduced fee using Form 13844.

Taxpayers who owe less than $50,000 may apply for a guaranteed or streamlined installment agreement by several methods: (1) apply online (2) call the phone number on the IRS notice or bill or (3) complete and mail a Form 9465, Installment Agreement Request. A taxpayer who owes more than $50,000 will have provide additional financial information on a Form 433-F.

A taxpayer who can pay the full amount owed within 120 days may want to apply for a 120-day suspension of collection activity to provide time to gather the funds.1 In cases of financial hardship, a longer suspension of collection activity may be possible.2 This procedure allows the taxpayer to avoid the fees for setting up an installment agreement.

• 1I.R.M. 5.14.5.5.
• 2I.R.C. § 6161(a)(1); 26 C.F.R. § 1.6161-1(a).

The IRS will always want the liability to be paid off before the Collection Statute Expiration Date (CSED). If the CSED is near, the monthly payments needed to pay the liability may be higher than the taxpayer can afford. Partial installment agreements are now authorized.1 This is appropriate when the taxpayer can afford to make a monthly payment, but the amount will not pay off the entire liability before the CSED. Taxpayers who request partial installment agreements will have to show that they cannot pay more each month after paying basic expenses and that they do not have any assets that can be liquidated to pay off the entire liability. If the partial installment agreement is accepted, the taxpayer will make the required payments until the CSED at which point the liability will be extinguished. The advantage of a partial installment agreement is that the IRS will not take other collection actions while the monthly payments are being made.

• 1I.R.C. § 6159; I.R.M. 5.14.2.1.

A taxpayer will qualify for a “guaranteed” installment agreement without a financial analysis if the taxpayer owes less than $10,000, has been in tax compliance for the 5 prior years, and can fully pay the tax within 3 years.

An individual taxpayer may apply for a streamlined installment agreement if the aggregate unpaid balance is less than $50,000 and can be fully paid within 72 months.1 Full compliance (including filing of tax returns) is required for a streamlined installment agreement. A streamlined installment agreement can be granted without submission of a collection information statement or financial documents to the IRS. Most installment agreements obtained for taxpayers fall in this category.

• 1Memorandum SBSE 05-0112-013 (Jan. 20, 2012); see also I.R.M. 5.14.5, .10 (providing I.R.M. implementation rules).

A taxpayer who does not qualify for a guaranteed or streamlined installment agreement will have to apply for a regular installment agreement. This procedure requires completion of a Form 9465-FS and a Form 433-F collection information statement. Form 433-F is used to analyze the taxpayer’s ability to pay based on IRS collection financial standards. The IRS generally does not grant regular installment agreements if the taxpayer can fully pay the liability from assets and disposable income. In general, the IRS will usually grant an installment agreement if the liability will be paid within 6 years or before the CSED, even without financial documentation.

Taxpayers may pay installment agreements by check, money order, direct debit from a checking account (Form 433-D), payroll deduction (Form 2159), Electronic Federal Tax Payment system, or credit card. A direct debit installment agreement may qualify a taxpayer for withdrawal of a lien after 3 months of probation.1 The set-up fee for the installment agreement will also be lower for those who choose direct debit.

• 1I.R.C. § 6323(j)(2)(B); Memorandum No. SBSE-05-0411-036 (April 7, 2011).

Once the installment agreement is approved, the IRS and the taxpayer are bound by the agreement unless the taxpayer misses a payment, fails to file tax returns, provided inaccurate information during the negotiations, or has a changed financial condition. Denials or terminations of installment agreements may be appealed using Form 9423 and later reviewed in Tax Court under the abuse of discretion standard. The IRS will reinstate an installment agreement one time upon payment of a reinstatement fee. A taxpayer who is in danger of default on an installment agreement should contact the IRS. It is possible to get a temporary hold on payments.

You have heard TV ads about settling IRS debt for pennies on the dollars? These tax debt settlement firms are peddling help with filing an “Offer in Compromise” (OIC).  An Offer in Compromise (OIC) is a settlement in which the taxpayer offers to pay less than the amount owed. An OIC can provide substantial relief to a qualified taxpayer. Indigent and disabled taxpayers, with no assets, can settle tax debt for very small amounts. The analysis is similar to requesting CNC status, but the attorney will have to argue that the taxpayer’s inability to pay the full liability is permanent.

Tax lawyers at legal aid programs help taxpayers with OIC applications for free. Some private firms scam taxpayers by taking fees as high as $3,000 and then doing very little to get the IRS to approve the OIC. These firms often fail to provide the back-up documents and focused negotiation required for a successful OIC. Some firms also take fees from taxpayers who have no chance of getting an OIC such as taxpayers with substantial retirement accounts or real estate holdings.

An OIC may be submitted on the basis of doubt as to collectability, doubt as to liability, or effective tax administration.1 Most offers are submitted for doubt as to collectability. This generally requires a showing that the taxpayer cannot afford to pay the liability and does not have assets that can easily be liquidated to pay the liability and that this situation is permanent. Many elderly and disabled persons with limited income are eligible to receive an OIC on this basis. 

• 1I.R.C. § 7122.

An OIC is initiated by filing a Form 656, which requires information and supporting documentation of the taxpayer’s income, assets, and expenses. The filing fee is a non-refundable $186. However, the fee may be waived for a taxpayer whose income is below 250% of the poverty line.1 A taxpayer must file all required tax returns in order for an OIC to be considered. This may lead to the taxpayer incurring more liability before all of the liability can all be settled with an OIC. You may need to request CNC status for your client while the tax returns are being processed or the OIC is being prepared. Collection actions are suspended while the OIC is being processed by the IRS. 

The purpose of the Offer in Compromise program is to settle tax debts for the maximum amount that the taxpayer can pay from net current assets and future income potential. The amount of the offer is computed as the sum of net realizable assets2 and gross income minus necessary living expenses. Even if the computed “offer” amount is zero, the taxpayer must still offer at least $1. The Internal Revenue Manual has extensive rules on how the maximum collection potential is determined.3 After the filing of the Offer, an attorney will often need to advocate with the IRS for the proposed offer amount. The Internal Revenue Manual rules are useful in this advocacy since the IRS is supposed to follow them.4 IRS requests for additional information should be timely responded to.

The IRS may allow the taxpayer to pay off the debt in a lump sum payment or in installments over a period of time, usually between 6 months and 2 years.5  In the latter case, the taxpayer will be given a fixed monthly payment amount. Be sure to structure a realistic compromise that provides the taxpayer with adequate means for basic living expenses.

If an OIC is accepted, a taxpayer must file tax returns and pay taxes owed for the next 5 years. Non-compliance could result in a default and enforcement of the compromised taxes by the IRS. Be sure to advise your client of the duty to file and pay taxes per the OIC agreement. Document your advice in writing.

Levy is suspended while an OIC is pending or in effect.6 The IRS is not required to release a prior levy upon the taxpayer’s filing of an OIC. However, it will usually release the levy if the taxpayer shows economic hardship. 

A “rejection” of an OIC may be appealed to the IRS Appeals Office.7 The rejection notice should state specific reasons why the OIC was not accepted so the taxpayer can respond in an appeal. Levy is suspended pending an appeal.8 If the OIC was submitted as part of a collection due process hearing, the rejection may be appealed to Tax Court under an abuse of discretion standard.9

If an OIC is “returned”, this means that the OIC was incomplete and that the OIC agent attempted to contact the taxpayer and/or the representative but did not get a response. The IRS takes the position that a “returned” OIC cannot be appealed and that the only remedy is to submit a new OIC. Some OIC agents seem to quickly return an Offer without giving adequate time to respond or even ignore phone messages or faxes sent by the taxpayer. If this is the case, the matter should be appealed to the OIC agent’s supervisor and possibly IRS Appeals. 

• 1Use Form 656A for waiver of the fee.
• 2“Net realizable assets” equals the Quick Sale Value of an asset (generally 80% of fair market value) minus the first encumbrance, fix-up costs, broker fees, etc.
• 3I.R.M. 5.8.5; 5.15.
• 4Fairlamb v. Comm’r, T.C. Memo 2010-22.
• 5I.R.M. 5.8.1.10.4.
• 6I.R.C. § 6331(k).
• 7I.R.C. § 7122(e); see I.R.C. §§ 6320, 6330; Rev. Proc. 2003-71 (Collection Appeals Program). Returns of Offers for additional information are not “rejections.”
• 8I.R.C. § 6331(k).
• 9See, e.g., Blosser v. Comm’r, T.C. Memo 2007-323; Samuel v. Comm’r, T.C. Memo 2007-312.

Taxpayers who own their own homes may have equity. Although the IRS will generally not require a taxpayer to sell the home, the agency may require a taxpayer to obtain a bank letter denying a mortgage on the home. Thus, a client who has equity in a home but whose income is too limited to get a mortgage may still be eligible for an OIC. 

The IRS will generally allow a taxpayer to have one vehicle for personal use unless it is an especially valuable vehicle with a lot of equity. 

A taxpayer may also have whole life insurance, savings, or a pension that could satisfy the tax liability. If the attorney can show that these funds are needed to pay future living expenses, the taxpayer may be able to keep these assets and still be approved for an OIC. The attorney will have to show that the taxpayer’s income is insufficient to pay for basic expenses, that this situation is permanent, and that the asset is needed to offset the negative income for the remainder of the taxpayer’s life. Use the Social Security life expectancy charts when making this argument. These charts can be found online at the Social Security website. 

Possible disadvantages to an OIC include an extension of the 10-year statute of limitation by the pendency of the offer plus 1 year, forfeiture of certain tax refunds, filing of tax liens to protect the IRS’s interests, adverse impact on bankruptcy options, and, if the taxpayer defaults on the offer, reinstatement of the full debt plus penalties and interest.1 An OIC will also preclude a subsequent innocent spouse claim for a tax year covered by the OIC.2 Until recently, even when an OIC was accepted, the IRS could still seize the next year’s tax refund. This policy has now been changed so that no new seizures will occur after the OIC is accepted. 

• 1The IRS will not process an Offer in Compromise for a taxpayer who is in bankruptcy. See Rev. Proc. 2003-71; I.R.B. 2003-36.
• 2I.R.M. 25.15.5.15.

Always order an account record or tax transcript from the IRS for a client filing a bankruptcy. You may want to obtain transcripts for the last 15 years to make sure all needed returns have been filed. The client may not be sure of the amount of liability or the years owed. This information will help you to determine what taxes are owed and whether they are dischargeable. Without accurate information on the assessment dates and tax return filing dates, you may file a bankruptcy before a tax becomes dischargeable and saddle the debtor with tax debt that could have been discharged. Also, a tax transcript or account record will enable you to verify that your client has filed all required tax returns.

At least 7 days before the first date set for the creditors meeting, the debtor must provide the trustee with a copy of the federal income tax return (or tax transcript) for the most recent year ending before the commencement of the case, if a return was required for that year.1 A copy of this return must be given to any creditors who request one at least 14 days before the first date set for the creditors meeting.2 The bankruptcy court may dismiss the petition of a debtor who fails to file a required return or transcript.3 If an interested party has filed a motion to dismiss of these grounds, the debtor must show that the failure to file was due to circumstances beyond the debtor’s control.

Because most low-income taxpayers use professional tax preparation services, a copy of a lost return can usually be obtained from the tax preparer. Attorneys who work for Low-Income Taxpayer Clinics also have immediate electronic access to IRS tax transcripts provided the client signs a Form 2848 authorizing the low-income tax clinic attorney to represent the client in tax matters for the relevant years. If these options are not available, you should immediately file an IRS Form 4506-T to obtain the client transcripts for the tax year in question. 

• 111 U.S.C § 521(e)(2)(A).
• 211 U.S.C. § 521(e)(2)(A)(ii); Fed. R. Bankr. P. 4002(b)(4).
• 311 U.S.C. § 521(e)(2)(B).

Chapter 13 debtors must file all required tax returns for tax periods ending within 4 years of the debtor’s bankruptcy filing. These must be filed before the first meeting of the creditors. A debtor may request that a trustee hold the creditors meeting open for an additional 120 days to enable the debtor to file the required returns. The failure to file the required returns will prevent confirmation of a Chapter 13 bankruptcy plan and will result in the dismissal of the Chapter 13 case or conversion to case under Chapter 7.

For all bankruptcies, a debtor must file any tax return that becomes due after the commencement of the bankruptcy case or obtain an extension for filing the return before the due date. If the debtor fails to timely file required returns or extensions, a taxing authority may request that the court dismiss the bankruptcy or convert it to another chapter of the Bankruptcy Code. If the debtor does not file the required return or obtain an extension within 90 days after the taxing authority’s request, the court must dismiss or convert the case. You should advise bankruptcy clients of their duties to file tax returns and ensure that they comply.

Certain income tax debts may be discharged in a Chapter 7 or a Chapter 13 bankruptcy. In a bankruptcy, you should always evaluate whether any of the income tax debt can be discharged. Many attorneys mistakenly assume that federal tax debt cannot be discharged. The rules for determining whether an income tax is dischargeable are very complex.1  The analysis should be done for each tax year.

If most of the client’s debt is federal tax, an Offer in Compromise may provide the client with better relief from his tax debt than a bankruptcy.2  In some cases (e.g., if the taxpayer filed the tax return after the IRS assessed the tax by a Substitute for Return), an Offer in Compromise may be the only option.

• 1See Nat’l Consumer L. Ctr., Consumer Bankruptcy Law and Practice § 15.4.3.1.1 (12th ed. 2019); Effectively Representing your Client Before the New IRS ch. 21 (ABA 8th ed. 2021); Morgan D. King, Discharging Taxes in Consumer Bankruptcy Cases (2012).
• 2For a complete discussion of Offers in Compromise, see Section 7.3.

Income taxes are dischargeable only if six separate tests are each met.

The Timely-Filed Return Test. 11 U.S.C. § 523(a) prohibits discharge of tax debt in the absence of a return. The First, Fifth, and Tenth Circuits have ruled that a tax, where the return is late, is not dischargeable. This has become known as the “one-day-late” rule. This means that a taxes on a return filed even one day late are not dischargeable. In a 2010 Chief Counsel notice, the IRS declared that a late filed tax return would not bar bankruptcy discharge of the related tax unless the return was filed after an assessment pursuant to § 6020(b) Substitute for Return.1  Nevertheless, the Fifth Circuit has continued to hold that a late-filed return (with the possible exception of a return filed pursuant to I.R.C. § 6020(a)) can never be a “return” for bankruptcy discharge purposes.2

The 3-year tax return due date test. To satisfy this test, the tax return must have been due at least 3 years before the bankruptcy filing.3  For example, if a 2022 tax return was due on April 15, 2023, the bankruptcy petition must be filed after April 15, 2026 for the 2022 income tax to be dischargeable.4  The 3-year lookback period may be suspended by bankruptcy and collection due process appeals.5  Offers in Compromise don’t suspend the 3-year period.6

The 2-year tax return filing date test. To satisfy this test, the tax return must have been filed at least 2 years before the bankruptcy filing. This test will exclude debtors with unfiled returns and certain late-filed returns. For example, if a 2022 tax return was not filed until April 15, 2024, the bankruptcy could not be filed until after April 15, 2026, if the debtor seeks to discharge the 2022 income taxes. Note that the “filing date” in the IRS records may be weeks or even months after the debtor mailed the return to the IRS. The only way to know the IRS filing date is to obtain the tax transcript or account record from the IRS.

A Substitute for Return will not qualify as a tax return for the purposes of this test.7  The IRS also maintains that a tax can’t be discharged if the taxpayer filed the tax return after the IRS assessed a tax deficiency following the taxpayer’s failure to respond to the 90-day deficiency letters based on the IRS’s preparation of a Substitute for Return.8

The assessment date test. For a tax debt to satisfy this test, the IRS must have assessed the tax against the tax debtor at least 240 days before the bankruptcy petition was filed. You can only determine the assessment date by reviewing the IRS tax transcript or account record.9  Generally, assessment is made within 3 years of the tax return’s due date. You don’t want to file a bankruptcy petition before 240 days (with extensions) has run from the assessment. The 240-day period may be extended if the taxpayer filed a prior bankruptcy in which case, the length of the bankruptcy plus 6 months must be added to the time periods.10  Offers in Compromise, collection due process appeals, and Taxpayer Assistance Orders may also toll or increase the time requirements.11

The fraud or willful evasion test. A fraudulent return or a willful attempt to evade or defeat tax will prevent discharge of the tax debt.12  The IRS bears the burden of proof on fraud or evasion.13

The timely notification test. To discharge a tax, the debtor must notify the IRS of the bankruptcy in time for the IRS to file a timely proof of claim.14

• 1Internal Revenue Serv., Chief Counsel Notice, No. CC 2010-016 (Sept. 2, 2010), For a more extensive discussion of a Substitute for Return, see Section 6.2.
• 2See, e.g., In re McCoy, 666 F.3d 924 (5th Cir. 2012) (interpreting post-2005 language of 11 U.S.C. § 523(a)(1)(B)(i)); In re Fahey, 779 F.3d 1 (1st Cir. 2015); In re Mallo, 774 F.3d 1313 (10th Cir. 2014).
• 3For an example of the interplay between the look back periods, see Severo v. Comm’r, 129 T.C. 160 (2007), aff’d, 586 F.3d 1213 (9th Cir. 2009).
• 4See Loving v. United States (In re Loving), No. 11-01439-MAM-7, 2011 WL 3800042 (Bankr. S.D. Ala. Aug. 29, 2011) (taxes not dischargeable because debtor filed on April 8, 3 years after she filed her tax return, but less than 3 years after due date of the return).
• 511 U.S.C. § 507(a)(8).
• 6Chief Counsel Advice 2004-04-049 (Jan. 5, 2004).
• 7Rev. Rul. 2005-59, I.R.B. 2005-37; I.R.M. 4.12.1.8.2. For a more extensive discussion of a Substitute for Return, see Section 6.2.
• 8Internal Revenue Serv., Chief Counsel Notice, No. CC 2010-016 (Sept. 2, 2010), (citing 11 U.S.C. § 523(a)(1)(B)(i)). But see In re Colsen, 446 F.3d 836 (8th Cir. 2006) (under pre-2005 law, return filed after assessment pursuant to “substitute for return” may qualify as a tax return for bankruptcy discharge purposes).
• 9See Effectively Representing Your Client Before the IRS § 17.2 (ABA 8th ed. 2021) (giving information on how to ascertain assessment date).
• 10Severo v. Comm’r, 129 T.C. 160 (2007), aff’d, 586 F.3d 1213 (9th Cir. 2009).
• 11I.R.C. § 507 (a)(8)(A)(ii); I.R.M. 5.9.13.19.3(2) (concept of tolling); see also In re Emerson, 224 B.R. 577 (Bankr. W.D. La. 1998) (appeal of rejected offer in compromise does not toll the 240-day period in I.R.C. § 507).
• 12See, e.g., In re Bruner, 55 F.3d 195 (5th Cir. 1995).
• 13Grogan v. Garner, 498 U.S. 279 (1991).
• 14United States v. Hairopoulos, 118 F.3d 1240 (8th Cir. 1997).

A Chapter 13 bankruptcy may secure a more favorable repayment plan for taxes than an installment agreement. The maximum repayment period for a Chapter 13 bankruptcy is 5 years. 

If the taxpayer has less than 5 years to repay federal tax liability, Chapter 13 can extend the payment period, resulting in lower monthly payments.

The Chapter 13 plan must provide for priority and secured tax debts. Older taxes may be “non-priority” and therefore dischargeable. In some cases, you can also prevent a tax debt from becoming “secured” by filing the bankruptcy before the IRS files its lien.

Before 2005, some tax liability that was non-dischargeable in a Chapter 7 bankruptcy because it failed to satisfy one or more of the six tests discussed in the previous section could be discharged in a Chapter 13 filing as long as the liability was listed. This was true even if the liability was not entirely paid in the 5-year payment period. This was commonly known as a “super” discharge. For the most part, the 2005 bankruptcy legislation eliminated the Chapter 13 “super” discharge. Although the scope of dischargeable debts in Chapter 13 has been narrowed, Chapter 13 can still be used to discharge priority taxes paid with money from loans and credit cards, tax penalties, and post-petition interest on certain taxes.

If Louisiana spouses are jointly liable for federal taxes because they filed a joint tax return, the IRS may collect taxes from either spouse’s separate property and from any of their community property.1

In some cases, only one spouse may owe the tax liability. This situation may arise when one spouse incurred a pre-marital tax debt, the spouses did not file a tax return, the spouses filed separate returns, one spouse qualified for innocent spouse relief, or one spouse incurs self-employment tax liability.

The IRS may collect a liable spouse’s pre-marital tax debt from all of the liable spouse’s separate property. Because Louisiana is a 100% community property state for tax collection purposes, the IRS can collect a liable spouse’s pre-marital or post-marital tax debt from 100% of the community property.2  Currently, a spouse’s wages, even if the spouses are separated, are community property in Louisiana and may be levied by the IRS to collect a federal tax debt. However, a levy against a non-liable spouse’s wage is not a “continuous levy” under I.R.C. § 6331(e), and so, a separate levy must be issued for each paycheck. A non-liable spouse may also claim the exemptions for levied wages.3

Jointly owned property can be seized by the IRS. However, the IRS must compensate the nondebtor for the value of the nondebtor’s share of the community asset being seized.4  District courts have some discretion under I.R.C. § 7403 to refuse to order a foreclosure sale if the IRS holds a lien on only part of the house.5

• 1I.R.M. 25.18.4.1.
• 2Rev. Rul. 2004-72, I.R.B. 2004-30; I.R.M. 25.18.4.6. In states that are “50% community property” states, the IRS may be limited to collection against 50% of the community property.
• 3I.R.M. 25.18.4.3.
• 4United States v. Rodgers, 461 U.S. 677, 699 (1983); I.R.M. § 25.18.4.1.
• 5Rodgers, 461 U.S. 677; United States v. Jensen, 785 F. Supp. 922 (D. Utah 1992) (harm to terminally ill nondebtor outweighed delay to IRS); United States v. Jones, 877 F. Supp. 907 (D.N.J. 1995) (nondebtor wife kept house in return for paying one-half of the imputed rental value of the property to IRS).

Under I.R.C. § 6402, the IRS may offset tax refunds to satisfy certain unpaid debts. Thus, a taxpayer’s tax refund may be seized to pay delinquent child support obligations, state taxes, or past due federal debts. Federal debts can include Social Security overpayments, past due Small Business Administration loans, or past due federally insured education loans. Typically, the IRS seizes part or all of the tax refund to pay the qualified creditor that invoked the § 6402 offset procedures.

In Louisiana, the IRS may seize or offset 100% of the spouses’ tax refund to collect one spouse’s unpaid federal tax debt.1  However, the rights of other creditors to an offset of a non-liable spouse’s tax refunds are more limited. These creditors may not offset against the non-liable spouse’s share of community property.2  However, if a state tax refund is community property, the State of Louisiana may offset the refund to satisfy one spouse’s separate debt.3

If a joint return was filed and both spouses had income and tax payments on the return, the non-liable spouse may request the portion of the tax refund attributable to that spouse by filing a Form 8379. For example, if the non-liable spouse worked and had income taxes withheld from the paycheck, that spouse is permitted to obtain the portion of the refund attributable to the withheld payments. This form should be filed along with the Form 1040 but can also be submitted later.

Louisiana residents may apply for injured spouse relief if they were not required to pay the past due amount that was offset by the IRS at the request of a qualified creditor. Overpayments are allocated according to state law.

• 1See Rev. Rul. 2004-72, I.R.B. 2004-30.
• 2I.R.M. 25.18.5.8.
• 3La. C.C. art. 2345 (a spouse’s separate obligation may be satisfied from community property during the community); Price v. Secretary, 95-887 (La. App. 3 Cir. 12/6/95), 664 So. 2d 802 (wife’s wages garnished to satisfy husband’s separate tax obligation). In Louisiana, child support that accrues during a second marriage is a community obligation. Gill v. Gill, 39,406-CA (La. App. 2 Cir. 3/9/05), 895 So. 2d 807. The State of Louisiana will offset a community tax refund to collect child support owed by one spouse for children of a prior marriage, whether it accrues during the second marriage or is for arrearages that pre-date the second marriage.

Ownership of tax refunds is governed by state law.1  Because Louisiana is a community property state, division of a tax refund may require an analysis of the community and separate nature of the underlying income earned. In Louisiana, the classification of property as community or separate is fixed at the time of acquisition.2

For most low-income taxpayers, the Earned Income Credit (EIC) accounts for most of their tax refund. The portion of the refund attributable to the EIC is the separate property of the spouse who was entitled to the credit regardless of state law concerning the classification of income as community or separate property.3  Because the spouse with the earned income and/or the right to claim a dependent is entitled to the credit, the other spouse does not have a community property interest in any portion of the EIC

• 1See, e.g., Rev. Rul. 2004-72, I.R.B. 2004-30; Rev. Rul. 74-611, 1974-2 C.B. 399; see also Gray v. United States, 553 F.3d 410 (5th Cir. 2008) (analyzing interest in tax refund under Texas community property laws). Note that the allocation of tax refunds in non-community property states may involve an analysis of the spouse’s earnings, payments, and separate tax liabilities. See, e.g., I.R.M. 25.18.5.3; Rev. Rul. 80-7, 1980-1 C.B. 296; In re Palmer, 449 B.R. 621 (Bankr. D. Mont. 2011).
• 2Robinson v. Robinson, 1999-3097 (La. 1/17/01), 778 So.2d 1105. By comparison, stimulus refund payments may be owned 50-50 without regard for the parties’ respective incomes. See, e.g., In re Thompson, 396 B.R. 5 (Bankr. N.D. Ind. 2008).
• 3Rev. Rul. 87-52, 1987-1 C.B. 347.

If a married couple files separate tax returns in a community property state, each spouse must report one-half of the community income.1  In a community property state, each spouse should be limited to 50% of any cancellation of debt income claimed by the IRS.2

If the spouses have physically separated but not yet divorced, the higher-income spouse will typically benefit from this reporting requirement. A lower-income spouse may obtain relief by showing that one of 4 exceptions applies:

• The spouses lived apart for the entire year, filed separate returns, and did not transfer more than a de minimis amount of earned income between them.3
• The taxpayer was not notified by the other spouse of the nature and amount of the income before the due date (including extensions) for the filing of the taxpayer’s return, and the spouse acted as if solely entitled to the income.4  Only the IRS may invoke this exception.5
• Traditional innocent spouse relief6  from community property laws under I.R.C. § 66(c) for an item of community income if (a) the requesting spouse did not file a joint return for the tax year; (b) the income item omitted from the gross income of the requesting spouse’s income would be treated as the other spouse’s income under I.R.C. § 879(a);7  (c) the requesting spouse did not know of, and had no reason to know of, the item of community income; and (d) taking into account all of the facts and circumstances, it is inequitable to include the item of community income in the requesting spouse’s individual income.
• Equitable relief under the “flush language” of I.R.C. § 66(c) for spouses who don’t meet the requirements for traditional innocent spouse relief.8

Be aware that the time limitation for requesting traditional innocent spouse relief under I.R.C. § 66(c) is different from the time limitations for I.R.C. § 6015 innocent spouse relief or I.R.C. § 66(c) equitable innocent spouse relief.9  Traditional innocent spouse relief under I.R.C. § 66(c) must be requested no later than 6 months before the statute of limitation on assessment expires for the non-requesting spouse.10  By contrast, equitable innocent spouse relief under §66(c) must be claimed within 2 years of the first collection activity against the electing spouse.11

Some community property income may be excluded from a spouse’s income by other laws. For instance, a pension distribution in a community property state is usually considered community property and to be taxable income for both spouses. But spouses may have a state court judgment called a Qualified Domestic Relation Orders (QDRO). A QDRO establishes the non-employee spouse’s right to receive payments. Payments pursuant to a QDRO are taxable to non-employee spouse but not to the employee spouse, even when the employee spouse receives the distribution and turns the funds over to non-employee spouse.12  The employee spouse is not taxed on the non-employee spouse’s community property share of the IRA distribution.13  Similarly, this spouse would not be liable for the I.R.C. § 72(t) additional tax on an IRA distribution.14

• 1United States v. Mitchell, 403 U.S. 190, 196–97 (1971); Reg. § 1.66-1.
• 2Cf. Brickman v. Comm’r, T.C. Memo 1998-340.
• 3I.R.C. § 66(a); 26 C.F.R. § 1.66-2. I.R.C. § 66(a) relief is automatic if the requirements are met. For purposes of § 66(a), any amount of income transferred for the benefit of the spouses’ child is not treated as a transfer to the spouse. 26 C.F.R. § 1.66-2(c).
• 4I.R.C. § 66(b); 26 C.F.R. 1.66-3. The IRS may deny a spouse the federal income tax benefits of community property law on items of community income. Under the regulations, a spouse will not have acted as solely entitled if the income was “used or made available for the benefit of the marital community.” 26 C.F.R. § 1.66-3(a). It is not clear whether a small amount of funds paid for family support would bar the IRS from invoking I.R.C. § 66(b) against a taxpayer.
• 5I.R.C. § 66(b); Hardy v. Comm’r, 181 F.3d 1002 (9th Cir. 1999).
• 6If a married couple filed a joint return, I.R.C. § 6015 would govern requests for innocent spouse relief. I.R.C. § 66(c) does not apply to joint filers.
• 7The other spouse’s wages or income from a trade and business operated as a sole proprietorship are the most common examples of this type of income.
• 8See Rev. Proc. 2003-61, I.R.B. 2003-32; IRS Notice 2012-8. Note that the “absence of significant benefit” test is different for equitable relief under I.R.C. § 66(c) than for traditional relief under I.R.C. § 66(c)(4). See Felt v. Comm’r, T.C. Memo 2009-245. It is easier to meet the § 66(c) “absence of substantial benefit” test.
• 9For more complete discussion of innocent spouse relief, see Section 9.3.
• 1026 C.F.R. § 1.66-1(j).
• 11Rev. Proc. 2003-61, 2003-2 C.B. 296. Note that “collection activity” has a technical definition. See, e.g., McGee v. Comm’r, 123 T.C. 314 (2004).
• 12Powell v. Comm’r, 101 T.C. 489 (1993); see also Mitchell v. Comm’r, 131 T.C. No. 15 (2008) (QDRO distribution taxable to non-employee spouse in community property state). A different outcome may result when the employee spouse pays the non-employee spouse with the employee spouse’s separate wages rather than the pension distribution. Comm’r v. Dunkin, 500 F.2d 1065 (9th Cir. 2007).
• 13Bunny v. Comm’r, 114 T.C. 259, 262 (2000).
• 14Morris v. Comm’r, T.C. Memo 2002-17.

Net self-employment income is community property. Generally, community property rules will govern regular income tax liability and require the non-earning spouse to include one-half of the earning spouse’s income in any separate tax return. However, even in a community property state, self-employment income will be allocated entirely to the self-employed spouse for the purposes of self-employment tax.1  In other words, community property law is disregarded for the purposes of calculating self-employment taxes. This rule can provide significant tax relief for the non-earning spouse because self-employment tax is often about 60% of the tax liability faced by low-income taxpayers.

• 1I.R.C. § 1402 (a)(5); 26 C.F.R. § 1.1402 (a)(8); IRM § 25.18.2.2; Charlton v. Comm’r, 114 T.C. 333; Davis v. Comm’r, T.C. Memo 1989-46; Gilliam v. Comm’r, 60 F. App’x 720 (10th Cir. 2003).

Both federal and Louisiana law have provisions that relieve innocent spouses from tax deficiencies or understatements. You should be able to identify when a client may have a potential innocent spouse relief claim. Appropriate claims should be filed with both the IRS and the Louisiana Department of Revenue. Innocent spouse relief often arises in domestic violence cases.

Innocent spouse relief cases are complex.1  The IRS has a spousal tax relief eligibility explorer on its web page to assist with evaluating eligibility for innocent spouse relief. It is recommended that these cases be referred to a Low-Income Taxpayer Clinic or other tax law specialist.

• 1For a comprehensive discussion of § 6015 innocent spouse relief, see Robert B. Nadler, A Practitioner’s Guide to Innocent Spouse Relief: Proven Strategies for Winning Section 6015 Tax Cases (2011). This manual is currently out of print but is available from the law library of the Texas A&M University School of Law. The manual is free to LITC attorneys and to private practitioners for a small fee.

Section 6015(b) innocent spouse relief can’t be used for an underpayment, which occurs when the tax is admitted to be due on the return, but it is not paid at the time of filing.1  But, innocent spouse relief is appropriate for an understatement of tax, i.e., the offending spouse filed a return with incomplete or false information. Generally, if the other spouse did not know or have reason to know about the unreported income or erroneous items and did not receive benefits from the unreported income or erroneous items, that spouse may be eligible for innocent spouse relief. A single return may have a mixture of underpayment and understatement issues.

If the requesting spouse knew or had reason to know of the understatement, innocent spouse relief is not available.2  The reason-to-know standard considers all the facts and circumstances (e.g., the nature of the item, the requesting spouse’s education and business background, the extent of that spouse’s participation) and inquires whether a reasonable person in similar circumstances would have known of the understatement.3  The existence of domestic violence in the marriage can be an important factor; in these situations, an abuser often controls the household’s finances and an abused spouse may have been afraid to inquire about these matters.

• 1Hopkins v. Comm’r, 121 T.C. 73, 88 (2003).
• 226 C.F.R. § 1.6015-2(a)(3).
• 326 C.F.R. § 1.6015-2(c).

A separate tax liability election under § 6015(c) is available for a taxpayer who, at the time of election, is no longer married to or has been living apart for at least 12 months from the person with whom the taxpayer originally filed a joint return.

To elect this relief, a taxpayer must prove that a portion of the understatement was attributable to the other spouse. A taxpayer can’t use § 6015(c) for an underpayment of tax liability.1  The determination of separate liability is made without regard to community property rights. Thus, taxes are based on the electing taxpayer’s own income as if the taxpayer had filed a separate married return. If the taxpayer had no income, the tax liability will be zero.

Taxpayers are often successful under § 6015(c). Relief is easier to obtain under § 6015(c) than under § 6105(b) because the IRS can only deny apportioned liability under § 6015(c) if it proves actual knowledge of an erroneous item, as distinguished from a mere “reason to know.”2

• 1Hopkins v. Comm’r, 121 T.C. 73, 88 (2003).
• 2Generally, the burden of proof is on the taxpayer for innocent spouse relief with the exception of the requirement that the IRS must prove actual knowledge to deny apportioned liability under § 6015(c). See, e.g., Culver v. Comm’r, 116 T.C. 189 (2001).

If relief is not available under the innocent spouse rule (§ 6015(b)) or the separate liability election (§ 6015(c)), the IRS may relieve an individual of liability if it would be inequitable to hold the individual liable for any unpaid tax or deficiency.1   The IRS automatically considers a taxpayer for equitable relief if innocent spouse and separate liability relief are denied.

Low-income clients, particularly survivors of domestic violence, often qualify for equitable relief under § 6015(f) or § 66(c).2  I.R.C. § 66(c) provides equitable relief in community property states where a joint return was not filed; I.R.C. § 6015(f) applies if a joint return was filed (even in community property states). Unlike I.R.C. § 6015(b) and (c), § 6015(f) and § 66(c) permit equitable relief from an underpayment of income tax. The requesting spouse may even be able to obtain a refund in some circumstances.3

Under the requesting spouse must satisfy 7 threshold conditions for § 6015(f) relief.4  Conditions 1 and 2 don’t apply for a § 66(c) equitable relief request. These conditions are:

1. Filing a joint return
2. Denial of relief under § 6015(b) and (c)
3. Application within 2 years of first collection activity5
4. No transfer of assets as part of fraudulent scheme
5. No transfer of disqualified assets to the requesting spouse
6. Requesting spouse did not file or fail to file with fraudulent intent
7. Item resulting in deficiency or underpayment is attributable to non-requesting spouse unless (a) attribution is due to operation of community property laws and the item is only nominally owned by requesting spouse; (b) the non-requesting spouse misappropriated funds and the requesting spouse had no knowledge or reason to know of the misappropriation; or (c) abuse not amounting to duress led the requesting spouse not to challenge treatment of items.6

If a case involves an underpayment on a joint return, the IRS will ordinarily grant § 6015(f) equitable relief if the taxpayer meets the 3 “safe harbor” conditions in § 4.02 of Rev. Proc. 2003-61: marital status, no knowledge of underpayment, and economic hardship.7  In some cases, the marital status factor may be met even if the spouses lived separately in the same house.8  Equitable relief under § 4.02 is available to all joint return taxpayers with underpayments, including taxpayers in community property states.

If only partial relief is granted under § 4.02, a taxpayer may still be eligible for total relief under § 4.03.9  Equitable relief is available under § 4.03 for a “community property state” taxpayer who did not file a joint return, who requested relief under I.R.C. § 66(c), and who met the applicable threshold conditions of § 4.01, i.e., conditions 3 to 7. It is also available to a spouse who filed a joint return and met the § 4.01 threshold conditions, but did not qualify for “safe harbor” relief under § 4.02.

Under § 4.03, no single factor is determinative. All factors must be considered and weighed appropriately.10  The Tax Court now reviews IRS denials of § 6015(f) equitable relief under a de novo standard of review and a de novo scope of review.11 The Tax Court regularly reverses IRS denials of equitable relief. If the Tax Court finds that the IRS erred in denying equitable innocent spouse relief, it must decide the appropriate relief and may not remand the case to the IRS.12

• 1I.R.C. § 6015(f).
• 2For a sample analysis of § 6015(f) equitable innocent spouse relief, see Stephenson v. Comm’r, T.C. Memo 2011-16. For a sample analysis of § 66(c) equitable innocent spouse relief, see Bennett v. Comm’r, T.C. Summ. Op. 2005-84.
• 3See Rev. Proc. 2003-61, § 4.04; see also Washington v. Comm’r, 120 T.C. 137, 152–54 (2003).
• 4See Rev. Proc. 2003-61, § 4.01.
• 5The IRS has decided not to impose the 2-year time limit for § 6015(f) equitable relief claims. See Notice 2011-70, 2011-32 I.R.B. 135. However, the IRS has decided that that the Rev. Proc. 2003-61 time limits for § 66(c) equitable relief claims are invalid.
• 6For helpful discussion of the “abuse exception”, see Nihiser v. Comm’r, T.C. Memo 2008-135; Brown v. Comm’r, T.C. Summ. Op. 2008-121.
• 7Gonce v. Comm’r, T.C. Memo 2007-328.
• 8Nihiser v. Comm’r, T.C. Memo 2008-135.
• 9Cf. Bruen v. Comm’r, T.C. Memo 2009-249.
• 10Rosenthal v. Comm’r, T.C. Memo 2004-89.
• 11Porter v. Comm’r, 132 T.C. 2003 (2009).
• 12Friday v. Comm’r, 124 T.C. 220, 222 (2005); Nihiser v. Comm’r, T.C. Memo 2008-135.

The primary laws for innocent spouse relief from state taxes are La. R.S. 47:101(B)(7) and 47:1584.1  These laws are similar to the IRS rules for innocent spouse relief and are retroactive to all tax years. If possible, file the innocent spouse claim within two years of the first collection activity directed to the innocent spouse.2  Innocent spouses may also be relieved from suspension of driver’s licenses for failure to pay state taxes greater than $1,000.3

• 1Guidelines for filing state innocent spouse relief claims are found in Louisiana Department of Revenue Technical Advisory Memorandum 99-003.
• 2Although La. R.S. 47:101 establishes a 2-year limit for assertion of innocent spouse relief, La. R.S. 47:1584(B)(4) gives the Secretary authority to grant innocent spouse relief after the expiration of the two years.
• 3La. R.S. 47:296.

I.R.C. § 32 provides the statutory rules for the EIC. The easiest way to understand all the EIC rules is to consult Chapters 1 to 3 of IRS Publication 596, which allows you to quickly assess your client’s EIC eligibility.

This publication cogently groups the various EIC rules into 3 sets:

• Rules for Everyone
• Rules If You Have a Qualifying Child
• Rules If You Do Not Have a Qualifying Child

Chapter 4 explains the income limits for the EIC.

The basic rules for the EIC are income limits, earned income, ineligibility of persons who legally must file as “married filing separately”, and the relationship, age, and residency tests for any qualifying child. A low-wage worker can receive an EIC refund even if there is no dependent, but most of the issues confronted by the tax attorney will involve the claiming of dependents and whether the dependent is a qualifying child or relative for EIC purposes.

For each tax year, there will be AGI limits for the EIC by family size and filing status.

Historically, the AGI limits have increased each year. In 2021, the AGI limits will range from $48,000 to $57,000 for married couples with children. Look to the Form 1040 instructions for the current AGI limits.

Earned income includes wages, salaries, tips, and other employee compensation (but only if these are includible in gross income)1  plus net earnings from self-employment.2  Earned income may also include an employer’s disability retirement plan benefits until the worker reaches minimum retirement age.

Earned income does not include pensions, annuities, unemployment compensation, social security, welfare, alimony, child support, inmate compensation, nontaxable workfare payments, and scholarship or fellowship grants not reported on a Form W-2.

If a married couple in a community property state such as Louisiana has been separated for more than 6 months and is separated at the end of the year, one spouse may elect to file a separate return as a “Head of Household” and use their own earned income to qualify for the EIC.

Proof of “earned income such as W-2 or 1099 Forms may be required by the IRS. Self-employed individuals should have records of their income, such as check stubs, bank statements showing deposits, or other business records.

• 1Prior to 2002, earned income included nontaxable earned income, e.g., voluntary salary reductions, 401(k) contributions, mandatory contributions to a state or local retirement plan, etc.
• 2Compensation paid by a third party for damages due to lost self-employment income will not constitute “earned income” for the purposes of the EIC.

Taxpayers who are married on December 31 of the tax year and who cannot file as “married filing jointly” face special problems. These taxpayers will not qualify for the EIC unless they meet the requirements for head-of-household filing status.1

If a married taxpayer did not live with the spouse at any time in the last 6 months of the year, the taxpayer may be able to file as the head of household if the taxpayer furnished more than half of the cost of maintaining the household.2  Unmarried taxpayers do not have to be the head of household in order to get the EIC.

Many EIC errors involve married taxpayers who could not legally file as single or head -of-household. If a taxpayer was married on December 31 of the tax year, review the taxpayer’s proof of separate residences and the 50% support test for head-of-household filing status.

If married taxpayers incorrectly filed as head-of-household or single, they may be able to file an amended tax return to get the allowable EIC for their income level. However, they are precluded from filing a joint return after a Notice of Deficiency has been issued and a Tax Court petition filed.3  Therefore, a joint return claiming an EIC should be filed before either spouse files a Tax Court petition if this is a feasible option.

• 1I.R.C. § 32(d); Mischel v. Comm’r, T.C. Memo 1996-553.
• 2I.R.C. §§ 2(b)(1), 7703(b).
• 3See, e.g., I.R.C. § 6013(b)(2); Pelayo-Zabalza v. Comm’r, T.C. Summ. Op. 2002-134; Benitez v. Comm’r, T.C. Summ. Op. 2002-12.

Only taxpayers with a “qualifying child” get large EICs. A “qualifying child” must meet 3 tests: relationship, age, and residency. The definition of “qualifying child” also requires that the child be younger than the person claiming the child and that the child have not filed their own return. This situation can happen when a person adopts an older adult to insure that benefits or property flow to that person upon death.1

• 1This was a common estate planning technique for same-sex couples before the U.S. Supreme Court legalized same-sex marriage in Obergefell v. Hodges, 576 U.S. 644 (2015).

Under the relationship test, a qualifying child is a child who is the taxpayer’s (a) child, stepchild, adopted child, foster child,1  or a descendant of any of them; or (b) sibling, step-sibling, half-sibling, or a descendant of any of them.

Under the age test, to be a qualifying child, the child at the end of the tax year must be (a) under the age of 19; (b) under the age of 24 and a “full-time” student; or (c) permanently and totally disabled at any time during the year, regardless of age.

• 1An eligible foster child is a child placed by an authorized placement agency, i.e., a court, state or local government agency or a tax-exempt organization licensed by the state. Hegwood v. Comm’r, T.C. Summ. Op. 2002-156.

The majority of issues that arise under the “qualifying child” definition involve the residency test. Generally, the contested issues involve documentation of the child’s residency and not legal issues.

The child must have lived with the taxpayer in the United States for more than half of the year.1  Note that for the EIC, there is no “support” or “household maintenance” test if the taxpayer can properly file as single or married filing jointly. A taxpayer can meet the residency test even if the other parent has custody under a court decree and provided more than half the support.2

A home is anywhere the taxpayer regularly lives and can include nontraditional homes such as homeless shelters. The legislative history of the EIC indicates that determinations of an individual’s principal abode should be made under rules similar to those for the head-of-household filing status.3

Temporary absences can count toward the half-year or whole-year requirements if the taxpayer or child is away from home due to special circumstances such as illness, school attendance,4  business or military service, vacation, detention in a juvenile facility, kidnapping (if not committed by a family member), or disaster displacement. Although not listed in IRS Publication 596, pre-conviction detention in a jail and custody agreements where the child is absent for less than 6 months may also count.5  In Rowe v. Commissioner, the taxpayer was eligible for the EIC even though she was absent from the household for the last 7 months of the year due to her confinement in jail.6

Tax preparation services often counsel a taxpayer not to claim a resident child if someone else has already filed for the EIC based on that child, even if the other person was not eligible to claim the child. The IRS will deny an electronic return where someone else has already filed for the EIC. In this situation, the proper procedure is to file a paper return, which will prompt an IRS examination to determine which taxpayer is entitled to claim the child for the EIC. The taxpayer will then have the chance to offer evidence of residency and to appeal if necessary.

• 1Prior to 2002, an “eligible foster child” had to live with the taxpayer for the whole year in order to be a qualifying child for the taxpayer’s EIC claim.
• 2Webb v. Comm’r, T.C. Memo 1990-581.
• 3H.R. Rep. No. 101-964 (1990).
• 4College attendance cannot count as a “temporary absence” if the child resided away from home at college and does not intend to return to the taxpayer’s home. Schatz v. Comm’r, T.C. Memo 1981-341.
• 5Cf. 26 C.F.R. § 1.2-2(c)(1) (temporary absence pursuant to custody agreement is “special circumstance”); Rowe v. Comm’r, 128 T.C. 13 (2007).
• 6Rowe, 128 T.C. 13.

Sometimes, a child is the “qualifying child” of more than one person. However, only one taxpayer (or a married couple filing jointly) can claim the EIC for the child.

If the EIC is claimed by two individuals who are each eligible to claim the child, a series of tiebreaker rules apply:

1. A parent wins over a non-parent.1
2. Where parents lived apart for some portion of the year, but each lived with child for at least 6 months, the parent who lived with child longer wins.
3. Where the child lived with each parent same amount of time, the parent with the higher AGI wins.
4. If neither parent is an eligible claimant, caretaker with highest AGI wins.

The law presents some planning opportunities for unwed parents who live together, but cannot file as “married.” If both unwed parents are the biological parents of a child, they can decide who claims the child for the EIC. If they have more than 1 child together, they can split their children. If both claim a child, the first tie breaker favors the parent who lived longer with the child. If residency is equal, the parent with the higher AGI wins.

When evaluating cases involving the EIC, take care to check if the claimed dependent was claimed by another household for public benefits, such as housing subsidies, food stamps, or Medicaid. This will be an obstacle to proving residency. If another claimant wrongly claimed the dependent as living in their household, that claimant may be examined if your client prevails on their EIC claim and may have to repay the benefits that were received. This should be explained to the client, especially if the other claimant is a family member.

• 1A parent should win over a step-parent.

The IRS seems to deny any EIC when it finds that the taxpayer does not have a qualifying child. However, a taxpayer whose income is low enough may qualify for the EIC even without a qualifying child.1  To be eligible, such a taxpayer (or the spouse, if filing jointly) must be at least 25 but under 65, not be a dependent or qualifying child of another person, and have lived in the United States more than half of the year.

If a parent’s dependent is not a “qualifying child”, check to see if the dependent qualifies as a “qualified relative.” Receipt of Social Security, food stamps, and rental subsidies may affect an indigent taxpayer’s ability to claim a dependency exemption for a “qualifying relative” as distinguished from a “qualifying child.”

• 1Chandler v. Comm’r, T.C. Summ. Op. 2002-74.

In the past, low-income taxpayers and their paid tax preparers have not developed documentation to support EIC claims as part of the tax return preparation. If the tax return is selected for audit, the IRS will demand documentation. It can be more difficult to obtain such documentation when the audit occurs. Taxpayers throw out or lose documentation. Agencies or businesses that may have documentation may close, have a difficult time locating older records, or be unwilling to cooperate. Witnesses may move. Therefore, if you have the opportunity to prepare the return, you should advise the taxpayer to obtain and maintain documentation of residency and support for that tax year.

A mother claiming a child can prove relation simply by submitting the child’s birth certificate. More birth certificates may be required if the taxpayer is claiming a grandchild or a niece or nephew. Submit all the birth certificates needed to show the relationship between the taxpayer and the claimed child.

Problems can arise for male taxpayers who may not be listed as the father on a birth certificate. That taxpayer will have to take steps to legally acknowledge the child if he wants to claim the child on his tax return. The taxpayer may have already done this in the context of a child-support proceeding. New birth certificates can be obtained when the legal acknowledgment is done.

Taxpayers claiming adopted children and children placed in foster care by a state agency will have to show documentation of those facts.

Residency is commonly contested in an EIC audit. The key is to provide third-party records that show the names, common addresses, and dates of common addresses of the taxpayer and any qualifying children. Low-income people frequently change apartments. This can make the documentation quite burdensome. Nonetheless, the taxpayer can generally find some records to establish her own address, e.g., leases, rent receipts, subsidized housing records, utility bills, other bills, food stamp records, public assistance notices, medical records, driver licenses, pay stubs, etc.

On the other hand, it can be difficult to find third-party records that establish the address of a child, particularly a young child. The IRS suggests school records, day care records, medical records, and social service agency or community-based organization records to establish a child’s address. Records submitted to the IRS should show a common residency of more than 6 months, e.g., a record from the beginning of the year and a record at least 6 months later with the same address.

If these records do not exist, the taxpayer should try to get a letter on official letterhead from the child’s school, medical provider, childcare provider, or the taxpayer’s clergy, employer, or landlord. Ask the potential affiant if they would be willing to testify in Tax Court if necessary. Explain that they can probably participate virtually if needed. If possible, the affidavits should be notarized. They should state that the taxpayer and children lived together for 6 months or more during the tax year in question. This can be difficult since these third parties may not know the exact duration of the common residency.

IRS examiners are less impressed by letters and affidavits from relatives, friends, and neighbors. You should try to get another letter or some corroborating documents if the taxpayer must rely on letters from relatives, friends, and neighbors. As a practical matter, relatives, friends, neighbors, school bus drivers, or lawyers handling divorce or custody matters are often more competent witnesses on the issue of common residency than the affiants preferred by IRS auditors. Fortunately, the IRS Appeals officers and the Tax Court, unlike the IRS examiners, can and do give weight to affidavits or testimony by such witnesses.

Tax Court judges can and do rule in favor of the taxpayer based primarily or exclusively on a taxpayer’s credible testimony. Of course, testimony by other credible witnesses is also helpful. As a practical manner, the IRS generally will not have any witnesses on the EIC issues with the possible exception of a competing claimant. The Tax Court has even ruled in taxpayers’ favor when the testimony as to the child’s address is contrary to the address in school records. The taxpayer’s credible testimony can be given more weight than “official” records.1  Never send original documents to the IRS. The IRS routinely loses documents. You should write the taxpayer’s Social Security number on each document that you send to the IRS.

• 1See, e.g., Coats v. Comm’r, T.C. Memo 2003-78; Sliwinski v. Comm’r, T.C. Summ. Op. 2003-49; Gingrich v. Comm’r, T.C. Summ. Op. 2002-158.

Lastly, the IRS may contest the “earned income” claimed by the taxpayer if it is not collaborated by a W-2 or 1099. This can eliminate the EIC even if the taxpayer can prove a qualifying child. Many low-income taxpayers have small businesses such as styling hair, cutting grass, or childcare, in which their income is not reported to the IRS by a third party. They will have to provide evidence of their income through bank records, cancelled checks, or other business records. Receipts can be used to substantiate the expenses incurred with the business. Affidavits from customers or suppliers may have to be used if no other records exist.

There are several “big picture” principles that you should know for the defense of a typical EIC audit or disallowance.

For most low-income taxpayers, the disallowance of the EIC will account for most, if not all, of the tax adjustment or deficiency proposed by the IRS. Therefore, your primary goal is to protect the EIC. The related Child Tax Credit can also be large.

Even one qualifying child can get a taxpayer a large EIC. The IRS wrongly denies the entire EIC claim when it finds that a claimed child does not meet the residency, relationship, and age tests. You may find that a taxpayer who claimed more than one child has one qualifying child and another child that is not eligible. It is worthwhile to appeal on the issue of claiming the second child.

Single and head-of-household filers get the same EIC. The amount of the EIC is based on the taxpayer’s AGI. Therefore, the head-of-household filing status generally does not affect the amount of the EIC. If a married but separated taxpayer needs head-of-household status to qualify for the EIC, the taxpayer will need to document expenses for the household and dependents.

An unwed or divorced taxpayer can qualify for the EIC because that taxpayer can legally file as “single.” It is amazing how many IRS agents and paid tax preparers do not know this. Instead, they take the position that a single taxpayer has to meet the head-of-household filing status to get the EIC. They are wrong. The head-of-household status is, however, absolutely crucial for taxpayers who are married on December 31 of the tax year and who cannot file as “married filing jointly.”

Many low-income taxpayers receive money from third parties, e.g., Social Security, welfare, or subsidized housing assistance. These funds do not count as support by the taxpayer.1

Therefore, these taxpayers may not qualify for the head-of-household filing status if their earned income is less than their income from third parties.

• 1See, e.g., Huynh v. Comm’r, T.C. Memo 2002-237 (HUD rental assistance); Gulvin v. Comm’r, 644 F.2d 2 (5th Cir. 1981), aff’g T.C. Memo 1980-111; Lutter v. Comm’r, 514 F.2d 1095 (7th Cir. 1975); Rev. Rul. 74-543, 1974-2 C.B. 39; IRS Pub. 501.

A taxpayer whose EIC was reduced or denied by the IRS must file a Form 8862 with a subsequent return in order to claim the EIC.1  This form asks for additional information about claimed dependents.

• 126 C.F.R. § 1.32-3.

If the EIC was denied for tax returns (beginning in 1997) and the IRS determines that the error was due to reckless or intentional disregard of the EIC rules, the taxpayer cannot claim the EIC for the next 2 years. If the error was due to fraud, the taxpayer cannot claim the EIC for 10 years.1  Such disallowance could cost the taxpayer several thousand dollars per year in tax refunds. IRS determinations of reckless disregard or fraud are reviewable through the Tax Court deficiency procedures.2  The EIC 10-year ban is often asserted with a civil fraud penalty. The IRS generally finds fraud if they see the taxpayer has made the same errors for three or more continuous years.

Such determinations can be appealed if you believe your client made a good-faith effort to follow the rules and was not alerted to the errors. A client may file several returns before the IRS makes a final decision on an EIC audit. You would want to appeal if the client has cognitive or mental disabilities. You may also be able to shift blame to a tax preparer who gave bad advice, did not question the client about eligibility, or did not collect the correct documentation. It is helpful to file a Tax Preparer Complaint in this situation. If a client filed a return without assistance, the client’s level of education or experience with tax returns may be a relevant issue. Lastly, clients with limited English proficiency may provide an opportunity to argue that they were unable to understand the complex EIC rules or that they were taken advantage of by an unscrupulous preparer.

• 1I.R.C. § 32(k).
• 2I.R.C. § 6213(g)(2).

In most cases, a child of divorced or separated parents is the “qualifying child” of the custodial parent for EIC purposes. The “custodial parent” is the parent with whom the child lived for the greater part of the year.1

• 1I.R.C. § 152(c)(1)(B).

Even if a noncustodial parent may have been able to take a deduction or a tax credit for a “qualifying child” under I.R.C. § 152(e),1  the fact that a noncustodial parent may claim a child as a dependent under the general rules of the Tax Code does not automatically allow the noncustodial parent to claim that child for the EIC; these rules only allow the noncustodial parent to claim other child-related credits such as the childcare credit.

Many noncustodial taxpayers claim the EIC, believing that the same rules apply to all child-related credits. A state divorce or custody decree cannot change the federal requirements for the EIC. In order for a taxpayer to claim a dependent for the EIC, the dependent must reside in the taxpayer’s household for 6 months or more. As a result, few noncustodial parents will be eligible for the EIC. Many family law attorneys do not adequately explain this to their clients, leading noncustodial parents to wrongfully claim the EIC.

Nevertheless, a parent who meets the relationship, age, and residency tests should still get the EIC regardless of the custody arrangement.

Federal law deems the EIC to be the taxpayer’s separate property.2  One-time tax refunds are not “income” for the purposes of child support calculations.3

• 1See Section 9.4.
• 2Rev. Rul. 87-52, 1987-1 C.B. 347.
• 3La. R.S. 9:315(C)(3)(a).

Generally, income from debt cancellation is includible in gross income.1  The amount of income is the difference between the face value of the debt and the amount paid in satisfaction of the debt. Income is recognized in the year the debt cancellation occurs.2  Debt cancellation often occurs in a foreclosure sale.3  Cancellation of a large debt may result in taxability of Social Security benefits for a low-income taxpayer or loss of Earned Income Credits.4

Typically, debt cancellation income arises when a lender forgives a debt or a government entity waives an overpayment. Examples of potential debt cancellation income include reduction or forgiveness of personal credit card debt or loans,5  personal vehicle repossession, loan workout agreement or modification, mortgage foreclosure, quit claim or reconveyance to creditor, short sale, abandonment,6  Truth-in-Lending rescissions,7  and government waiver of overpayment by the government.8

• 1I.R.C. § 61(a)(12).
• 2Rood v. Comm’r, T.C. Memo 1996-248, aff’d, 122 F.3d 1078 (11th Cir. 1997); Jelle v. Comm’r, 116 T.C. 63 (2001).
• 3If local law provides a right to redeem a foreclosure sale, the sale is generally not final for tax purposes until the right to redeem expires. Great Plains Gasification Assocs. v. Comm’r, T.C. Memo 2006-276.
• 4Jelle, 116 T.C. at 70–71 (2001); Payne v. Comm’r, T.C. Memo 2008-66, n.3.
• 5The Tax Court has ruled that a reduced payment in settlement of a credit card debt constitutes debt cancellation income. Payne, T.C. Memo 2008-66 (purchase price adjustment exclusion denied); Plotinsky v. Comm’r, T.C. Memo 2008-244 (gift exclusion denied). Because no exclusions applied in Payne and Plotinsky, the write-off of the credit card debt was income to the taxpayer. See also Hill v. Comm’r, T.C. Memo 2009-101 (debt cancellation income where credit card judgment and debt written off after Ch. 13 bankruptcy dismissed).
• 6Frazier v. Comm’r, 111 T.C. 243 (1998).
• 7Schlifke v. Comm’r, T.C. Memo 1991-19.
• 8See, e.g., Waterhouse v. Comm’r, T.C. Memo 1994-467 (waiver of VA overpayment creates debt cancellation income). On the other hand, the IRS has privately ruled that the VA’s discharge of a veteran’s mortgage due to hardship was not taxable when the VA intended to reduce the veteran’s future benefits for the amount of the debt forgiveness. Priv. Ltr. Rul. 8839026 (June 29, 1988). Also, cancellation or waiver of an overpayment due to economic hardship should be excluded from income under the general welfare exclusion doctrine. See, e.g., Rev. Rul. 78-46, 1978-1 C.B. 22.

Debt cancellation income is income from the discharge of a debt. To evaluate the potential tax liability, first determine whether there was a “debt”.

If there is a dispute as to whether the taxpayer owed the debt, a compromise may not give rise to a discharge of a “debt.” Furthermore, a creditor may not need to report debts that are cancelled by operation of law.1  A settlement or “forgiveness” of a disputed or unenforceable debt does not result in income to the taxpayer.2  In Zarin v. Commissioner, no taxable income resulted from the settlement because the amount of the discharged debt was void ab initio due to the underlying illegality or fraud.3  Refinancing of a debt may also provide an exception to debt cancellation income.4

To win a Zarin argument, there must be evidence of a dispute as to the amount or enforceability of the debt. A settlement alone does not prove that a good faith dispute existed.5  The taxpayer has the burden of proof.6  If the taxpayer raises a reasonable dispute as to the amount of debt cancellation income on the Form 1099-C, the IRS must produce reasonable and probative information as to the amount of debt cancellation income and can’t rely on the Form 1099-C.7

To avoid tax consequences to the debtor, the settlement should include an agreement by the parties that the settlement agreement reflects settlement of disputed claims, that it does not represent a discharge of indebtedness for purposes of I.R.C. § 61(a)(12), and that the lender will not report the transaction as resulting in income to the debtor to any taxing authority. Lenders rarely agree to the last of these conditions, but that disagreement does not make the debt cancellation taxable income.

What are the tax consequences if the taxpayer successfully rescinds a transaction pursuant to the Truth-in-Lending Act or another consumer protection law? The IRS will argue that the difference between the loan principal and the amount paid by the taxpayer for rescission is debt cancellation income.8  The taxpayer can argue that there was no debt cancellation income under Zarin because the debt was disputed. This may be a successful argument, at least to the extent the taxpayer did not deduct interest in prior tax returns.

However, if the taxpayer took deductions for interest paid on this debt in prior tax years, the IRS will argue that recovery of the same is taxable income under the tax benefit rule. In Schlifke v. Commissioner, the Tax Court ruled that there was income from a rescission under the tax benefit rule to the extent that the taxpayer had taken deductions for interest on the rescinded mortgage.9

• 1See, e.g., IRS Chief Counsel Adv. Mem. 201112008 (Mar. 11, 2011) (principal reduction in negotiated settlement of unfair lending practices case); IRS Priv. Ltr. Rul. 2008-02-012 (Jan. 11, 2008).
• 2See, e.g., Zarin v. Comm’r, 916 F.2d 110, 115 (3d Cir. 1990).
• 3Id.; see also Estate of Smith v. Comm’r, 198 F.3d 515 (5th Cir. 1999) (unliquidated claim for contribution or restitution is not a “debt” that creates debt cancellation income).
• 4See Zappo v. Comm’r, 81 T.C. 77, 85–86 (1983).
• 5McCormick v. Comm’r, T.C. Memo 2009-239.
• 6Rood v. Comm’r, T.C. Memo 1996-248, aff’d, 122 F.3d 1078 (11th Cir. 1997).
• 7McCormick, T.C. Memo 2009-239.
• 8See Schlifke v. Comm’r, T.C. Memo 1991-19.
• 9Id.

A debt is discharged when it is clear that the debt will never have to be paid.1  Recourse debt is not discharged to the extent that there is a deficiency judgment or an unpaid deficiency that survives the foreclosure judgment.2  In some cases, the debt may not be discharged until the statute of limitations has expired.3  The applicable statute of limitations may be a complex issue.4  A creditor who sells credit card debt to a “debt buyer” may write off the debt and issue a Form 1099-C. However, in such cases, the debt is not discharged because the debt buyer usually continues to try and collect the debt. The tax attorney can provide copies of the new collection notices or other attempts at collection to prove that no discharge has occurred.

• 1Friedman v. Comm’r, 216 F.3d 537 (6th Cir. 2000); Cozzi v. Comm’r, 88 T.C. 435 (1987).
• 2See, e.g., Aizawa v. Comm’r, 99 T.C. 197 (1992), aff’d, 29 F.3d 630 (9th Cir. 1994); Webb v. Comm’r, T.C. Memo 1995-486.
• 3See Coburn v. Comm’r, T.C. Memo 2005-283 (abandonment of collateral on recourse liability, alone, did not extinguish underlying liability).
• 4See, e.g., Portfolio Recovery Assocs., LLC v. King, 927 N.E.2d 1059 (N.Y. 2010).

Creditors defined as “applicable entities” by I.R.C. § 6050P(c)(2) are required to issue a Form 1099-C reporting debt cancellation income to the IRS when they reduce a debt by at least $600. The duty to issue a Form 1099-C is triggered when there is a discharge of debt, which is deemed to occur when there has been an “identifiable event” as defined in 26 C.F.R. § 1.6050P(b)(2)(I). The IRS will argue that a discharge of debt occurred when the “identifiable event” occurred. But the IRS may be wrong. In some cases, the “identifiable event” may not constitute a discharge of the debt for determining when or whether debt cancellation resulted in income.

A Form 1099-C does not establish that a debt was discharged or the date of discharge.1  A Form 1099-C is not dispositive. If the taxpayer asserts a reasonable dispute with respect to reported income, I.R.C. § 6201(d) may shift the burden of production to the IRS, requiring it to produce reasonable and probative evidence in addition to the Form 1099-C.2  Unjustified reliance on Forms 1099-C by the IRS has led to attorney fee awards for taxpayers.3

The issuance of Forms 1099-C has skyrocketed in recent years. In 2005, debt buyers were, for the first time, required to issue Forms 1099-C.4  Most buyers of credit card debt have no idea or records of the balance due by the borrower before the original creditor charged off the debt. This ignorance produces inaccurate Form 1099-C reports of debt cancellation income. Often, debt buyers don’t know where the debtors live. So, many taxpayers never receive their Forms 1099-C.

Many low-income taxpayers don’t understand Forms 1009-C or their potential tax liability. A taxpayer should review Form 1099-C (or Form 1099-A) for accuracy and request correction by the lender/creditor if inaccurate. If the debt was transferred to a debt buyer, it is likely that the discharged debt is wrong if reported by the debt buyer. IRS Publication 4681 explains how to read Forms 1099-A and C. A taxpayer who erroneously paid taxes on cancellation of debt income may be able to amend the tax return to claim a refund.

• 1Sims v. Comm’r, T.C. Summ. Op. 2002-76.
• 2McCormick v. Comm’r, T.C. Memo 2009-239; cf. Portillo v. Comm’r, 932 F.2d 1128 (5th Cir. 1991).
• 3See, e.g., Owens v. Comm’r, 67 F. App’x 253 (5th Cir. 2003).
• 4Unfortunately, debt buyers are now “applicable entities” and are required to report debt cancellation. See Debt Buyers’ Ass’n v. Snow, 481 F. Supp. 2d 1 (D.D.C. 2006).

A common exclusion of “debt cancellation income” from taxable income results if the taxpayer was insolvent in the year that the debt was cancelled. “Insolvent” means that the taxpayer’s liabilities exceed the fair market value of the assets.1  This is a common option for removing cancelled debt income as many creditors only cancel debt after determining that the taxpayer is insolvent. Obtain a copy of the taxpayer’s credit report for that taxable year, which should list all the taxpayer’s debts.

Income in excess of insolvency is includible in a partially insolvent taxpayer’s income.2  The insolvency exclusion won’t apply to a discharged debt to which the § 108(a)(1)(E) exclusion for “qualified principal residence indebtedness” applies unless the taxpayer elects the § 108(a)(1)(B) insolvency exclusion. Cancellation of a debt that would have been deductible if paid, e.g., mortgage interest, is excluded from income.3

In Carlson v. Commissioner, the Tax Court has held that exempt assets, e.g., a homestead exemption for the family home, must be included in determining whether a taxpayer is “insolvent.”4  Some consideration should be given to challenging Carlson since it has been criticized.

Another issue is whether a separated spouse’s assets must be included in the insolvency analysis. Prior to Carlson, the IRS had issued a private letter ruling that a spouse’s separate assets should not be considered in determining whether the other spouse is insolvent for the purposes of the § 108 exclusion.5

• 1I.R.C. § 108(d)(3).
• 2I.R.C. § 108(a)(3).
• 3I.R.C. § 108(e)(2).
• 4Carlson v. Comm’r, 116 T.C. 87 (2001).
• 5Priv. Ltr. Rul. 8920019 (Feb. 14, 1989).

Debts that are discharged as part of a court-approved bankruptcy should not be reported as taxable cancelled debt income, but some creditors mistakenly do so. The tax attorney should include a copy of the Discharge Order from the bankruptcy court when filing the return or during an examination. The bankruptcy exclusion will not apply if the taxpayer fails to obtain a bankruptcy discharge granted by the bankruptcy court or under a plan approved by the bankruptcy court.1  Make sure that the bankruptcy resulted in a discharge and not a dismissal.

• 1See I.R.C. § 108(C)(2); Hill v. Comm’r, T.C. Memo 2009-101; Schachner v. Comm’r, T.C. Summ. Op. 2006-188 (debt was not discharged or dischargeable in this Ch. 13 bankruptcy).

The Mortgage Forgiveness Debt Relief Act of 2007 allows the exclusion of debt cancellation income from mortgage restructuring or mortgage foreclosure on a taxpayer’s home for debts forgiven for the years, 2007-2013.1  This Act has been extended numerous times and now covers the years 2014 through 2026. The exclusion is limited to $2 million ($1 million if filing status is married filing separately). The Act applies only to forgiveness or cancellation of debt to buy, build, or substantially improve a “principal residence” or to refinance debt incurred for these purposes. Refinanced home mortgage debt may include acquisition indebtedness and home equity debt. The home equity debt is not eligible for the qualified principal residence exclusion.2  Lenders’ principal reductions pursuant to the National Mortgage Settlement may qualify for exclusion from income under I.R.C. § 108(a)(1)(E) if the debt was acquisition debt and the cancellation occurred before January 1, 2014 or any extended date of the Act.

“Principal residence” in § 108 has the same meaning as in “principal residence” in I.R.C. § 121.3  A § 108(a)(1)(E) exclusion does not apply in a bankruptcy discharge.4  The § 108(a)(1)(B) insolvency exclusion does not apply to discharged debt to which § 108(a)(1)(E) applies unless the taxpayer elects a §108(1)(B) insolvency exception.5  A Form 982 must be filed with the taxpayer’s return to claim the § 108(a)(1)(E) exclusion from income.

Income excluded under I.R.C. §§ 108(a)(1)(A)–(C) must be applied to reduce the debtor’s “tax attributes.” As a practical matter, this reduction of basis in an indigent taxpayer’s assets will have little or no effect on the ultimate tax liability since the basis will likely be small. The basis in an asset is the price originally paid for it, along with certain maintenance and repair costs.

• 1Pub. L. No. 110-142, 121 Stat. 1803; see I.R.C. § 108(a)(1)(E).
• 2I.R.C. § 108(h)(4).
• 3See I.R.C. § 108(h)(2), (5).
• 4I.R.C. § 108(a)(2)(A).
• 5I.R.C. § 108(a)(2)(C).

A seller’s reduction in the price of the property does not give rise to cancellation of debt income.1  Instead, the buyer’ basis in the property is reduced. If a lender reduces the principal for an early payout or as part of a loan modification, the amount of cancelled debt is cancellation of debt income. However, if the debt is non-recourse and the owner retains the collateral, the owner does not have cancellation of debt income.

• 1I.R.C. § 108(e)(5).

Under I.R.C. § 102, a gratuitous release of a debt (something for nothing) may exclude debt cancellation from income. The issue is whether the creditor had a donative intent.1  Proving a §102 exclusion is difficult in consumer or commercial debt cases.

• 1See Plotinsky v. Comm’r, T.C. Memo 2008-244.

A Form 982 should be used to claim the insolvency, bankruptcy, or Mortgage Forgiveness Debt Relief Act exclusions from income. IRS Publication 4681 can be helpful to a correct preparation of a Form 982.