5.17.9  Chapter 7 Bankruptcy (Liquidation)

5.17.9.1  (08-01-2010)
Overview

  1. This section discusses Chapter 7 bankruptcies. It explains the provisions and concepts of bankruptcy law that are unique to Chapter 7.

  2. A glossary of the bankruptcy terms used in this section is found in Exhibit 5.17.8-1.

5.17.9.2  (08-01-2010)
Purpose

  1. The most common form of relief sought by debtors under the Bankruptcy Code is liquidation under Chapter 7.

    1. A Chapter 7 case may be started by a voluntary or involuntary petition and involves three major participants: the debtor, the trustee, and the creditors.

    2. The trustee’s job is to take possession of and to liquidate the debtor’s nonexempt assets. The trustee distributes the proceeds to the creditors in accordance with their legal priorities.

  2. The primary purpose of Chapter 7 from the creditors’ standpoint is fair and equal treatment of creditors in accordance with their relative priorities.

  3. One of the primary purposes of Chapter 7 from the debtor’s viewpoint is to obtain a discharge of debts, thereby giving an individual debtor a "fresh start."

    1. A discharge in a Chapter 7 case is given to individuals only, not to partnerships or corporations.

    2. The right of an individual to a discharge is not absolute, as grounds may exist to oppose a discharge. Generally, if a debtor is honest and follows the rules of the Bankruptcy Code and the court, the debtor will obtain a discharge, which releases the debtor from personal liability on most of the debts owed at the time of the filing of the petition.

    3. Even if a discharge is obtained, certain debts of an individual debtor may be nondischargeable and survive bankruptcy. In particular, priority tax debts and taxes related to unfiled returns or late returns filed within two years of the bankruptcy petition date are not subject to discharge. Taxes related to fraudulent returns or a willful attempt to evade or defeat the tax in any manner are also excepted from discharge.

  4. In general, what happens in a Chapter 7 case is the collection, reduction to cash, and distribution of the debtor’s assets. To accomplish this the court must determine:

    1. the debtor’s prepetition rights and interests;

    2. the prepetition rights and interests of some or all of the creditors against other creditors or transferees;

    3. the rights of the debtor or trustee to recover property held by third parties;

    4. the rights of the debtor to retain existing or future (after-acquired) property, including rights to retain certain property as exempt from the bankruptcy process; and

    5. the relief granted to the debtor by the Bankruptcy Code from unpaid creditors.

5.17.9.3  (08-01-2010)
Automatic Stay

  1. The automatic stay is triggered by the filing of a bankruptcy petition and continues until the bankruptcy case is closed or dismissed, or in the case of an individual, the time a discharge is granted or denied, whichever event occurs first. The automatic stay remains on property of the estate until it is no longer estate property.

  2. The automatic stay prohibits any act to collect a prepetition debt; any act to create, enforce or perfect a lien against property of the estate or property of the debtor; or the commencement of any proceeding against the debtor to collect a prepetition debt.

  3. For a complete listing of acts prohibited by the automatic stay, see 11 USC § 362(a).

  4. The refiling of a Notice of Federal Tax Lien (NFTL), making an assessment or sending notice and demand, demanding tax returns, sending a statutory notice of deficiency, or setting off prepetition income tax refunds against prepetition income tax liabilities does not violate the automatic stay. 11 USC §§ 362(b)(9) and (26).

  5. If the Service willfully violates the automatic stay, it may be subject to damages and attorney’s fees under 11 USC § 362(k) and IRC § 7433(e). See, e.g., In re Chestnut, 422 F.3d 298, 300 (5th Cir. 2005) (determining that creditor violated stay when it foreclosed on an asset to which the debtor had only an arguable claim of right); In re Price, 42 F.3d 1068 (7th Cir. 1994) (IRS willfully violated stay by sending postpetition notice of intent to levy to Chapter 13 debtors, with knowledge of the bankruptcy proceedings, and declining to stop collection action); In re Bulsom, 117 B.R. 537 (B.A.P. 9th Cir. 1990) (IRS initiation of automated collection proceedings, based on mistaken belief that the bankruptcy case was closed, constituted a willful violation of the stay).

5.17.9.4  (08-01-2010)
Who May Be a Chapter 7 Debtor

  1. Generally, any entity with the exception of governmental units, railroads, insurance companies, banks and other financial institutions may be a debtor under Chapter 7.

  2. Eligible entities include individuals, partnerships and corporations.

  3. As a result of changes made to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), for bankruptcy petitions filed on or after October 17, 2005, an individual may not file a Chapter 7 petition unless such person received a briefing from an approved nonprofit credit counseling agency, including a budget analysis, within 180 days before the petition date. 11 USC § 109(h).

    Exception:

    Individual debtors are excepted from this requirement if (1) the United States Trustee determines that the approved nonprofit credit counseling agency for the district in which the debtor resides is not reasonably able to provide services to additional debtors, or (2) the bankruptcy court excuses the debtor from the required credit counseling.

5.17.9.5  (08-01-2010)
Initiating a Chapter 7 Case

  1. A Chapter 7 case is commenced by the debtor filing a voluntary petition or at least three creditors filing an involuntary petition. A husband and wife can file a joint petition. 11 USC § 302.

  2. Bankruptcy Rule 1007 requires the Chapter 7 debtor to file certain supporting documents within a fixed time after filing the petition, including a mailing matrix, statement of financial affairs, and schedules. As part of the schedules, the debtor must also include Form B22A or a means test calculation statement which is required by 11 USC § 707(b)(2)(C).

  3. For cases filed on or after October 17, 2005, 11 USC § 521(e)(2) requires the debtor to provide the trustee, at least seven days before the first meeting of creditors, a copy of the return filed for the most recent tax year ending before the commencement of the case.

  4. For cases filed on or after October 17, 2005, 11 USC § 521(j) requires the debtor to file all returns as they become due after the commencement of the case. If the debtor fails to do so, the Service may request the court to convert or dismiss the case.

5.17.9.6  (08-01-2010)
The Trustee

  1. In a Chapter 7 case, the United States Trustee must appoint a member of the panel of private trustees as interim trustee promptly after the order for relief. 11 USC § 701. The interim trustee serves until a trustee is elected by eligible creditors. This election is held at the first meeting of creditors which must be held within a reasonable time after the order for relief. 11 USC § 341. If no trustee is elected, the interim trustee serves as trustee. The interim trustee has all the rights and powers of a bankruptcy trustee.

  2. A Chapter 7 trustee is a fiduciary and is accountable to the court for the trustee’s actions. The trustee represents the estate, in particular, the unsecured creditors.

    1. The Chapter 7 trustee’s duties under 11 USC § 704 include collecting the assets of the estate, which may include converting property to money, and examining claims of creditors and objecting where appropriate.

    2. In addition, the trustee must investigate the finances of the debtor, file tax returns where required, and pay taxes where due.

    3. If the debtor served as the administrator of an employee benefit plan at the time that the bankruptcy petition was filed, the trustee must continue to perform the debtor’s duties as administrator.

    4. At the end of the bankruptcy proceedings, the trustee is required to file a final report with the court and the United States Trustee. Any creditor, including the IRS, may object to this report or account.

    5. If the debtor is an individual and has mostly consumer debts, the trustee must also file a statement indicating whether the debtor’s case would be presumed to be an abuse of the Bankruptcy Code under 11 USC § 707(b)(2) within 10 days after the first meeting of creditors.

5.17.9.7  (08-01-2010)
Conversion or Dismissal

  1. Under 11 USC § 706(a), the debtor may convert a Chapter 7 case to Chapter 11, 12, or 13 at any time, if the case has not been previously converted from Chapter 11, 12 or 13. Also, the court may, upon request of a party in interest and after notice and hearing, convert a Chapter 7 case to Chapter 11, but may not convert a Chapter 7 case to Chapter 12 or 13 unless the debtor requests or consents to such conversion. 11 USC § 706(b) & (c).

  2. Under 11 USC § 707(a), the court may dismiss a Chapter 7 case only after notice and a hearing and only for cause, including:

    1. unreasonable delay by the debtor that is prejudicial to creditors;

    2. nonpayment of any required fees or charges; or

    3. failure of the debtor in a voluntary case to file the schedules required by 11 USC § 521 within 15 days of the commencement of the case, but only on motion of the United States Trustee.

  3. Courts can dismiss a case on other grounds, including bad faith in filing the petition.

  4. Section 707(b) provides that the court, on its own motion or by motion of the United States Trustee or any party in interest (e.g., panel trustee or a creditor), may dismiss a Chapter 7 case filed by an individual debtor, or convert the case to Chapter 11 or 13 (with the debtor's consent), if his or her debts are primarily consumer debts. In this situation the court must first find that granting Chapter 7 relief would be an abuse under 11 USC § 707(b)(2). There is a presumption of abuse if the debtor fails to meet a means test calculation based on income, expenses, and certain debts. In a joint case, the means test calculation would be based on the financial information of both spouses.

  5. A Chapter 7 case cannot be dismissed or converted based on any form of means testing if the debtor is a disabled veteran and the indebtedness occurred primarily during a period of active duty or while the debtor was performing a homeland defense activity. 11 USC § 707(b)(2)(D)(i).

  6. A Chapter 7 case cannot be dismissed or converted based on any form of means testing with respect to the debtor while the debtor is on, and during the 540-day period beginning immediately after the debtor is released from, a period of active duty or performing a homeland defense activity of not less than 90 days. 11 USC § 707(b)(2)(D)(ii).

5.17.9.8  (08-01-2010)
Proofs of Claim

  1. Generally, in Chapter 7 cases, a proof of claim must be filed in order to share in the distribution of the estate. The procedure for filing claims in Chapter 7 are set forth in Bankruptcy Rules 3001 and 3002.

  2. In a Chapter 7 case, if it appears from the schedules that there are no assets from which a dividend can be paid, the court may include in the notice of first meeting of creditors a statement that it is unnecessary to file proofs of claim. Bankruptcy Rule 2002(e). If the payment of a dividend subsequently becomes possible, further notice will be given for the filing of claims.

  3. In Chapter 7 cases, to be timely, an IRS claim must be filed within 90 days after the first date set for the first meeting of creditors or within 180 days after the order for relief, whichever is later. Bankruptcy Rule 3002(c). In Chapter 7 cases, a tardily filed priority claim may still receive priority treatment, as discussed below. 11 USC § 726(a)(1).

  4. As a result of BAPCPA’s amendments to 11 USC § 503(b)(1), for cases commencing on or after October 17, 2005, the IRS may file, but is not required to file, a proof of claim for its administrative expenses as a condition to being allowed a claim for such expenses.

5.17.9.9  (08-01-2010)
Bankruptcy Estate Income Taxes

  1. The bankruptcy estate in an individual Chapter 7 case is a separate taxable entity that must file its own tax return. The Chapter 7 trustee has the duty to file the estate tax return.

  2. In corporate and partnership Chapter 7 cases, no separate taxable entity is created. The trustee is responsible for filing required tax returns.

  3. If certain requirements are met, individuals in Chapter 7 have the right to terminate their tax year when the petition is filed. IRC § 1398. This creates two short taxable years in the year in which the bankruptcy petition is filed, one with a prepetition liability for which the estate is liable and one with a postpetition liability which is the debtor’s responsibility. See IRM 5.9.6.15 and IRM 5.9.6.16 for further discussion on the separate taxation of an individual Chapter 7 debtor and the bankruptcy estate.

5.17.9.10  (08-01-2010)
Treatment of Tax Liens

  1. Under 11 USC § 724(b), tax lien claims are subordinated to claims entitled to priority under 11 USC §§ 507(a)(1) through 507(a)(7), including administrative expenses and certain other priority claims. If a case was converted from Chapter 11 to 7, administrative expenses, other than wages, salaries, or commissions arising after the date of the petition, only include the expenses incurred during the Chapter 7 case. 11 USC § 724(b)(2).

  2. Thus, property of the estate that is subject to a tax lien or proceeds of such property is distributed in the following order:

    1. to the holders of liens senior to the tax lien;

    2. to priority claims specified in 11 USC §§ 507(a)(1) – (7), up to the amount of the allowed tax claim that is secured by the tax lien;

    3. to the holder of the tax lien, in the amount equal to the difference between the amount of the priority claims above and the actual amount of the tax lien;

    4. to the holders of liens junior to the tax lien;

    5. to the holder of the tax lien in the amount of the allowed tax claim that is not paid under c above; and

    6. to the estate.

  3. Before subordinating a tax lien claim to the priority claims described above, the trustee must first use all unencumbered assets of the estate to satisfy those claims. 11 USC § 724(e).

5.17.9.11  (08-01-2010)
Distribution of Property of the Estate

  1. The trustee’s main goal is to produce an estate for the debtor’s unsecured creditors by liquidating the debtor’s nonexempt and unsecured assets and pursuing causes of action to recover money or property.

  2. Under 11 USC § 726, the property of the estate is to be distributed as follows:

    1. priority claims (timely filed, or if tardily filed, on or before the earlier of 10 days after the date that the summary of the trustee’s final report is mailed to creditors, or the date of final distribution) in the order specified in 11 USC § 507;

    2. general unsecured claims, including claims filed late due to the claimant’s lack of notice or actual knowledge of the case;

    3. other tardily filed general unsecured claims;

    4. claims (secured or unsecured) for a fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages to the extent such claims are not for actual pecuniary loss;

    5. interest at the legal rate from the date of the petition on any claim paid under the above; and

    6. the debtor.

  3. Upon conversion to a Chapter 7, administrative claims of the previous chapter retain their administrative status, but are paid after the administrative claims of the Chapter 7. 11 USC § 726(b).

  4. If funds are insufficient to pay all the creditors in a certain class, the creditors within that class will share pro-rata. 11 USC § 726(b).

5.17.9.12  (08-01-2010)
Adequate Protection and Turnover

  1. The concepts of adequate protection and turnover in bankruptcy are explained in IRM 5.17.8.11 and IRM 5.17.8.24, respectively.

  2. In Chapter 7 cases, adequate protection should rarely be the basis for the IRS to resist turning over property of the estate to the trustee. Because a secured tax claim in a Chapter 7 will be subordinated to unsecured priority claims pursuant to 11 USC § 724, and the IRS is only entitled to amounts determined in accordance with the distribution scheme of 11 USC § 726, adequate protection arguments are usually not warranted or reasonable.

  3. Adequate protection, however, may be warranted in a Chapter 7 where the trustee has determined that it is in the best interest of the creditors to keep the debtor’s business going to maximize the amount the business will ultimately bring at sale. In such a case, the trustee may continue to operate the business for some time, making arguments for adequate protection of the IRS’s secured interests more reasonable.

5.17.9.13  (08-01-2010)
Discharge

  1. Under 11 USC § 727, discharge is available to individuals in Chapter 7 cases. Except for nondischargeable debts under 11 USC § 523, the debtor is discharged from all debts that arose prior to the filing of the Chapter 7.

  2. Under 11 USC § 727, the grounds for denial of discharge include:

    1. with the intent to defraud or delay, debtor has transferred, destroyed, or concealed property of the debtor within one year before the bankruptcy or property of the estate during bankruptcy;

    2. debtor has concealed, falsified, destroyed, or failed to preserve financial records, unless justified under the circumstances;

    3. in connection with the bankruptcy case, debtor knowingly and fraudulently: (1) made a false oath or account; (2) presented or used a false claim; (3) gave, offered, or received money, property, or advantage for acting or forbearing to act; (4) withheld from an officer of the estate any recorded information relating to the debtor’s property or financial affairs;

    4. debtor has failed to satisfactorily explain any deficiency in assets available to meet liabilities;

    5. debtor has refused to obey a lawful order of the court or to testify, unless the order was to respond to a material question or to testify to a matter on which the debtor has asserted the privilege against self-incrimination and not been granted immunity;

    6. debtor has committed an act specified in a) through e) above on or within one year before the date the bankruptcy was filed, or during the case, in connection with the bankruptcy of an insider;

    7. debtor has received a discharge in a Chapter 7 or Chapter 11 case commenced within eight years of the filing of the petition;

    8. debtor has received a discharge in a Chapter 12 or Chapter 13 case commenced within six years of the filing of the petition unless the unsecured debts provided for in the plan were entirely satisfied, or at least 70 percent of the claims were satisfied and the plan was proposed in good faith and was the debtor’s best effort;

    9. after filing the bankruptcy petition, debtor has failed to complete the required personal financial management course (unless the court or trustee determines that the debtor is not required to complete such a course); or

    10. the court finds that there is reasonable cause to believe that 11 USC § 522(q)(1) applies to the debtor, and there is a proceeding pending in which debtor may be found guilty of a felony as described in 11 USC § 522(q)(1)(A) or liable for a debt as described in 11 USC § 522(q)(1)(B) (includes certain debts arising from violations of securities laws and criminal acts or willful misconduct that causes serious physical injury or death to another individual in the preceding 5 years).

  3. A discharge may be revoked by the court upon the request of the trustee, a creditor, or the United States Trustee under 11 USC § 727(d) if:

    1. the discharge was obtained through fraud of the debtor which the requesting party did not know of until after the discharge was granted;

    2. the debtor knowingly and fraudulently failed to report the acquisition of or entitlement to property of the estate;

    3. the debtor has refused to obey a lawful order of the court or to testify; or

    4. the debtor has failed to explain a material misstatement in an audit or failed to make documents related to the audit available for inspection.

  4. The request for revocation must be made within one year of the discharge in the case of a discharge obtained through fraud or before the later of one year after the discharge or the date the case is closed, in the case of failure to report property or failure to obey an order.

  5. While a Chapter 7 debtor may be granted a general discharge, any debt that is nondischargeable under 11 USC § 523 will not be barred from further collection activity. Additionally, post-petition interest on nondischargeable taxes is nondischargeable.

  6. If a debt is discharged, the discharge injunction under 11 USC § 524 prohibits any act to collect the debt against the debtor personally. If the IRS willfully violates the discharge injunction, it may be subject to damages and attorney’s fees under IRC §§ 7430 and 7433(e).

5.17.9.14  (08-01-2010)
Collection Outside Bankruptcy

  1. The IRS can collect nondischargeable liabilities from the exempt, abandoned, nonadministered and after-acquired property of an individual debtor.

  2. Regarding dischargeable liabilities, if an Notice of Federal Tax Lien has been filed prepetition, the IRS may collect on its lien from exempt or excluded property or property that has been abandoned or otherwise not administered by the trustee.

  3. Property excluded from the estate includes ERISA-qualified pension plans and other plans described in 11 USC § 541(b). The Service may enforce its unfiled assessment lien against excluded property after the automatic stay is lifted.


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