Really Subtle Trick For Discharging Taxes

While the IRS shows the early withdrawal penalty for taking money from an IRA as tax, several cases uphold treating it as a penalty, therefore,  dischargeable in Chapter 13.

No matter how often I go to NACBA events, I always end up with a couple of dynamite ideas that justify the time and expense.  This one comes from Billy Brewer and the Advanced Issues in Chapter 13 track.  Usually I write about things I’ve done;  this one I haven’t tried, but it seems both sound and beneficial to the client.

The basic issue is that priority tax claims have to be paid in full in a Chapter 13 while penalties are treated as a general unsecured claim and discharged at the end of the plan.

A premature withdrawal from an IRA or 401(k) can trigger an early withdrawal penalty.  When the IRS issues a tax transcript, however, it treats that penalty as a tax.

Billy cites two cases which disallowed the early withdrawal penalty characterization as a tax:  Cassidy, 983 F.2d 161 (10th Cir.1992) , and a case he won, Cespedes, 393 B.R. 403.

The practical problem is calculating how much of the outstanding tax liability is comprised of the penalty.  Sounds like it required getting info on the amount of the penalty and developing an analytical approach to allocation of any post assessment payments made by the debtor.

Let me know if you find clients who are facing recent early withdrawal penalties and your success in arguing that it’s not a tax for bankruptcy purposes.

More on tax issues:

Four Means Test Mistakes

Bankruptcy and Offers in Compromise

Tax Liens in Bankruptcy

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  1. What about a discharge under Chapter 7 where the penalty was incurred within 3 years of filing the bankruptcy petition?