Discharging Taxes in Bankruptcy

PART I

INTRODUCTION

 By

 Morgan D. King, Esq.
Of the California Bar

Originally appearing in the San Francisco Recorder in three parts 

This essay provides an introduction to the basic rules governing the discharge of personal income taxes, penalties and interest in consumer bankruptcy cases. The critical time periods, tolling events that may interfere with the time periods, and ancillary issues such as what constitutes a tax return and what conduct may be deemed tax evasion are covered.

a. The Taxpayers' Options

Delinquent taxes and accompanying interest and penalties are a big problem for a great many taxpayers. In tax year 1997 the IRS assessed over 23 billion penalties totaling over $13 billion dollars. After abatements and compromises the net penalties were a little over $8 billion. There were over $32 billion in assessed but unpaid taxes In tax year 1997. This does not include a sizable amount not assessed because no income information was submitted to the IRS. The latest estimate from the IRS, as of the last quarter of 1998, is that the national "tax gap," or the total amount of unpaid tax due to unfiled returns or unpaid assessments, stands at $195 billion.

These figures spill over into consumer bankruptcy filings. The IRS estimates that 40% of all consumer bankruptcy filings include delinquent tax claims.

These figures represent a problem for the U.S. Treasury. But it doesn't take a big number for a delinquent tax to make a huge problem for an individual or a family. Even a few thousand dollars is a major crisis if you can't pay it. The sword of the IRS hanging over one's head can drive one "crazy," or at least drive a taxpayer to desperation. And many desperate taxpayers seek a lawyer's counsel and advice to help solve the problem.

The tax professional has a cocktail of possible legal remedies for the delinquent taxpayer.

Among these choices are -

• 1. Pay the tax
• 2. Set up a voluntary installment arrangement
• 3. Dispute or litigate the liability
• 4. Set up an offer-in-compromise
• 5. Seek non-collectible status
• 6. Seek protection under a "Taxpayer's Assistance Order"
• 7. File bankruptcy

b. The bankruptcy option

A thorough exploration of these options may lead to the conclusion that bankruptcy may be the most feasible remedy. The question then arises, are the delinquent tax claims capable of being discharged in bankruptcy?

In a nutshell, in many cases the answer will be yes. In the case of personal in come taxes, for example, where the tax is for a tax year over three years old preceding the bankruptcy filing date, there is a genuine possibility of dischargeability of the tax and the accompanying interest and penalties. There are tax discharge opportunities in Chapter 7, Chapter 13 and Chapter 11, and counsel should examine the issue carefully to ascertain the extent of such dischargeability. In some circumstances sales taxes, excise taxes, property taxes, payroll withholding and employers' employment taxes may be dischargeable, as well.

c. Most frequent issues

The issues that tend to come up frequently regarding tax claims in bankruptcy are:

• 1. What categories of taxes may be discharged?
• 2. When are the taxes dischargeable?
• 3. What constitutes a tax "return" for purposes of dischargeability?
• 4. What kinds of taxpayer conduct constitute willful attempts to evade the tax?
• 5. Are the time periods for dischargeability tolled by a prior bankruptcy or other event?
• 6. When is it preferable to treat such claims in a Chapter 13, rather than in a Chapter 7?
• 7. Under what circumstances, and to what extent, are tax claims secured?
• 8. What are the ramifications of a secured tax claim?
• 9. How may tax liens be attacked in bankruptcy?
• 10. Under what circumstances should debtor's counsel file a claim on behalf of the taxing entity?
• 11. To what extent does the automatic stay restrain collection activities of a taxing entity?
• 12. Under what circumstances do interest and penalties stop accruing upon filing bankruptcy, and to what extent are they dischargeable in bankruptcy?
• 13. In what manner is it possible to contest or settle disputed tax claims in the bankruptcy proceeding (as opposed to tax court)?
• 14. What effect does the filing of a bankruptcy have on tax attributes (i.e. net operating loss, credit carryovers, capital loss carryovers, the taxpayer's basis, etc.)?

What follows is a discussion of the first six of the issues listed above, with statutory and case law where available.

d. Public Policy

The dischargeability of taxes should not be deemed a mere loophole to allow tax evaders to get out of paying their lawful taxes. Rather, the laws permitting debtors in certain situations to wipe out a tax obligation are a matter of clear and explicit Congressional intent, and are deemed to have important positive social value.

Public policy in connection with discharge of taxes is set in a context of broader policy justifying the bankruptcy privilege for debts in general. This broader policy has evolved over several centuries, originating in the bankruptcy laws of 18th century England. Over time the bankruptcy laws have evolved from their beginnings as laws primarily for the protection of creditors to a more humane scheme extending benefits to the debtor, as well.

There are two public policy purposes behind the modern bankruptcy system; 1) provide a means for the effective rehabilitation of the bankrupt, and 2) equitable distribution of assets among competing creditors. Thus, rehabilitation of the debtor and protection of creditors are the two fundamental underpinnings of bankruptcy policy in the U.S.

e. Legislative history

Prior to 1966 taxes could not be discharged in bankruptcy in the U.S., although they were dischargeable in the bankruptcy schemes of many of the major industrialized nations.

In 1966 Congress proposed a plan to make personal income taxes dischargeable in bankruptcy. Senate Report No. 1158 (May 12, 1966, report to accompany H.R. 3438) stated "The purpose of the bill (H.R. 3438) is to make dischargeable in bankruptcy debts for taxes... " The report further stated:

Although taxes have enjoyed [nondischargeability] for many years, the enormous increase in the tax burden during recent years and the consequent impact on both the distribution of a bankrupt's estate and his financial rehabilitation, require a modification of that status.

Frequently, the (nondischargeability) prevents an honest but financially unfortunate debtor from making a fresh start unburdened by what may be an overwhelming liability for accumulated taxes. The large proportion of individual and commercial income now consumed by various taxes makes the problem especially acute. Furthermore, the nondischargeability feature of the (then existing) law operates in a manner which is unfairly discriminatory against the private individual or the unincorporated small businessman.

- U.S. Code Cong. & Adm. News, 1966, Vol. 2, 2471 (House Report No. 687, 89th Cong. 1st. Sess.

As observed in Congressional literature;

... the Treasury's prior opposition to these proposals was based on an undocumented assumption that revenue would be substantially reduced. The assumption is now shown to be unfounded by the data furnished. The small loss of revenue as a result of the Commission's recommendations will be offset, perhaps to the extent of 50%, by a reduction in the amount of bad debt deductions taken by the other creditors.

- Report of the Commission of the Bankruptcy Laws of The United States, H.R. Doc. No. 137, Part I, 93rd Cong., 1st Sess. (Sept. 6, 1973).

Significantly, the 1966 proposals were supported by;

• The National Bankruptcy Conference
• American Institute of Certified Public Accountants
• Commercial Law League of America
• National Association of Credit Managers
• The American Institute of Accountants

The notion of discharge of taxes under the proper circumstances was supported by both the debtor and the creditor side. It is fair to presume that both sides supported it because it was deemed fair and equitable. The protection of revenue for the government played a minor, if any, role in the justification behind discharge of taxes for the honest but unfortunate debtor. The reason such entities as the Commercial Law League of America found themselves supporting a liberalization of tax discharge is not difficult to fathom:

[W]ith the proliferation of new taxes and the increased rates of old taxes, often little or nothing is left for distribution to general creditors who provided goods and services to the bankrupt. - S.R. No. 1158 (May 12, 1966).

The non-dischargeability of taxes for the individual debtor was perceived to be unfair to the other general unsecured creditors in bankruptcy cases.

... that the recognition of priority for an accumulation of "stale" taxes is unfair to general creditors ...

Furthermore, Congress observed that the amount of revenue that would be lost by allowing a limited amount of taxes to be dischargeable would be "insignificant to the federal government."

While granting the right to discharge personal income taxes, Congress provided for the protection of tax collection by providing for various time periods in which the taxing entity would have an opportunity to collect the taxes. Thus, priority taxes are not dischargeable, and a tax for a tax year less than three years old, or assessed less than 240-days would be deemed priority taxes. The purpose of the priority periods is to give the tax entity a reasonable time in which to collect the taxes;

Congress did not intend to grant the IRS an absolute priority in bankruptcy for delinquent taxes, however. Instead, sections 507 (a)(8) and 523(a) (1)(A) except from discharge income and employment tax liabilities only for those taxable years ending within three years of the filing of a debtor's bankruptcy petition. (cites) Congress imposed this three-year limit on the dischargeability of income and employment taxes "because the taxing authority should not be given priority for taxes that are unassessed or uncollected through lack of due diligence."

- In re Turner, 195 B.R. 476 (Bkrtcy.N.D.Alabama 1996), citing H.R. Report No. 595 (1978), at 191.

When the interests of the government were taken into consideration as well, a three-way compromise of competing interests was achieved, including the state's interest in the protection of tax revenue. This balance, or compromise of competing interests, has been identified in published case opinions.

The legislative history of the Bankruptcy Reform Act is replete with references to the effect the proposed legislation would have on the collection of taxes. See, e.g., S. Rep. No. 1106, 95th Cong., 2d Sess. (1978) (Committee on Finance); S. Rep. No. 989, 95th Cong., 2d Sess. (Judiciary Committee) reprinted in 1978 U.S. Code Cong. & Ad. News 5787). These references make clear that the Bankruptcy Code attempts to reconcile three sets of interests that usually coexist in tension; the interests of general creditors who do not want a debtor's funds to be exhausted by accumulated back taxes; the interests of debtors whose "fresh start" should not be burdened by accumulated taxes; and the interests of the public in not losing taxes whose collection the law has restrained.

- Tabb, History of Bankruptcy Laws In the United States, 3 Am. Bankr. L. Rev., 5 (Spring, 1995)-

And the balancing of competing interests in the Bankruptcy Reform Act of 1978 has been noticed in bankruptcy literature:

The treatment of individual debtors otherwise represented a fairly even balance between the interests of the credit industry and debtors (although creditors might take issue with that assertion!).

- Tabb, History, Supra., at 35

By proposing a truly equitable balance between the debtor and his creditors, the legislation obtained the support of a broad spectrum of the community having an interest in bankruptcy proceedings. In connection with proposals to allow the discharge of some taxes, the report observed that:

[the report] recognizes the principal that trade creditors and taxing authorities would both benefit more in the long run if they work together rather than in competition for the assets of the estate.

This policy requires that the interest of the debtor and all creditors, not merely the government, be considered and treated equitably vis-a-vis their some times competing interests.

In a broad sense, the goals of rehabilitating the debtors and giving equal treatment to private voluntary creditors must be balanced with the interests of governmental tax authorities who, if unpaid taxes exist, are also creditors in the proceeding.

The major focus of the tax discharge legislation, however, was to create a humane escape valve for the overburdened debtor. Thus, ultimately, Congress hoped that due to such legislation it would "... become feasible for an industrious debtor to reestablish himself as a productive and taxpaying member of society."

Said the Court, "The dominant purpose of the change (Bankruptcy Act) is to relieve a debtor of the burden of older taxes after bankruptcy." U.S. v. Sanabria 424 F.2d 1121 (7th Cir. 1970). For example, in the case In re Borck the debtor's income tax liabilities, which arose more than three years prior to filing of her Chapter 7 petition, were held to be dischargeable, where her returns for all tax periods in question were filed and tax returns were not fraudulent, nor was there any willful attempt on the debtor's part to evade or defeat such taxes. In re Borck, 81 B.R. 142 (Bkrtcy. S.D. Fla.1987).

Proceed to Part II - Discharge in Chapter 7