MORE THAN ONE WAY OUT
WIPING OUT TAXES IN BANKRUPTCY
DISCHARGE IN CHAPTER 7
Morgan D. King, Esq.
Of the California Bar
This article originally appeared in the San Francisco Recorder
When the Biblical injunction was given, Render Unto Caesar That Which is Caesar's, they didn't figure on penalties and interest compounded daily. If they had calculated how large and how devastating an overdue tax bill owed to Caesar could be, they might have changed the admonition to something like, Forget Caesar ... Take Heed of Thy Bankruptcy Attorney.
One of the best kept secrets of the I.R.S. is that, yes, taxes can often be wiped out in bankruptcy. And, it would seem, many lawyers (including bankruptcy attorneys) wish to help keep the secret, because they too seldom explore the possibility of a tax discharge with their clients.
What follows is a primer on the basics of tax dischargeability in Chapter 7. In Part II of this series we will look at the special benefits of handling tax claims through Chapter 13, with a brief nod to Chapter 11. Then, Part III will examine frequently seen problems and issues that arise in typical bankruptcy cases involving tax claims, including important unsettled areas of law.
Let's examine the simplest and most common situation ... an overdue federal or state personal income tax claim. In many cases a client will be able to wipe out all or a portion of an overdue tax, together with the interest and penalties, in Chapter 7. And, frequently a tax claim which may not be erased in Chapter 7 may be wiped out, or substantially reduced, in a Chapter 13. So, it is important to be aware of the key differences between 7 and 13 as they pertain to the issue of dischargeability.
TWO KEY CODE SECTIONS:
Nowhere in the Bankruptcy Code will one find language prescribing when an income tax may be discharged in Chapter 7. Instead, the text is framed in the negative, describing those categories of taxes which may not be discharged.
The key sections of the Bankruptcy Code are 11 U.S.C. § 523, Exceptions to Discharge, and § 507(a)(7), Priorities. Section 523, which is applicable in Chapter 7 cases, describes certain categories of taxes that may not be discharged, and in addition provides that those taxes defined in § 507(a)(7), Priorities, are, as well, not discharged. The corollary is that any tax not falling within the categories described in §§ 523 or 507(a)(7) are discharged, i.e., wiped out, in a simple Chapter 7 bankruptcy. We'll look at the negative text first, and then turn it around and summarize it in the affirmative.
In brief, 11 U.S.C. § 523 provides that a personal income tax may not be wiped out if the tax return for the year in question was not filed at least two years prior to the filing of the bankruptcy, or where the tax return, if filed, was fraudulent, or where the taxpayer had engaged in a willful attempt to evade or defeat the tax, or where the tax is a priority as defined by § 507(a)(7).
Section 507(a)(7) provides that a personal income tax is a priority tax (and hence nondischargeable by operation of § 523) where the tax is unsecured and the tax year in question is less than three years prior to the filing of the bankruptcy, or where the tax was assessed less than 240 days prior to the bankruptcy filing, or where the tax is a trust fund tax (such as a payroll withholding tax).
By reframing this text in the affirmative, we can construct a simple checklist that describes those federal or state personal income taxes which can be wiped out in Chapter 7, to wit:
THE PERSONAL INCOME TAX IS DISCHARGEABLE IF:
Ã The tax return was filed at least more than two years before the filing of the bankruptcy petition (the "Two-year Rule");
Ã The tax return was non-fraudulent;
Ã The debtor has not been guilty of a willful attempt to evade or defeat the tax;
Ã The tax year in question is more than three years prior to the filing of the bankruptcy petition (the "Three-year Rule");
Ã The tax was assessed more the 240 days prior to the filing of the bankruptcy petition (the "240-Day Rule");
Each of the above criteria must be met in order to discharge the tax. Now we'll look at each of these to see how they apply.
THE TWO-YEAR RULE
The tax return must have been filed at least two years prior to the date of the bankruptcy petition. The majority rule in case law provides that for purposes of this section, it is required that the taxpayer himself must have prepared and filed the return ... a substitute return filed on behalf of the taxpayer by the taxing entity does not count. See, for example, In re Bergstrom, 949 F.2d 341 (10 Cir. 1991). Also, an argument has been made that a return is deemed filed only if filed with the appropriate service center or state office for filing such returns. In other words, a tax return merely handed to a revenue officer in his local office may not count as a filed return.
The tax return must be non-fraudulent, and the taxpayer not guilty of a willful attempt to evade or defeat the tax. Merely not filing the return or paying the tax when due has been held to be neither fraudulent nor willful evasion of the tax. See, for example, In re Gathwright, 102 B.R. 211 (Or. 1989). And the court in In re Peterson, 132 B.R. 68 (Wyo. 1991) held that merely filing bankruptcy to wipe out a tax debt is not willful evasion of a tax within the meaning of the Code.
THE THREE-YEAR RULE
The tax year in question must be at least three years prior to the filing of the bankruptcy. This time period starts on the last date the tax return was due for the year in question. Hence, for the year 1988, if the return was due on April 15, 1989, the three year rule would be met on April 16, 1992. If an extension to file the return had been filed extending the due date to August 15, the three year period would be met on August 16, 1992.
THE 240-DAY RULE
The tax must have been assessed at least 240 days prior to the filing of the bankruptcy. For I.R.S. taxes, assessment is a discrete, formal act that takes place internally within the I.R.S. This date is ordinarily the date Form 23-C is signed and placed in the taxpayer's file (IRC § 6201 et seq.). The blue Notice of Federal Tax Lien sometimes mailed to the taxpayer ordinarily lists the dates of assessment. For state taxes, the precise date of assessment may be less clear. In California, the tax code does not provide a clear and specific act constituting an assessment, In the 9th Circuit the courts have ruled, as in In re King, 122 B.R. 383 (BAP 1991) that a state tax is assessed at the point it is deemed final and collectible by the taxing entity. Under the California Tax Code the claim becomes final 60 days after the date of the notice of proposed assessment.
Although the two Bankruptcy Code sections referred to above do not make this clear, a logical deduction from an overall reading of how liens are handled in bankruptcy suggests that, in order to be wiped out the tax claim must be unsecured. Otherwise, it will have to be paid one way or the other, assuming the taxpayer wishes to keep the property on which the claim is secured.
Briefly, a claim is unsecured if the taxing entity has not recorded a lien in the relevant county, or a lien has been recorded but the debtor owns no property to which the lien may attach, or the lien is legally defective in some manner. In a case where a lien has been recorded but the debtor's assets are worth less than the amount of the claim, then the claim is secured to the extent of the value of the assets, with the remainder of the claim being unsecured.
TRAP FOR THE UNWARY: TOLLING EVENTS
It is extremely important to be aware that certain events may stop the clock for the time periods described above. I refer to these events as Tolling Events. The three most common found in consumer bankruptcy cases are 1) an extension to file the return, 2) a prior bankruptcy filed or pending during any of the time-periods, and 3) an offer in compromise made or pending during the 240-day assessment period.
Where the debtor has filed an extension for filing the tax return, this stretches out the 3-year period, because the three years begin only on the last date the return was due.
Where the debtor has been in a bankruptcy during any of the time periods, the clock stops as to that time-period, and does not resume until the bankruptcy case terminates (caveat: some cases hold that the clock does not resume until the case terminates plus six months: see, e.g., In re Worthen, 137 B.R. 1016 (DC Or. 1992), In re Deitz, 116 B.R. 792 (D.Colo. 1990).
The making of a formal offer-in-compromise as to an I.R.S. claim stops the clock, which resumes when the offer is withdrawn, rejected or accepted, plus 30 days. 11 U.S.C. § 507(a)(7)(A)(ii).
The dischargeability of a tax penalty is much simpler than the tax itself. In brief, under the majority rule a tax penalty may be discharged in Chapter 7 if the penalty is a punitive penalty (which most tax penalties are), and it is either attached to a tax which is dischargeable, or it is attached to an event which took place more than three years prior to the bankruptcy. See, in the 9th. Cir., McKay v. U.S., 957 F.2d 689 (1992).
The rule regarding the dischargeability of interest can be stated, the interest follows the tax. In other words, where the tax itself is dischargeable, the interest is also dischargeable. Where the tax is non-dischargeable, the interest, as well, is not dischargeable.