EMERGING AND UNSETTLED ISSUES
IN TAX DISCHARGE CASES
 

by

Morgan D. King

Of the California Bar

This article originally appeared in CCH Journal of Tax Practice & Procedure

[This article was written for a non-bankruptcy, tax professional audience;
for purposes of simplification I have deleted most case citations]

I. History of tax discharge

2. What is willful evasion of tax?

3. Does a prior bankruptcy toll the time periods?

4. What is a tax return?

5. Does sovereign immunity protect the states?


1. History of tax discharge

When asked why tax discharge in bankruptcy is so "complicated," the best answer may be that this subject is not complicated in the sense of highly abstract issues but rather that there are so many issues. Tax discharge is a minefield of potential traps for the unwary. Accordingly, in order to handle a tax discharge case successfully the lawyer need not be brilliant, just careful and thorough.

Adding to this complexity is the nebulous nature of a number of issues that may have a bearing on a taxpayer's right to discharge delinquent taxes in bankruptcy. Below is a discussion of five such issues, any one of which may pop up in a routine case, making it difficult for the debtor's attorney to predict with confidence the final outcome of the matter.

This essay discusses five of those issues.

A little history and comment on public policy helps provide a frame of reference for the following discussion.

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.

In 1966 the Senate and House Judiciary Committees reported in favor of proposals to render certain taxes dischargeable in bankruptcy. 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 to all parties. 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.

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

When the interests of the government were worked into the formula, a three-way compromise of competing interests was achieved, including the state's interest in the protection of tax revenue.

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. . These references make clear that the Bankruptcy Code attempts to reconcile three sets of interests that usually co-exist 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.

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 sometimes 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 compassionate escape valve for the over-burdened 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."

It is against this backdrop of public policy that we explore several emerging or unsettled issues in connection with taxpayer relief under the Bankruptcy Code.

As a general rule, in any question of dischargeability of a debt, the benefit of the doubt is supposed to swing in the debtor's favor. And, a number of cases have cited this general proposition in the context of tax discharge cases. For example, in In re Fegeley, the court stated " ... exceptions to discharge are to be strictly construed in favor of the debtor." And the opinion recited the general rule that "... the burden of proving that the debtor's tax liabilities are nondischargeable under § 523(a)(1)(C) is on the United States."

What follows is a brief precis of some of the key problems emerging in this field.


2. WHAT IS FRAUD OR EVASION?

One of the issues that has come to the forefront in recent years is the question, what constitutes "fraud" or "evasion" within the meaning of section 523 of the Bankruptcy Code?

As a general rule personal income taxes are nondischargeable in bankruptcy if they fail to satisfy certain criteria set forth in the Bankruptcy Code. Pursuant to 11 U.S.C. § 523(a)(1)(C) a tax is not dischargeable (i.e., is excepted from discharge) in Chapter 7 if the taxpayer has "made a fraudulent return or willfully attempted in any manner to evade or defeat such tax." The courts have not had much difficulty figuring out what constitutes a fraudulent tax return. And, where there is a finding of a fraudulent tax return the opinions typically hold that such conduct also constitutes willful attempt to evade or defeat the tax, thus rendering the taxes nondischargeable.

The burden of proof for civil fraud within the meaning of the Tax Code as well as the Bankruptcy Code is "preponderance of the evidence." The preponderance of the evidence burden is simply that it is "more probable than not that the debtor made a fraudulent return or willfully evaded a tax." The burden of proof for criminal fraud under the Tax Code is proof beyond a reasonable doubt.

Affirmative conduct or mere omission?

The problem, however, is not with the burden of proof for fraud, but rather with the standard of proof for willful evasion; the Bankruptcy Code does not provide much guidance on what is meant by "willfully attempted." This lack of guidance has given rise to the question, for purposes of dischargeability in bankruptcy, in order to find that the taxpayer willfully attempted to evade or defeat the tax, is it necessary for the taxpayer to have committed some affirmative act evidencing his intent to evade the tax (i.e., the "criminal" standard of proof under the Internal Revenue Code; see 26 U.S.C. § 7206). Or, is it sufficient that the taxpayer merely omitted to perform an act that is required under law, such as failing to file a timely return, or failing to pay the tax (ostensibly, the "civil" burden under the IRC; see 26 U.S.C. § 6653)?

There is a growing split in published bankruptcy opinions, some holding that a finding of willful tax evasion requires more than mere omission, but rather requires an affirmative act evidencing intent to evade the tax. These opinions hold to the criminal standard of proof. Others hold instead that willful evasion may be found by mere omission alone, that is, the failure to perform a required act without other affirmative acts evidencing intent to evade the tax. This is the civil standard.

The growing debate centers around which standard is to be used in bankruptcy cases. More precisely, the debate is about the proper definition of "willfulness" in the context of the Bankruptcy Code. "Willfully" has generally been defined as "a voluntary, intentional violation of a known legal duty." If the debtor had his druthers, he'd druther the criminal standard was employed, because this imposes a higher burden on the taxing entity to establish its case.

Recent bankruptcy cases are increasingly acknowledging the confusion about this subject; the court in Burgess v. U.S. noted the "considerable controversy," arising to some extent because the language in section 523 is similar to both criminal and civil parts of the Internal Revenue Code.

This debate is found not only in the published opinions but also in the literature. For example, Anthony Sabino's 1993 article in Suffolk University Law Review weighs the arguments for and against these two standards, eventually concluding with a suggestion that the criminal standard should be used.

In his article Sabino noted that a then-recent bankruptcy case, U.S. v. Toti, -

[H]as recently added to the wise detour taken by certain of the nation's bankruptcy judges from applying that longstanding definition in cases deciding whether or not a debt arising from tax evasion is in fact dischargeable in bankruptcy. In so doing, that court has brought to the fore the rift between those bankruptcy decisions and the decisions of other bankruptcy courts that adhere to the Supreme Court's own postulation of "willfulness."

The criminal standard

Outside of the bankruptcy context merely failing to pay assessed taxes, without more, typically does not constitute criminal evasion of tax, though it may satisfy the requirements for the willful failure to pay taxes under § 7203. Only affirmatively evasive acts--acts intending to conceal--are punishable under § 7201. However, the offense of civil fraud may be demonstrated under the Internal Revenue Code without a showing of "evil motive "or "sinister purpose."

A non-bankruptcy case, United States v. McGill, stated

The elements of the felony of attempted evasion of payment of tax under § 7201 are three: 1) the existence of a tax deficiency; 2) an affirmative act constituting an attempt to evade or defeat payment of the tax; and 3) willfulness. Willful failure to pay tax under § 7203 contains two elements: 1) failure to pay a tax when due, and 2) willfulness.

The McGill court went on; "Section 7201 further requires proof of an affirmative act of evasion. One act will suffice." McGill held that the taxpayer's closing of bank accounts which had been levied by the IRS, and henceforward depositing money in bank accounts listed in other names constituted affirmative acts of tax evasion. Said the court:

Section 7201 encompasses two kinds of affirmative behavior: the evasion of assessment and the evasion of payment. Evasion of assessment cases are far more common. The affirmative act requirement in such a case is satisfied, inter alia, with the filing of a false return. See, e.g., Sansone, 380 U.S. at 351-52. If the false filing is shown to be willful, the offense is complete with the filing. See id. Evasion of payment cases are rare, and the required affirmative act generally occurs after the filing, if there is a filing at all. United States v. Mal, 942 F.2d 682, 687 (9th Cir. 1991) (evasion of payment "involves conduct designed to place assets beyond the government's reach after a tax liability has been assessed") (emphasis added).

McGill was charged with evasion of payment.

Another way of looking at the standards was expressed by the court in In re Lilley, which posited that the first prong of section 523 (fraudulent return) is directed at "cheats," while the second prong (evasion) is directed at "protesters."

Bankruptcy court opinions

The use of the criminal standard in bankruptcy cases has been adopted by a number of courts. An illustrative case is Haas v. IRS.

In Haas the debtor filed returns but failed to pay the taxes for eight years. He was then charged with and pleaded guilty to two counts of willful failure to pay under the Tax Code. Haas faithfully complied with terms of probation that included a payment schedule for the back taxes. The Bankruptcy court employed the criminal standard and found that the debtor had not engaged in any affirmative act of evasion, and therefore the taxes were dischargeable. On appeal the District Court reversed, employing the civil standard. Then on appeal to the Eleventh Circuit the court reversed and held the taxes dischargeable. After first noting that using the civil standard would make virtually all taxes nondischargeable, a result Congress did not intend, the court then noted that the Tax Code makes it a crime to evade any tax or "the payment thereof," while the Bankruptcy Code omits the words "or the payment thereof." Said the Court,

The omission of the words "or the payment thereof" from section 523(a)(1)(C), in light of Congress's previous inclusion of these words on four previous occasions, indicates that Congress did not intend that a failure to pay taxes, without more, should result in the nondischargeability of a debtor's tax liabilities in bankruptcy.

In Dalton v. I.R.S., the court ruled against the debtor. The Dalton court recited the general proposition that exceptions to discharge are strictly construed in favor of debtors. The Dalton court rejected the notion that mere omission could be sufficient to constitute willful evasion.

We conclude that any other application would ignore the congressional intent to enact a statute of limitations beyond which the honest debtor's unpaid taxes will be discharged. Thus, we hold that nonpayment, by itself, does not compel a finding that the given tax debt is nondischargeable. Rather, nonpayment is relevant evidence which a court should consider in the totality of conduct to determine whether or not the debtor willfully attempted to evade or defeat taxes.

In Dalton the debtor had, among other things, transferred substantial sums of money into his fiance's bank account knowing at the time that he was the subject of an IRS investigation that would probably result in a substantial assessment of taxes. This was enough affirmative conduct to find willful attempt to evade the tax.

Other opinions illustrate the employment of the criminal standard. Held, debtors' transfer of homestead to family members, while insolvent, for consideration of $10 less than two years prior to filing bankruptcy was not, by itself, sufficient to constitute willful evasion of tax. But, held, tax claims were found nondischargeable based on willful tax evasion when debtor quitclaimed his interest in the family home to his wife for no consideration following notice of tax deficiency.

Held, husband was not guilty of fraud or willful evasion even though he signed joint tax return, where it was his custom and habit to sign without reviewing and return was prepared by spouse (spouse had embezzled substantial sums of money from employer and filed false income tax returns).

Held, taxes not dischargeable where debtor had high level of sophistication and concealed funds in foreign bank accounts.

Held, failure to pay taxes, by itself, does not constitute willful attempt to evade the tax (debtor deposited money in wife's bank account, refused to open an account in his own name, and refused to hold property in his name; taxes held dischargeable).

Affirmative acts of evasion of payment have been evidenced by conduct such as: placing assets in the name of others; dealing in currency; causing receipts to be paid through and in the name of others; and causing debts to be paid through and in the name of others, keeping a double set of books, making false entries or alterations, or false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling of one's affairs to avoid making the records usual in transactions of the kind, and any conduct, the likely effect of which would be to mislead or to conceal.

For example, in Spies, the petitioner "insisted that certain income be paid to him in cash, transferred it to his own bank by armored car, deposited it, not in his own name but in the names of others of his family, and kept inadequate and misleading records." The Supreme Court found this evidence sufficient to sustain a finding of attempted evasion. Spies, 317 U.S. at 499 (emphasis added). In Conley, the Court of Appeals for the Seventh Circuit affirmed a § 7201 conviction where the defendant placed assets in his sons' names, deposited his assets with others, dealt in currency, and paid creditors but not the government. And see United States v. Voorhies affirming a Tax Code § 7201 conviction where defendant traveled out of country on three occasions in one year, carrying over $80,000 in negotiable assets, did not declare these amounts to customs, and was later unable to account for use of large amount of cash and gold coins; United States v. Hook affirming § 7201 conviction where the defendant did most of his business in cash, used credit cards belonging to others, and bought a house in his girlfriend's name; United States v. Shorter, affirming § 7201 and § 7203 convictions where defendant carried on a "cash lifestyle."

The civil standard

Where courts employ the civil standard, it is easier to find willful evasion.

In U.S. v. Toti the taxpayer failed to file returns or pay taxes for seven years, then only filed his returns after being charged and pleading guilty to three criminal counts of failing to file under 26 U.S.C. § 7203. Toti argued that the criminal standard should be used in the bankruptcy case on the issue of dischargeability because the language of § 523 in the Bankruptcy Code was almost identical to that of IRC § 7203, which employed the criminal standard. The sixth circuit disagreed, holding that "...the definition of "willfully attempted to evade" was consistent with the definition found in other civil tax cases, which equates "willful" with voluntary, conscious, and intentional evasions of tax liabilities.[cites]

The court in Fegeley, supra., ruled against the taxpayer, holding that an affirmative act evidencing willful intent to evade a tax is not required, but that a finding of mere "culpable omission," or failure to perform a lawfully required act could be sufficient to find willful intent to evade.

In that case the debtor had failed to file timely tax returns or pay taxes for several years. He was charged with a criminal failure to file returns under 26 U.S.C. § 7203 and pleaded guilty to one count. He subsequently filed all of the tax returns.

After a Bankruptcy Court trial on dischargeability the debtor was found to have had sufficient funds in his bank accounts to have paid his taxes when due, but the Bankruptcy Court nevertheless ruled that merely failing to paying taxes was insufficient to constitute a willful attempt to evade the tax. On appeal, the District Court reversed, and this ruling was affirmed by the Third Circuit, holding that by having the means to pay the taxes and willfully failing to pay them, his conduct amounted to a willful attempt to evade the tax, and thus the tax was not dischargeable. The court ruled that to prevail, the IRS need show only that the debtor "... had a duty under the tax law, knew he had that duty, and voluntarily and intentionally violated that duty."

Congressional intent

In bankruptcy cases should a finding of willful evasion of a tax be limited to those cases which the taxpayer engaged in some affirmative act evidencing an intent to evade the tax?

Congress contemplated that some taxpayers, those "honest but unfortunate" ones, would become delinquent in their payment of taxes. The Code was written to permit such taxpayers to discharge the taxes if they qualified under the time period rules, and the taxpayer was not guilty of fraud or willful evasion. Accordingly, the Code contemplates that a taxpayer may have failed to file a return on time or paid the tax when due, but as long as he or she eventually files the return the failure to file it in a timely manner would not by itself render the tax excepted from discharge. But the creation of an escape hatch in the Bankruptcy Code for delinquent taxpayers presupposes that those same taxpayers, somewhere along the line, failed to pay some or all of their legally required taxes; otherwise the issue would not be before the court.

Virtually every adult American citizen knows that he or she is required to pay taxes. If the discharge is limited to only those few who are actually ignorant of their legal obligation to pay taxes, then Congress's largesse in creating the bankruptcy escape hatch suddenly shrinks to protect such a small handful of "honest but unfortunate" taxpayers that Congress needn't have bothered. Or, the legislative comments should have expanded the criteria to state the discharge was available to "honest, totally illiterate, inexperienced, uneducated and rather stupid, but unfortunate" taxpayers." In the real world, this would limit the discharge to a class of individuals who typically earn too little to owe taxes in the first place.

According to Ronald Rhodes, IRS assistant commissioner for collection, in testimony before the National Commission on Restructuring the IRS in 1998, approximately 40 percent of filers for bankruptcy owe federal taxes. Were all of these people tax cheats? This seems unlikely ... according to a statistical survey conducted by the IRS in 1993, over a third of those individuals who failed to file tax returns were actually due a refund.

Toward a resolution

In 1994 Congress established the National Bankruptcy Review Commission whose task it was to recommend improvements in the Bankruptcy Code. The final report to Congress dated October 20, 1997 made numerous recommendations for amendments to the Bankruptcy Code to clarify the meaning and intent of certain sections, phrases and words. Included among these recommendations was commentary on the issue of how to define willful intent to evade or defeat a tax. However, ultimately the NBRC took no stand on this issue.

One of the professional organizations contributing recommendations to the Commission was the American Bar Association. The ABA Tax Section Task Force submitted its report to the Commission on April 22, 1997.

In its report the ABA addressed this issue. Its recommendation was that Section 523 of the Bankruptcy Code should be amended to state

[E]vidence of intent merely to defer payment, failure to file a lawfully required return when due, or to pay a lawful tax when due, shall not, without further evidence of affirmative misconduct evidencing an intent not to pay the tax, justify a finding of willful attempt to evade the tax.

In explaining its position on this issue, the ABA report stated:

The Code obviously contemplates that a taxpayer may have failed to pay all or a portion of a lawful tax liability; the mere failure to pay the tax would seem to be insufficient by itself to render such tax nondischargeable, or else the whole portion of section 523 dealing with tax discharge would seem pointless; why provide for the discharge of unpaid taxes, and in the same breath provide that if one owes taxes he or she must be guilty of tax evasion, and therefore not eligible for discharge of the taxes?

Does "culpable omission" provide an answer?

An argument may be made that in the bankruptcy context the criminal standard requiring affirmative misconduct should prevail in order to reconcile the liberal legislative intent in favor of discharging taxes over three years old. However, the argument might be more easily settled by shifting the premise of the argument. As long as the argument is between the criminal and the civil standard, it may in the end be impossible to settle without Congressional intervention. Absent that, However, we might craft a workable rule by accepting the civil standard as the proper one in the bankruptcy context, but shift the premise of the debate from the choice between the criminal and civil standard, to a different question; is there or should there be a different definition of the civil standard of willfulness as applied in the bankruptcy context?

The court in Fegeley, supra., in finding the debtor guilty of willful evasion, used the term "culpable omission." This is a phrase not seen in most of the cases dealing with this issue. Is there a difference between ordinary omission and culpable omission? In most, if not all, of the cases holding that mere omission is sufficient to find willful evasion, the opinions include evidence of the debtor's culpable conduct in addition to mere failure to file or pay. For example, although purporting to follow the rule in Toti (willfulness may be found on mere omission), the court in Ketchum, supra, cited evidence that the debtor not only failed to file or pay taxes, but also fraudulently filed a false w-4 withholding statement "... so that his employers would withhold no money from his pay checks." In Toti itself the opinion acknowledges that the debtor did not merely failed to file returns, but refused to file them even after demand by the IRS. And in Fegeley the taxpayer not only failed to file the returns but, during several years of unusually high income made "lavish expenditures," and, though filing extensions to file returns substantially underestimated his income.

Thus it might be appropriate to agree that the civil standard shall apply, but draw a distinction between mere omission, and culpable omission. Thus, the rule may state that the debtor may be found guilty of attempt to evade or defeat the tax, for purposes of nondischargeability, if he or she engaged in either affirmative acts of evasion, or culpable omission to perform a required act, where culpable omission is something more than mere omission.


3. DOES A PRIOR BANKRUPTCY TOLL THE RUNNING OF THE TIME PERIODS FOR TAX DISCHARGE PURPOSES?

Among other things, in order to discharge income taxes in chapter 7 bankruptcy the tax must satisfy the three "time" rules. In a nutshell, these are; 1) the tax year in question must be at least three years old; 2) the tax return must have been filed for at least two years; and 3) the tax must have been assessed for at least 240 days.

In many jurisdictions the rule is that certain events may extend or "toll" one or more of the three time periods for dischargeability, thus stretching them out and making the tax nondischargeable if the case is filed within the stretch-out period. Thus, for example, there is substantial case authority that a prior bankruptcy, to the extent it overlaps one of the time periods, extends the time period for the time the bankruptcy overlapped the time period. And, in many jurisdictions the period is tolled for the time in bankruptcy plus an additional six months.

Congressional intent is clear that the IRS is supposed to have a fair chance to collect the taxes before they become dischargeable in bankruptcy. This intent has been translated into the three time periods described above. However, if the taxpayer files a bankruptcy before one of the time periods expires the IRS is prevented from attempting to collect the tax by operation of the automatic stay. Thus, in theory the debtor could, for example, obtain the protective shield of chapter 13 until the time periods expired, then voluntarily dismiss the chapter 13 and file a chapter 7, discharging the taxes. There is no statute either in the tax code or the bankruptcy code that appears to explicitly prohibits this result.

The courts have struggled with this, noting the obvious intuitive sense that such a result makes a mockery of the time periods, if those periods are supposed to give the IRS a fighting chance to collect the taxes.

This is an unsettled issue, and the courts are divided about how or whether the IRS should be able to extend the time periods. The opinions basically break out into three camps; those holding that a proper interpretation of the tax and bankruptcy codes dictate that a prior bankruptcy tolls the period; those holding that the respective codes do not require a tolling but the court's equitable powers under § 105 permit equitable tolling; and those holding that it is a question of equity based on the debtor's misconduct. In addition, among those cases holding that the time periods are tolled, the opinions are split on the question of whether it is appropriate to add six additional months to the tolling time.

The court in In re West, ruling that a prior bankruptcy case tolls the periods, based its reasoning on statutory interpretation and legislative intent. Bankruptcy Code § 108(c) provides that the filing of a bankruptcy will toll the running of a non-bankruptcy statute of limitations, while the stay is in effect, as to any claim a creditor may have against the debtor. And, the Internal Revenue Code provides that a bankruptcy will toll the running of the statutes of limitations for assessment or collection of a tax, as provided by the IRC, for the time in bankruptcy plus an additional six months. West acknowledged that § 108 only tolls "non-bankruptcy" statutes, and therefore "facially" did not affect the time periods set forth in the Bankruptcy Code. But the West Court took what it deemed to be the obvious intent of these two statutes, that a creditor should be given his full opportunity to take a bite out of the apple, and more or less created new language, merging the effect of § 6503 of the Tax Code with that of §§ 108, 523 and 507 of the Bankruptcy Code, with the result that a bankruptcy would toll the bankruptcy time periods for the time in bankruptcy, plus six months. To not allow this, observed the West court, would "... allow a debtor to create an impenetrable refuge by filing a bankruptcy petition, waiting for [§ 507(a)(8)'s] priority periods to expire, and then dismissing the case and refiling..." In other words, to not explicitly provide for the tolling effect in the statutes was a mere legislative oversight that should be cured by the courts.

The substantial majority of opinions employ the West reasoning:

The Panel follows the overwhelming majority of the courts of appeals that have considered the issue and concludes that although the text of § 507(a)(8)(A)(i) supports the Debtor's position, the text should not be applied because it is at odds with the clear Congressional intent to provide the IRS with a full three-year opportunity to collect a tax debt before that tax debt becomes dischargeable in bankruptcy.

A large number of opinions reject the statutory interpretation of West and rely, instead, on the equitable power of the bankruptcy court pursuant to 11 U.S.C. § 105 to invoke equitable tolling. Of these cases, some slant in favor of the IRS regardless of the debtor's conduct, but others hold that the court should resort to equitable tolling only upon a showing of debtor misconduct. At least one case acknowledged the court's power to invoke equitable tolling based on the equities, but ruled against the IRS because of evidence of the IRS's misconduct in attempting to collect the ostensibly discharged tax without first seeking relief from stay.

The basis for the rejection of the statutory approach is that the time periods prescribed for tax discharge are not statutes of limitations, and therefore do not fall within the scope of section 108.. For example, the court in In re Nolan observed;

The three year look back in § 507(a)(8)(A)(i) is a substantive element of the government's cause of action under § 523(a)(1)(A), not a statute of limitations. (cites) Ordinary principles of "equitable tolling" employed by many of the reported decisions are not applicable. (cites) This element of the government's cause of action can be supplied by a court applying equitable principles only upon proof of substantial debtor misconduct. (cites) The courts that have allowed "equitable tolling" without proof of debtor misconduct have mistaken the three year look back for a statute of limitations.

Also rejecting the West line of cases, some of the statute based opinions reject the addition of six months to the time following the conclusion of the prior bankruptcy. The Court in Avila observed that neither § 108 of the Bankruptcy Code nor § 6503 of the Tax Code apply to bankruptcy code periods, and therefore there is no statutory basis to add six months. And, contrary to the typical reasoning regarding legislative intent, the Avila court held that the time periods were tolled by operation of 11 U.S.C. § 507(a)(8)(A) (defining priority taxes), stating that legislative intent was to provide the IRS with three years to collect nondischargeable taxes, but that the legislative intent language does not refer to protecting dischargeable taxes.


4. WHAT IS A TAX RETURN?

In order for an income tax to be dischargeable in chapter 7 bankruptcy the debtor must have filed his tax return for the relevant year at least more than two years before the bankruptcy filing date. House Report No. 687 (1965) stated:

Since the purpose of this bill is to provide relief for the financially unfortunate and not to create a tax evasion device, section 2 of the bill specifically excepts from discharge taxes "which were not assessed in any case in which the bankrupt failed to make a return required by law," or with respect to which he had made a false or fraudulent return or which he had otherwise attempted to evade.

Even though the taxpayer has not filed his return the IRS frequently assesses an additional tax and posts a "substitute for return" (SFR) on behalf of the taxpayer pursuant to 26 U.S.C. § 6020(a). However, case authority is virtually unanimous that an SFR, by itself, does not constitute a "return" for purposes of dischargeability under § 523.

A tax "return" for purposes of § 523 has been defined in numerous opinions rather broadly as (1) there must be sufficient data to calculate a tax liability; (2) the document must purport to be a return; (3) an honest and reasonable attempt must be made to satisfy the requirements of the tax laws; and (4) the taxpayer must execute the return under penalty of perjury. Another opinion states, "If a document discloses data from which the tax can be calculated, is executed by the taxpayer, and is lodged with the IRS, then it is considered a return."

Besides not filing a return at all, what the taxpayer may think is a return may be deemed otherwise by the IRS and the courts. For example, courts have held that "frivolous" tax returns are not valid tax returns; that a return filed in the wrong office is not a return; merely filing an amended return without having filed the original return does not constitute a "return"; an unsigned return is not valid; and incomplete "returns" filed by chapter 7 debtor did not qualify as tax returns for purposes of dischargeability where the returns contained only taxpayer's name, address and social security number and no information upon which the IRS could calculate the tax liability.

Non-standard "returns"

Nevertheless, courts have found a wide variety of documents and even conduct to constitute a return.

Ideally, a taxpayer is supposed to file his or her return using IRS Form 1040. However, bankruptcy courts have often elected to look to the spirit of the return requirement in the Bankruptcy Code, rather than the letter. The fundamental intention of the return requirement is that the taxpayer cooperates with the IRS and willingly supplies all the information necessary for the IRS to calculate the tax.

Thus, a number of cases have held that information provided by the taxpayer, while not necessarily supplied on form 1040, may nevertheless constitute the equivalent of a return for purposes of dischargeability in bankruptcy. These cases provide some opportunity to obtain a discharge of the tax even where the taxpayer may not have actually filed a 1040 tax return.

Held, an SFR followed by a signed voluntary payment agreement and 433-D constitutes a "return" for purposes of the two-year rule under § 523; SFR agreed to by taxpayer or prepared with taxpayer's cooperation could constitute a return; a taxpayer cooperating with the IRS and filing a "schedule" containing sufficient information constituted a return; And see IRC § 6020(a), SFR signed by taxpayer "may be received by the Secretary as a return of such person."

But absent evidence of cooperation, the taxpayer may not fair so well in Bankruptcy court. Held, IRS taxes nondischargeable in chapter 7 because debtor failed to sign substitute tax returns prepared by IRS, and did not file requested papers until five years later, thus had not filed a return for purposes of § 523.

Following the filing of an SFR, or the failure to file a 1040 return, the taxpayer may engage in other kinds of conduct that may add up to a return for purposes of the bankruptcy code; held, IRS form 4549 relating to income tax examination changes, signed by the taxpayer, may be a filed tax return for purposes of dischargeability; testifying under oath in a court proceeding, if the testimony provides information normally found on a return, may constitute the equivalent of a filed tax return; taxpayer signing a form containing same information as normally found in tax return, may constitute a valid filed tax return;

Subsequently filed return

If the IRS files an unagreed SFR, and then the taxpayer files his tax return, is the taxpayer's return deemed valid, or is it a nullity on account of the prior filed SFR? The rulings appear to favor the taxpayer-debtor.

Held, an amended return filed after an SFR was filed nevertheless constitutes a "return" under § 523; debtor filed a valid tax return for purposes of tax discharge, even though he filed it after the IRS had filed a substitute for return and assessed the taxes; late returns filed after debtor stipulated with the IRS regarding the tax claims constituted returns.

IRS estopped

An ancillary issue related to the above is the evidentiary problem arising where the taxpayer insists he filed a return, but the IRS disagrees. The drift of the courts appears to be toward a preponderance of the evidence, with a fairly liberal tilt toward the taxpayer. Held, the IRS was equitably estopped from requiring the debtor to produce tax returns; three years after debtor's bankruptcy discharge the IRS asserted prepetition taxes were not discharged because of failure to file returns; the debtor alleged he could not produce copies of returns because the IRS seized the originals several years before the bankruptcy.

Is a state tax "report " a "return"?

Yet another issue in connection with tax returns is presented by state tax law.

In those states having a personal income tax, state tax law often requires the taxpayer to report to the state taxing entity any increase in federal income tax due to an audit or other reason. Obviously, this is so the state taxing entity can do a piggy-back assessment for the concomitant increase in the state tax.

Typically the state law will require that the report or amended tax return be filed within a certain prescribed time. For example, in California the Revenue and Taxation Code requires that a report be filed within six months of a final assessment by the IRS that results in an increase in the tax.

It is typical, as well, for the taxpayer to not know the state tax law requirement. Consequently, many taxpayers fail to file the required report or amended return.

The problem this presents is that the Bankruptcy Code requires that any "return, if required" must be filed more than two years prior to the bankruptcy in order to discharge the tax listed in the return. Many states have recently argued that the report or amended return required by their respective tax codes is the same thing as a required return, thus triggering a new two-year period as to any additional tax the report or amended return contains. The taxpayer's failure to file such a return, or to file it more than two years before the bankruptcy, will make the additional state tax nondischargeable.

Here, unlike the issue involving unusual forms that might constitute a return, discussed above, the taxpayer will argue the opposite position; that anything that is not strictly a regular first-time return is not a return as far as the states are concerned. If a report or amended return is not a return, then the IRS assessment would not trigger a new two-year period.

The bankruptcy opinions are divided on this question.

Cases holding that a state requirement to file a report or amended return following an IRS audit which results in additional taxes, constitutes a "return" within the meaning of 11 U.S.C. § 523 and § 507 include In re Blutter, 177 B.R. 209 (Bkrtcy.S.D.N.Y. 1995); Haywood v. State of Illinois, 62 B.R. 482 (Bkrtcy.N.D.Ill. 1986); Cohn v. State of Illinois, 96 B.R. 827 (Bkrtcy.N.D.Ill. 1988); Greenstein v. Ill. Dept. of Rev. 95 B.R. 583 (Bkrtcy.N.D.Ill. 1989); In re Lamborn, 181 B.R. 98 (Bkrtcy.N.D.Okla. 1995); In re Fernandez, 188 B.R. 34 (Bkrtcy.D.Nev. 1995) (interpreting Hawaiian state tax law); In re Jones, 158 B.R. 535 (Bkrtcy.N.D.Ga. 1993); In re Gambone, 224 B.R. 611 (Bkrtcy.N.D.Ohio 1998).

Cases holding the contrary include Dyer v. State of Georgia Dept. of Rev. 158 B.R. 904 (Bkrtcy.W.D.N.Y. 1993); In re Jackson, 220 B.R. 683 (C.D.Cal. 1998); In re Blackwell, 115 B.R. 86, 89 (Bkrtcy.W.D.Va. 1990). And see the recent case holding that a "report" is not a "return," but vaguely suggesting that an "amended return" is a return for purposes of the Bankruptcy Code, California Franchise Tax Board v. Jerauld (In re Jerauld), 208 B.R. 183 (9th Cir. BAP 1997), BAP No. SC-96-1816-RyRO, Adv. No. 96,90070-M7, April 28, 1997; same, In re Rowley, 1997 Bankr. LEXIS 760 (9th Cir. BAP. 1997). Said the Jerauld court,

The plain meaning of the word "return" should be conclusive, as it has a very specific meaning in the world of taxation. Certainly, taxpayers know what it means to have to file a tax return; they do it each year.

And see In re Olson, apparently holding that an amended return is a return within the meaning of the Bankruptcy Code, but holding that the state must establish that an amended return, and not merely a report, was actually required by state law.

Under federal rules an amended return is not deemed a "return." Thus the only consequence of an additional assessment of IRS income taxes is the triggering of a new 240-day assessment period as to such additional taxes. The U.S. Treasury gets a mere 240 days in which to collect the tax before it can be discharged. If, however, a report or amended return due a state taxing entity triggers a new two-year waiting period before the concomitant additional state tax may be discharged, the result is that the state tax will receive substantially more protection from bankruptcy discharge than the federal tax; the state will have two years, rather than merely 240 days, in which to collect the tax. Surely, this cannot be what Congress intended. Unfortunately, there is little explicit Congressional or legislative guidance on this issue.


5. STATES' SOVEREIGN IMMUNITY

A governmental taxing entity may from time to time attempt to collect a tax against a debtor who is in bankruptcy, or attempt to collect a discharged tax following conclusion of the bankruptcy. In either event such conduct would obviously be a violation of either the automatic or the permanent stays.

A debtor's remedy for violation of the stay by a creditor is to seek sanctions or damages pursuant to 11 U.S.C. § 362, or under the general contempt powers of the court. In the case of a culpable governmental entity, however, the doctrine of sovereign immunity may present a stumbling block. In a nutshell, sovereign immunity is a holdover from America's Anglo heritage standing for the proposition that "the King can do no wrong," and is therefore immune from suit for alleged trespasses. Although the United States obviously has no King, the doctrine survives in the form of a general notion that one cannot sue a governmental entity without such entity's consent. The Bankruptcy Code provided some openings for a debtor to get around the immunity of federal entities. However, the potential obstacle of immunity was always a source of potential frustration.

In the case of alleged IRS violations of the stay in the bankruptcy context, the shield of sovereign immunity has been for most purposes eliminated by Congress; the Bankruptcy Reform Act of 1994 amended section 106 to provide that in virtually all bankruptcy proceedings the IRS is deemed to have waived sovereign immunity. The language of § 106 as amended purports to waive immunity as to all governmental taxing entities, which ordinarily would include states, as well.

However, the issue of sovereign immunity is more problematical in connection with a state's violation of the automatic or permanent stay. Notwithstanding the automatic waiver provided by the Reform Act, rulings coming down subsequent to enactment of the Reform Act have apparently narrowed the abrogation of the states' sovereign immunity provided by § 106. Issues exist regarding under what circumstances a state may be deemed to have waived immunity, and the extent to which damages, attorneys' fees, and injunctive relief may be available.

Seminole Tribe of Florida

In 1996 the U.S. Supreme Court held that the Seminole Tribe of Florida could not sue the state of Florida in federal court to enforce the Indian Gaming Regulatory Act because the Constitution bars Congress from restricting the sovereign immunity of the states. Hence it would appear that Congress does not have the power under the U.S. Constitution to impair the sovereign immunity of the states.

This ruling may effectively invalidate the portions of 11 U.S.C. § 106, as amended by the Bankruptcy Reform Act of 1994, which purport to nullify the states' sovereign immunity in all bankruptcy cases. And since that ruling many bankruptcy court opinions have fallen in line, denying a debtor's power to sue a state directly for violation of the stay.

Not all avenues toward piercing the immunity shield were diminished by the Seminole Tribe ruling. Thus, holding a state liable for sanctions for violation of the automatic stay (or other violations or legal issues) is still possible where the debtor establishes evidence of some affirmative act of the state which has the effect of waiving sovereign immunity, pursuant to those sections of § 106 not affected by the ruling in Seminole Tribe. For example, these pre-reform act sections provide that a governmental entity may consent to waive immunity by filing a claim in the bankruptcy case).

What's a debtor to do?

If a debtor cannot go after an offending state tax entity for violation of the stay, how can the debtor (or the bankruptcy courts in general, for that matter) enforce the stay against such entities, or obtain relief for violations of the stay? Can a state ride roughshod over the debtor's bankruptcy rights unfettered by fear of sanctions?

The bankruptcy courts are struggling to invent remedies that avoid the fatal restrictions of Seminole Tribe.

§ 106 waiver is valid

A few cases, going against the mainstream, have held that Congress can waive sovereign immunity of states despite Seminole Tribe. But these are in the minority.

Where state files claim in case

Where the state undertakes to participate in the bankruptcy process by filing a claim or other similar action, immunity is waived.

The cases are split as to what constitutes filing a claim in the case. Held, the state of Texas did not file a claim in the case where it did not file a proof of claim in the case but only sent the debtor a postpetition demand letter.

Held, state did not waive sovereign immunity in bankruptcy case as to proof of claim for one tax by filing a proof of claim in same case for different type of tax, where the two types of taxes did not arise out of the same transaction or occurrence.

Held, by filing claim in chapter 11 case Oakland County, a political subdivision of the state of Michigan, waived sovereign immunity.

Immunity for states' officers and employees?

The most interesting avenue being tested by the courts is the notion that if the state itself cannot be sued, its individual employees can be.

Even if the rule in Seminole Tribe nullifies the automatic waiver of states' .i.sovereign immunity; provided for in § 106, the rule does not necessarily prohibit the debtor from seeking relief against an officer or employee of the state. The U.S. Supreme Court opened the door to this opportunity in Ex Parte Young, This doctrine has been applied in a recent case to allow prospective relief, namely injunctive relief, against an officer of a state agency in Natural Resources Defense Council, et al. v. Cal. Dept. of Transportation.

The doctrine of Ex Parte Young is premised on the notion that a state can not authorize a state officer to violate the Constitution and laws of the United States. Thus, an action by a state officer that violates federal law is not considered an action of the state and, therefore, is not shielded from suit by the state's sovereign immunity. [cites] ... Therefore, a plaintiff may bring suit in federal court against a state officer accused of violating federal law.

Ex Parte Young has appeared in several published bankruptcy cases; Colon v. Royal Hart, Chief Clerk, City of Philadelphia, where the court held that the debtor could proceed in bankruptcy court against an officer of the City of Philadelphia; In re Guiding Light Corp., Debtor v. State of Louisiana; Idaho v. Couer d'Alene Tribe. Another case held in a strongly worded dicta that the Supreme Court opinion in Seminole Tribe alluded to the Ex Parte Young doctrine and reinforced its "vitality," and thus an aggrieved debtor could sue the individual state employee, at least for prospective injunctive relief and attorney's fees.

See sample complaint for sanctions against an employee of the State of California, naming the head of the Franchise Tax Board as a defendant, together with the bankruptcy court's decision upholding the Ex Parte Young doctrine.

A good summary of the arguments for and against the applicability of Ex Parte Young may be found in a recent bankruptcy case out of the Ninth Circuit, In re Ellet.

In Ellet the debtor scheduled dischargeable personal income taxes owed to the California Franchise Tax Board in a completed chapter 13 case, and provided for payment of 12% of the claims. The FTB never filed a claim in the case. Following discharge the FTB attempted collection for the ostensibly discharged taxes.

The debtor filed suit for declaratory decree of discharge, and sanctions, not against the state taxing entity, but rather the director of the FTB personally. The State of California moved for summary judgment on the ground that both the state and its individual representatives were immune under Seminole Tribe.. The debtor acknowledged that the state was immune, but asserted that the executive director as an individual could be reached under Ex Parte Young.

The bankruptcy court held that sovereign immunity protected the state, but not the Director personally, saying "... an action by an official that violates federal law is not considered an act by the state, and the state can not cloak that officer in its sovereign immunity."

The court also addressed related issues raised by the Supreme Court in Idaho v. Coeur d'Alene Tribe of Idaho, which further restrict the uses of the Ex Parte Young rule.

Coeur d'Alene, in a case seeking among other things injunctive relief against officials of the state, held that Ex Parte Young could not be used where there was already a specific federal legal remedial scheme in place for enforcement against a state for violation of a particular federal right. The Ellet opinion observed that the Bankruptcy Code's remedies for violations of the stay are general, and not specific as to a state's violation of the stay. Accordingly, Ellet holds that this Coeur d'Alene rule does not apply.

Next, Coeur d'Alene held that a federal court could not proceed against the state's employees individually where such action would infringe upon a state's "special sovereign interests." However, the Ellet opinion concluded that, unlike the special facts in Coeur d'Alene, seeking injunctive relief against an individual personally for violation of the Bankruptcy Code, while related incidentally to the state's interest in collecting taxes, was not so invasive as to constitute an infringement of its special sovereign interest.

Finally, Coeur d'Alene held that an aggrieved party could not proceed in federal court against an individual employee of a state if an adequate remedy was available in the courts of that state. However, the opinion in Ellet points out that the majority of concurring judges in Coeur d'Alene rejected the notion that there had to be an absence of state remedy before Ex Parte Young could be used against an employee. And, the Ellet opinion held that there is no adequate remedy under California state law, noting specifically that the California Constitution prohibits enjoining the collection of tax and requires an aggrieved party to first pay the tax, then object.

Figuring out which forum has jurisdiction to hear a violation of the stay against the state is only part of the challenge. The other is the nature and extent of damages that may be obtained.

An important limitation of Ex Parte Young is that apparently the only remedies permitted against individual state officers by that doctrine are prospective injunctive relief, declaratory relief and possibly attorney's fees; damages for past violations may be unavailable, as well as a turn-over order of seized assets. Natural Resources Defense Council, supra. Thus where the state has succeeded in collecting a tax that was discharged in the bankruptcy, the debtor may be able to obtain injunctive relief in the bankruptcy court, but possibly not an order for disgorgement or refund of the illegally seized money. For that the debtor may have to rely solely on a state statutory remedy, and hope there is one in existence.


© Morgan D. King 2000