Yet Another Malpractice Trap: Failure to Properly Discharge Client Federal Income Tax Liability

Eliminating Income Taxes Through Bankruptcy. Mr. Snyder is a senior partner with Snyder & Associates of Portland, Oregon. We appreciate their permission to reprint this article. TLIE has noted several claims in recent years in which allegations were made that attorneys did not properly seek discharge of Federal Income Tax liabilities in bankruptcy. We have edited the article to eliminate references to considerations unique to Oregon. Make certain to consult bankruptcy decisions specific to your locality before relying on this article.

It is not true that the only things which are certain in life are death and taxes. Many types of tax debts can be discharged (eliminated) through bankruptcy proceedings. This article focuses only on the discharge of income tax debts in Chapter 7 and Chapter 13, although the dischargeability provisions of Chapter 11 and Chapter 12 are very similar to the ones discussed here.

Be aware that the provisions relating to the discharge are complex and full of traps for the unwary. Mistakes made in this area are a major source of complaints for malpractice. The information presented here is not all inclusive due to space limitations.

Assessment, in general, refers to the determination by the taxing authority of the amount of the tax. The assessment date is a key date. Federal income taxes are assessed on the date a summary record is signed by the assessments officer. 26 USC § 6203. Do not rely on your client for the assessment date, filing or due dates. Have your client sign an authorization so you can request a tax transcript of the relevant tax years from the IRS. Confirm key dates on the transcript with the IRS agent in charge of the file, or have your client call and request a tax transcript. The IRS has 3 years from the date a return is filed to make an assessment and this time period can be extended by waiver.

Make sure you have included all possible tax claims in your analysis. For example, the debtor may be most concerned about the IRS claim and fail to mention the concomitant state tax claim that is lurking in the background.

DISCHARGE IN CHAPTER 7

The discharge provisions for Chapter 7 applicable to taxes are found in §523(a)(1). The first exception to discharge is simply stated: if the tax is entitled to priority under §507(a)(8), it is not discharged. §523(a)(1)(A). A quick review of these priority taxes:

• Income taxes where the return WAS DUE within the 3 years prior to the petition being filed. If the return was due on August 15, 1990 (the debtor requested an extension), the tax is priority in any bankruptcy filed prior to August 16, 1993. This is known as "the three year rule." §507(a)(8)(A)(i).
• Income taxes where the assessment was made within 240 days, prior to the petition date. This period of time is tolled while an offer-in-compromise is pending, plus 30 days. This is "the 240-day rule." §507(a)(8)(A)(ii).
• Income taxes are a priority where the tax remains assessable and the tax does not arise from 1) a non-filed tax return 2) a delinquent return filed within 2 years of the petition, or 3) a fraudulent return. For example, if the debtor has extended the assessment period by agreement with the IRS under 26 USC §6501(c)(4) or if the assessment has been prohibited due to litigation pending in the Tax Court, 26 USC §6231(a), the tax is assessable after the bankruptcy petition is filed and is granted priority. §507(a)(8)(A)(iii). Also see In re Massoni, 20 BR 416 (Bankr KS 1982) and In re Easton, 59 BR 714 (Bankr CD I11 1986).

In addition to priority taxes, other types of taxes are nondischargeable in Chapter 7:

• Taxes for which a return, if required was not filed are not dischargeable. §523(a)(1)(B)(i).
• Taxes arising from a return which was filed within two years before the petition date are not discharged. This is known as "the two-year rule". §523(a)(1)(B)(ii). Taxes arising from returns filed after the petition date are also not discharged. A substitute return prepared by the IRS under 26 USC §6020(b) does not constitute a filed return for this section. In re Bergstrom, 949 F.2d 341 (10th Cir. 1991).
• A discharge is not allowed for taxes where the debtor filed a fraudulent return or willfully attempted in any manner to evade or defeat the tax. §523(a)(1)(C). The conduct must be deliberate, not accidental, and done with fraudulent intent. In re Gathwright, 102 BR 211 (Bankr D Or 1989).
• Non pecuniary loss tax penalties (e.g., late filing, failure to pay, negligence, fraud, etc.) are not discharged unless either 1) the tax to which they are attached is discharged or 2) the penalty is based upon events that occurred more than three years before the date of the petition. §523(a)(7). In re McKay v. United States, 957 F.2d 689 (9th Cir. 1992). The "transaction or event" which gives rise to most penalties is the due date of the return. Therefore, the penalties are calculated from that date.

DISCHARGE IN CHAPTER 13

Chapter 13 offers greater dischargeability of taxes than Chapter 7. The discharge granted in Chapter 13 after the plan is successfully completed, specifically excludes the exceptions to discharge found in §523(a)(1) and (7) that cause a problem in Chapter 7. §1328(a).

If the taxes are entitled to priority under §507(a)(8), they must be accorded full payment through the Chapter 13 plan. However, if the government has notice and fails to timely file a claim and the claim is unsecured, the debt will be discharged upon completion of the plan. §502(b)(9). Yes, the government does periodically fail to timely file claims. Whether or not the tax is entitled to priority is discussed above.

Where no tax return was filed or where the debtor filed a fraudulent tax return or engaged in activity that is deemed willful evasion of a tax obligation, the claim is dischargeable in Chapter 13 except to the extent the claim is secured, as discussed below. If returns have not been filed, it is best to file the Chapter 13 before the returns are filed in order to avoid having the taxes become entitled to priority treatment under 507(a)(8)(ii) or (iii). Taxes for which the original returns were due more than three years before the petition is filed will remain non-priority and dischargeable. §507(a)(8)(i).

Non-pecuniary tax penalties are dischargeable regardless of whether they are attached to a dischargeable claim, or when the transaction giving rise to the penalty occurred.

SECURED TAX CLAIMS

If a notice of lien has been filed in the county in which the debtor owns real property, the taxes are secured to the extent of the debtor's equity in the property and must be dealt with through the plan - i.e., pay the value of the equity or surrender the collateral. §1325(b)(5). While the debtor may be able to assert a homestead exemption against some state tax liens, no such exemptions exist against the Federal tax lien. In re Ridgley, 81 BR 65 (Bankr D Or 1987). Also, the Federal lien attaches to all personal property if it is recorded in the Secretary of State's office. This includes household belongings, clothing, etc. The debtor's equity in such property must also be included in calculating the amount of the secured claim under §506(a).

POTENTIAL PROBLEMS

In determining whether a particular income tax is dischargeable, one must look to see whether any prior bankruptcies have been filed. If there are prior cases, the time limits for the three year rule, the 240-day rule and the two year rule must be adjusted. Those periods are tolled during the pendency of any bankruptcy proceeding.

For Federal taxes, an additional 6 months must be tacked onto each period. In re West/Worthen, 5 F.3d 423 (9th Cir. 1994) cert denied, U.S. (1994).

Although a Chapter 7 may discharge tax debts, the discharge does not eliminate tax liens. §522(c)(2)(B). Tax debts and tax lines are separate.

Generally, if the debtor has no real property and no significant personal property, the IRS will voluntarily discharge its lien. It does not do so where the debtor has real property. To discharge the lien, the debtor should file a Chapter 13 and pay the lien to the extent of the debtor's equity.

CONCLUSION

Although the rules are complex, when they are followed correctly, a debtor can gain tremendous relief by discharging income tax debts through bankruptcy. Pay careful attention to gathering all relevant information before filing the case.

A CHECKLIST FOR FEDERAL TAX LIABILITY DISCHARGE

This is a checklist of relevant information that you need if your client wants to eliminate income taxes through bankruptcy:

• Was a tax return filed?
• If so, when was the return filed?
• When was the tax return due?
• Was an extension of the due date of the return requested?
• When was the tax assessed?
• Was the return fraudulent or was there a willful attempt to evade or defeat the tax?
• Did the debtor submit an offer-in-compromise to the IRS? If so, when and when was it denied or withdrawn?
• Has a tax lien been filed in counties where the debtor owns property?
• Did the debtor extend the assessment date by agreement with the IRS?
• Was assessment of the tax prohibited by pending Tax Court litigation?
• Did the debtor file a prior bankruptcy petition which caused any of the key dates to be tolled?

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