Discharge of Unfiled Taxes under BAPCPA: No More Super Discharge
The article details the effects of the new bankruptcy law on income tax discharges.
The basic concept of chapter 13 bankruptcy filing was always to allow individual debtors to reorganize his/her finances. The policy of giving the debtor a chance to have a fresh start in his/her life was foremost behind Congress’s providing the debtor with a discharge of his/her debts which were incurred through false representation/ fraud/ or recent consumer debt. The term of art bankruptcy and tax law practitioners were using in dealing with a discharge of this type of liabilities was called a “super” discharge.
As it was correctly mentioned by Thomas E. Ray, in his 1994 analysis of the complex evolution of the “super” discharge provision of the Bankruptcy Code, the “original version of the Code did not have a liberal provision with respect to the discharge of the debts listed in §523 (a)”. Only in 1978 did Congress recognize that based on the concept of a “fresh start”, the debtor should be allowed to discharge his/her debts which were not “innocently” incurred. Subsequently, Congress’s policy turned and this reversal was not in favor of the debtors. In 1984, Congress added §1325 a “disposable income” provision in which debtor’s needed to repay in order to get a confirmation of their chapter 13 Plan. In 1990, Congress added a provision which disallowed discharges of student loans, injuries arising from drunk driving and criminal restitution payments.
The development of the “super” discharge provision of the Bankruptcy law was always controversial. There was always a struggle between allowing the discharge of the debts mentioned in §523 of the Bankruptcy Code and protecting innocent and honest debtors. It appears that the urge to protect honest citizens won. The rational that the Congress used was why should the law help dishonest debtors walk away from intentionally incurred dishonest obligations?
Although the Code §1325(a)(3) already had a good faith requirement which, in some ways protects the system from manipulative filings, Congress probably decided that it needs to help the judge in determination of good faith with a strict provision that black and white outlaws the discharge of dishonest obligations. In support of this position back in 1994, Janet L. Chubb, Esq. wrote a letter in response to a Thomas Ray’s article stating that “ how can a chapter 13 judge …know about “ con artists” when processing several hundred chapter 13 cases each month”. Basically, the Congress “listened” to Ms. Janet Chubb’s opinion and the like and finally outlawed a “super” discharge provision with the adoption of a Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ( BAPCPA).
In this article we would like to concentrate on the discussion of the dischargeability of income tax debts under the new law, after briefly summarizing the general rules.
Since the 2005 BAPCPA went into effect on October 17, 2005, bankruptcy law practitioners dealing with tax debt discharges within bankruptcy have had to find new ways of dealing with their clients’ “unfilled old” or “substantial old” tax liabilities.
The reason for such statement is that according to the “old” law, debtors with income tax debts that were not completely dischargeable under chapter 7 were able to deal with it by filing chapter 13 bankruptcy. Some of the chapter 13 bankruptcies were filed solely by debtors to deal with unfilled income tax liabilities or for substantially old income tax liability.
Three Part Test for a Tax Liabilities Discharge under Chapter 7
Pursuant to 11USC § 523(a)(1) a tax debt discharge was allowed and still is possible if the tax debt would satisfy a three part test. All three parts of the test has to be satisfied when applied to the debtor’s situation.
The first part of the test is known as a “three year rule” meaning that the income taxes on the gross receipts had to be due three or more years before the filing date. The second part of the test is known as a “two year rule”, meaning that the debtor had to file the return at least 2 years before filing for bankruptcy. And the third part of the test is called a “240 day rule”, meaning that taxing authorities must have assessed the tax at least 240 days prior to filing for bankruptcy with addition of all the applicable stays. For these rules to apply the tax return had to be filed by the debtor himself and not by the IRS after assessment.
Chapter 13 Option for Debtors with Unfilled Taxes ( Old Law)
An interesting trick that bankruptcy and tax practitioners were able to do is to discharge within the life of the chapter 13 Plan unfilled taxes. Under the USC §1328(a), a discharge was granted to all debts properly provided for in the plan, with exception of claims for which the last payment is due after the final payment under the plan as well as claims relating to alimony, maintenance and child support. Interpreting this section, if the debtor’s plan properly provides for the payment of income taxes owing, the taxes would have been discharged, regardless of the age of the tax claims owing or other status. In order for a discharge to apply the plan had to provide: 1) for the full payment of taxes entitled to priority; and 2) for payment of the value of all assets to which a filed federal tax lien has attached as of the filing date of the bankruptcy.
To summarize, the bankrupt taxpayer needed to follow all of the above mentioned rules regarding the treatment of priority taxes in order to discharge taxes as a general unsecured claim, meaning that as little as .10 cents to a dollar is allowed to be paid within a chapter 13 Plan to discharge such tax liabilities.
Of course in cases where the federal lien was filed the plan had to provide for its repayment. All secured claims had to be repaid in full.
Chapter 13 Option for Clients with the Intent to Evade or Defeat the Tax or Clients with the Recent Tax Debt (Old Law)
Section 1328(a) of the old Bankruptcy Code allowed debtors to discharge their tax liabilities even for fraudulently filed tax returns or with an intent to evade or defeat such tax, as well recent tax debts could be included into the repayment plan. Chapter 13 in this sense was a very convenient harbor for those “irresponsible” tax “nonpayers” and “non filers”.
As October 17, 2005 was approaching many debtor’s rushed to file their chapter 13’s just for the sole purpose of dealing with the income tax debt on unfilled tax years in question or for taxes that might be deemed to be fraudulent.
BAPCPA 2005 Provision and Practical Advice
Under the new law a discharge of unfilled taxes or fraudulently filed taxes is no longer available to debtor taxpayers.
Section 1328 (a) specifically references §523 (exceptions to a discharge) and states a prohibition to a discharge of any unfilled tax debt as well as debt per fraudulently filed returns.
Based on an everyday practice and going from the experience, we can state that today if the taxpayer has this sort of a problem you can address it by filing a chapter 7 bankruptcy and then, while it is pending, file an adversary proceeding against the taxing authorities. As practice shows IRS officials want attorneys who deal with tax debt over 100,000.00 to commence an adversary proceeding, because for them a presumption arises that the taxpayer had intent to evade or defeat the tax. Because of this presumption the IRS officials want debtors to argue their position in court and let the judge decide was the tax debt incurred intentionally and is it dischargeable or not.
The bigger change is that under chapter 13, which the new law is encouraging clients to file, the procedure of dealing with the tax liabilities will be exactly the same. The practical problems that will arise are the following:
1) according to Section 1324 of the BAPCPA, the confirmation hearing has to be held within 45 days of the meeting of creditors. Section 1324 specifically reads that: “the hearing on confirmation of the plan may be held not earlier that 20 days and not later than 45 days after the date of the meeting of creditors under section 431(a), unless the court determines that it would be in the best interests of the creditors and the estate to hold such hearing at an earlier date and there is no objection to such earlier date.”
The problem with that provision is that with the adversary proceeding being usually lengthy you never know when the chapter 13 trustee’s patience will run out and he/she will bring a motion to dismiss the case. The practice shows that at least in New York, where we practice, it was always hard even without adversaries pending to get adjournments. (We are talking about situations when attorney is working on the settlements of taxing authorities claims for example). Getting adjournments for the confirmation hearings for years would seem to be really problematic.
2) another issue is that the chapter 13 proceeding with an adversary proceeding within will become very pricy for the client debtor. Many people might be better off filing an Offer in Compromise (OIC) with the taxing authorities instead of chapter 13.
At present time to help a taxpayer with the tax liabilities, the attorney for the debtor needs to:
a) urge a client to file his tax returns for the years in question;
b) make sure that the tax owed is old enough to qualify for a discharge under the two year rule, and 240 day rule. Here, of course, if the client is filing his tax return after he came to a consultation with an attorney, debtor will have to wait for at least two years to file any chapter. The question might arise, what if during these two years the taxing authorities assess the tax? A good advice can be to enter into an installment agreement during these two years. If you do that it will stop any assessment proceedings that the taxing authorities might take;
c) a third way is to deal with the liabilities outside the bankruptcy court and file an OIC with taxing authorities.
The intent behind the BAPCPA was to encourage debtors with disposable income to file for Chapter 13 in lieu of Chapter 7. With respect to debtors with tax liabilities this might not be the result. A few examples will illustrate this (assume for all the examples no assets and some disposable income):
1) the debtor has $90,000.00 of unsecured debt, $50,000.00 priority debt . Under the old law the debtor was able to file chapter 13 and pay 100% of priority debt and 10% of unsecured debt. Under the BAPCPA, debtor can file chapter 7 and qualify under means test because priority taxes are deducted over 5 years and then file an Offer in Compromise with taxing authorities;
2) the debtor has $100,000.00 of unfilled unsecured taxes and $25,000.00 of priority taxes. Under old law, the debtor was able to file chapter 13 and pay 10% of unsecured debt and 100% of priority liabilities. Under BAPCPA, the debtor might disappear off the tax roll or file Offer in Compromise after filing the returns;
3) the debtor has $225,000.00 of unsecured tax debt and $0.00 priority debt. Under the old law the debtor would file chapter 7 and commence an adversary proceeding. Under BAPCPA, debtor might have to file chapter 13 if he/she fails the means test and file an adversary within the chapter 13. This means that the confirmation hearing might have to be adjourned for years and attorney for the debtor will have to make a fee application to be paid within a five year plan. Another issue arises here, if the debtor will have to show sufficient income to support the plan with huge legal fees in adversary, more disposable income will lead to a higher settlement of adversary, which would lead to increased plan payments and more disposable income need.
ABOUT THE AUTHOR: Stephen B. Kass & Alina N. Solodchikova
Stephen B. Kass, is an Attorney & also a CPA with an LLM in Taxation.
He Practices Corporate Bankruptcy, Consumer Bankruptcy and Taxation.
Alina N. Solodchikova is an Attorney with an LLM.
She Practices Corporate Bankruptcy & Consumer Bankruptcy.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.