Federal income tax discharge. In certain circumstances, individual income taxes may be discharged in bankruptcy. It is important to understand the crossover effect between Bankruptcy Code section 507(a)(7)(A)(i) and Bankruptcy Code section 523(a)(1) (a). By reading these sections together, one can discern that income taxes arising from a tax year for which the tax return was last due, at least three years prior to the date of the filing of the petition, are potentially dischargeable.
The operative words here are “last due” and “potentially dischargeable.” It is important to determine whether a debtor filed an extension of the deadline for filing his or her tax return. If one files the petition on April 16, believing that the debtor will be able to discharge the taxes arising from the tax year three years past, he or she will be denied a discharge if that return had been on extension. Discharge emanates from the date when the return was “last due.”
Taxes that otherwise seem dischargeable under the three-year rule might not be, due to a number of other factors discussed below.
Recent assessments. Note that Bankruptcy Code sections 507 and 523 cross reference each other. A joint reading suggests that the income tax liability for the year or years in question must not have been assessed within 240 days of the date of the bankruptcy filing. Even if the three-year rule has been met, the tax liability itself must have been assessed more than 240 days ago.
It sometimes takes the IRS a long time to assess delinquent taxes. It cannot be assumed, that just because the unpaid taxes arose many years ago, they were also assessed many years ago.
A further reading of Bankruptcy Code section 507 indicates that there cannot be a discharge where there is an outstanding offer in compromise, or if less than 30 days had elapsed since it was withdrawn or rejected.
Tax Court litigation. Taxes that otherwise would be eligible for discharge are excluded from discharge ability if the taxpayer is currently engaged in litigation in Tax Court with respect to such liability (Bankruptcy Code sections 507(a)(7)(a) (iii) and 523(a)(1)(A)) or if the taxpayer, in the context of a settlement or workout arrangement, agreed to extend the limitations period on the assessment or collection of such taxes.
Late-filed returns. What if the debtor meets all standards for discharge ability, but filed returns late, or not at all?
If the return was never filed, the tax may not be discharged. Debtors have argued that “substitute returns” prepared by the IRS under authority of Code Sec. 6020, entitled them to discharge as if they had filed the tax return themselves. The courts have consistently rejected this. (See In re Bergstrom, 949 F2d 341 (CA-10, 1991)). To be eligible, the return must be signed by the debtor. Courts have also rejected “protest” returns, as not satisfying the standard for having filed a return. (See In Re Slater 96 Bkrptcy. Rpt. 867 (Bkrptcy, DC Ill., 1989)).
A debtor can be discharged for taxes even if the return is late filed, if at least two years have passed since the filing, and all other conditions for discharge have been met. (Bankruptcy Code Section 523(a)(1) (B)).
Willful evasion or fraudulent returns. Most litigation regarding the discharge ability of individual taxes relates to the issue of whether the debtor filed a fraudulent return or whether the taxpayer attempted in any manner to evade or defeat the payment of taxes. Under Bankruptcy Code section 523(a)(1)(C), the evasion must be willful. What constitutes “willful evasion” has been the subject of much court interpretation and the threshold for a finding of willfulness is a high one: a finding of affirmative acts seeking to evade or defeat collection of taxes.
Litigating the tax discharge. Assuming the debtor has satisfied all of the criteria for discharge ability and the court issues its standard blanket discharge order, is it safe to assume that he or she need no longer be concerned with IRS enforcement? The answer is a resounding “no.” The better practice is to file an adversary proceeding under Bankruptcy Rule 7001, seeking a declaratory determination that the specific taxes at issue are discharged by operation of law.
Under Code Sec. 7491(a), the IRS has the absolute burden of proof on all matters in such proceedings. Obtaining a specific court order as to discharge ability is the best safeguard from future collection action and prevents the client from having to move to reopen the bankruptcy case years down the road.