Bankruptcy Article #7
In a Chapter 7 case, Section 523 of the Code determines which tax debts are non-dischargeable. Included are:
- Taxes entitled to priority under Section 507(a). See Section 523 (a) (1) (A).
- A tax due upon filing a return, but the return is not filed. Section 523(a) (1) (B) (i).
- A tax with respect to which a required return was filed after the due date including extensions, but within two years of the petition date. Section 523(a) (1) (B) (ii).
- Taxes with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax. Section 523(a) (1) (C).
Priority taxes under Section 507 are always non-dischargeable, so it is critical to determine when the time periods run for taxes to fall under the priority umbrella. It is also important to understand which non-priority taxes are also non-dischargeable under Section 523(a).
Six types of taxes are entitled to priority under Section 507, the most common of which are income taxes which meet one of four tests. First, if the last due date of the income tax return, including extensions is within three years of the petition date, the tax is priority. Second, taxes assessed within 240 days of the petition date are priority taxes. Third, the 240 day rule is suspended for the time any offer in compromise is pending with respect to a tax assessment, plus 30 days, so taxes due within the time an offer in compromise is pending are priority. Fourth, taxes which are not assessed, but are assessable after the commencement of a case are priority taxes (such as when a notice of deficiency has been issued but the 90 day appeal period has not run).
The second type of priority taxes listed in Section 507(a) (8) is property taxes assessed before the commencement of the case and last payable without penalty after one year before the petition date. Third are taxes which are required to be withheld or collected and for the the debtor is liable in some capacity (such as sales, payroll, and trust fund taxes). The fourth type of priority taxes are employment taxes on priority wage claims. Fifth, certain excise taxes due or occurring within three years of the petition date. Finally, and sixth, penalties for actual pecuniary loss are priority taxes.
Certain non-priority taxes are also non-dischargeable. These taxes usually are non-dischargeable because the debtor has engaged in bad behavior, such as not filing a tax return, although the debtor is required to do so. If the debtor files a tax return late, and the return is within two years of the filing of the petition, the tax is non-dischargeable even though it may not be a priority debt. Of course, as one would expect, where a debtor files a fraudulent return, or willfully attempts to evade or defeat a tax, the tax is non-dischargeable. If there has not be a judicial determination of fraud prior to the bankruptcy filing, the tax authority may be required to litigate the fraud allegations in the Bankruptcy Court to succeed in making these taxes non-dischargeable. However, if there has been a Tax Court determination of fraud, the debtor may be collaterally estopped regarding the non-dischargeability of the debt. Grogan v. Garner, 498 U.S. 279, (1991).
In a Chapter 13 case, the "super discharge" under Section 1328(a) can discharge more taxes than possible under Chapter 7. A Section 1328(a) discharge occurs when a debtor successfully completes his or her payments under the confirmed Chapter 13 plan. If a debtor can not complete the plan, but is nonetheless deserving of a "hardship" discharge based upon his or her efforts in the case, the discharge enters under Section 1328(b). A Section 1328(b) discharge is the same as a discharge under Section 727 in a Chapter 7 case.
Taxes which are priority debt must be paid in full during the course of the Chapter 13 case. However, for unsecured priority taxes, while the principal tax and interest up to the date of filing must be paid as a priority debt, any penalties on that debt are paid as general unsecured debt (just like credit cards). Since penalties can significantly increase the amount of pre-petition taxes facing a debtor, an analysis of the amount of penalties associated with tax debt is essential in determining whether a feasible Chapter 13 plan can be constructed to pay the priority portion of the taxes in full.
In addition, if the tax authority fails to timely file a proof of claim, the tax debt can be discharged in full without any payment of the taxes (whether they are priority or not). Unfortunately for debtors, both the IRS and MRS are very attentive to the deadlines for filing claims in recent years.
Chapter 13 can assist a debtor to strip down a tax lien to the value of the property upon which the lien attachs. Once the taxes are no longer secured, it is still necessary to determine whether the taxes are priority or general unsecured claims in order to properly categorize them for payment under the plan.
Most interestingly, in Chapter 13, a debtor is only required to pay income taxes and interest in full if they are less than three years old. If income taxes are older than three years and are unfiled as of the petition date, they are still dischargeable in Chapter 13 when the tax returns are filed post petition. In that circumstance, the income taxes are paid as general unsecured claims.
STRATEGIES FOR LITIGATING TAX ISSUES
The basic tool used in litigating tax issues is contained in Section 505(a) (1). That section permits the Bankruptcy Court to determine the amount or legality of any tax, a fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. If, however, there was a judicial or administrative tribunal adjudication of a tax, fine, penalty, or addition to a tax, before the commencement of the bankruptcy case, the Bankruptcy Court may not determine these issues again under Section 505(a)(1). See Section 505(a) (2) (A).
The procedural vehicle to bring a Section 505 issue before the Court depends upon the relief sought by the debtor. If the debtor is seeking a determination of tax liability, that can be accomplished by an objection to the claim of the tax authority or by an independent motion to determine tax liability. Under either scenario, the Court will probably permit each party to engage in discovery similar to an adversary proceeding in an effort to fully air the underpinnings of the taxes assessed and the debtor's assertions that the taxes are not owed.
If the goal is a determination of the dischargeability of certain taxes, a complaint must be filed pursuant to Rule 7001(6). The full panoply of discovery devices is available to the parties through this form of litigation.
The burden of proof is upon the taxpayer that the tax authority's assessment is incorrect. See Raleigh v. Illinois Department of Revenue, 120 S. Ct. 1951 (2000). The official determinations of the IRS are entitled to a presumption of correctness. Delaney v. C.I.R., 99 F. 3d 20 (1st Cir. 1996); United States v. Kantaratos, 36 B.R. 928 (D. Me. 1984). But see 26 U.S.C. Section 7491, in which the taxpayer may have simply a burden of production while the IRS may have the ultimate burden of proof in certain circumstances (i.e. for tax periods after July 1998 where the taxpayer has maintained tax records and has cooperated with the IRS in providing documents as well as compliance with other requirements to substantiate the taxpayer's position).
In instances where the issue is whether the debtor is a "responsible person" by the tax authority for the payment of what was once called the "100% penalty" for corporate trust fund taxes (940, 941, or sales taxes), the First Circuit has simplified the test for determining who is a responsible person. 26 U.S.C. Section 6672 imposes trust fund tax liability upon a person, who willfully fails to collect, account for and pay for such tax if that person is "responsible" for the collecting, accounting, and paying of the taxes. In Vinick v. U.S., 205 F. 3d 1 (1st Cir. 2000), a.k.a. Vinick II, the First Circuit narrowed the scope of activities a person can engage in to be found a "responsible" person, by first acknowledging that there have been seven criteria generally followed by most Courts in making this determination:
- is the taxpayer an officer or member of the board of directors;
- does the taxpayer owns shares or possess an entrepreneurial stake in the company;
- is the taxpayer active in the management of the day-to-day affairs of the company;
- does the taxpayer have the ability to hire and fire employees;
- does the taxpayer make decisions regarding which, when and in what order outstanding debts or taxes will be paid;
- does the taxpayer exercise control over daily bank accounts and disbursement records; and
- does the taxpayer have check signing authority?
The First Circuit, in Vinick II, concluded that the last three criteria were the most important. The Court reasoned that the crucial inquiry is whether the person has the "effective power" to pay taxes - that is, whether the person has the actual authority or ability in view of his or her status in the company, to pay the taxes owed. A careful examination of the factual circumstances under which a debtor has been assessed the "100% penalty" may result in sufficient grounds to litigate the issue with the tax authority in the Bankruptcy Court and eliminate the penalty or provide fertile ground for a compromise with the tax authority.