Monthly Archives: September 2015

How Does “Innocent Spouse Relief” Protect Taxpayers From IRS Levies and Collections?

Taxpayers who file joint IRS 1040 tax returns are jointly and severally liable for the full tax liability no matter how much or how little they contribute to the total tax.  That liability is not affected by divorce.  Sure, a divorce court could order one party to pay all or part of the joint tax debt, but such an order does not change the fact that each spouse is jointly and severally liable to the IRS.  The IRS can pursue collections against either or both taxpayers no matter how the divorce court shifts responsibility between the joint filers.

What options are available to an ex-wife if the prior years’ joint tax liability really resulted from extraordinarily large income produced by the ex-husband and the ex-husband now refuses or is unable to pay the taxes? You should consider “innocent spouse relief” offered by the IRS pursuant to 26 U.S.C. §6015?

Tax professional must be able to distinguish between two separate scenarios that may offer “innocent spouse relief” to the ex-wife: one good, and one bad.

The good scenario relates to a situation where a tax return was never filed or the filed return understated the true tax liability.  That scenario causes the IRS to assess a tax for the never filed return or assess a tax deficiency for the understated portion of the tax liability.  Section 6015 of the Internal Revenue Code grants the IRS authority to eliminate the assessed tax deficiency under the “innocent spouse relief” program when the innocent spouse had no knowledge of the understatement and had no reason to know of the understatement.  A perfect example is a wife of a self-employed home-remodeler and the wife has no involvement with the business and no knowledge that the home-remodeler underestimated the tax liability on the joint tax return.

The bad scenario relates to a situation where a tax return was properly filed and did NOT understate the tax liability on the return; the tax liability exists because the taxpayers did not save sufficient funds to pay the tax liability.  That was the scenario in In re Mikels, 524 B.R. 805 (Bankr. S.D. IN 2015).  In Mikels, an ex-spouse applied to the IRS for innocent tax relief for several years.  Some of those years related to years no returns were ever filed, and other years related to years where the innocent spouse failed to pay the taxes that were properly reported on the returns.

The spouse in Mikels sought innocent spouse relief from the IRS before filing bankruptcy.  The IRS granted the innocent spouse relief as to the tax years when no tax return was filed and the IRS had assessed the tax deficiency. However, the IRS denied innocent spouse relief for the tax years that the tax return properly reported the tax liability.

The Mikels spouse filed bankruptcy and objected to the IRS’ proof of claim seeking payment for the properly reported tax liability.  The Mikels court overruled the spouse’s objection and allowed the IRS’ claim for the tax liability relating to the properly reported tax years.  The court ruled that “innocent spouse relief” is only available pursuant to 26 U.S.C. §6015 when the IRS assesses a tax deficiency and such relief is not available when the taxpayers merely fail to pay the tax.

PRACTICE POINTERS: Innocent spouse relief is a great tool for ex-spouses who were deceived by their self-employed ex-spouses who underreported net income and concomitantly underreported the total tax liability.  However, the tax professional must be able to spot when the IRS will grant such relief and when it won’t.  The simple rule is no relief when the tax was reported accurately, and relief may be available it the tax was underreported and the ex-spouse had no knowledge of the underreporting.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.
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Can a Bankruptcy Trustee Seize an Inherited IRA?

A Chapter 13 trustee cannot seize any IRA.  The worst the trustee can do is insist that the Chapter 13 plan provides to unsecured creditors an amount equal to the non-exempt value of the inherited IRA.  Whether the inherited IRA is exempt is a question of federal law for those states that have not opted-out of the federal exemptions (11 U.S.C. §522(b)) and a question of state law for those states that have opted-out.

A Chapter 7 trustee has greater powers than a Chapter 13 trustee.  A Chapter 7 trustee can seize and force the turnover of non-exempt inherited IRAs.  So the question is whether the inherited IRA is exempt or non-exempt from seizure.  This issue was addressed in In re Everett, 520 B.R. 498 (E.D.LA 2014).  In Everett, the taxpayer inherited an IRA from her ex-spouse and transferred the inherited IRA into a new IRA in her name. Later, a creditor obtained a $245,000 judgment against the taxpayer and claimed an interest in the inherited IRA.  Taxpayer responded by filing bankruptcy to discharge the debt. Taxpayer identified the inherited IRA as an asset and claimed the asset was exempt from collection.  Creditor objected to the exemption.

The Everett court found that the inherited IRA was NOT exempt under federal law.  The court cited the U.S. Supreme Court’s ruling in Clark v. Rameker, 134 S.Ct. 2242 (2014) that held inherited IRAs are not “retirement funds” within the meaning of §522(b)(3)(C) and therefore are not exempt assets.  The Supreme Court distinguished IRAs from inherited IRAs.  Inherited IRAs do not operate like ordinary IRAs.  Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time without paying a tax penalty.  Indeed, the owner of an inherited IRA not only may but must withdraw its funds.  The owner must either withdraw the entire balance in the account within five years of the original owner’s death or take minimum distributions on an annual basis.  And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account.  Consequently, the Everett court found that the taxpayer’s inherited IRA cannot be exempted under federal exemption laws of §522(b)(3)(C).

The Everett court next noted that that Louisiana had opted out of the federal exemption statute of §522(b).  The court then analyzed Louisiana exemptions and found that the inherited IRA was not exempt under Louisiana law because the inherited IRA was not a “tax-deferred arrangement” within the meaning of the Louisiana statutes and therefore not exempt from the bankruptcy estate under Louisiana law.

Therefore, the Everett court reversed the lower court’s order denying the objection to taxpayer’s exemption, which will result in the taxpayer losing the inherited IRA to creditors.

PRACTICE POINTERS:  Determine whether the taxpayer’s state has opted-out of the federal tax exemptions.  If opted-out, then determine the exemption status of inherited IRAs under the state law of taxpayer’s residence.  This analysis will help you advise the taxpayer whether the inherited IRA would be protected from the Chapter 7 trustee’s attempt to seize the property or force a turnover of the property.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Can the Government Take My Tax Refund If I File Bankruptcy?

It is not uncommon for the state government to intercept and keep tax refunds for a current year as a method of offsetting unpaid past debts.  But what happens to the refunds if the taxpayer files bankruptcy before the government intercepts the refunds?  That issue was addressed in In re Johnson, 521 B.R. 912 (Bankr. W.D.AR. 2014).

In Johnson, the taxpayer anticipated receiving a tax refund from the IRS at some point after the bankruptcy case was filed.  The taxpayer listed the anticipated tax refund as an asset on the bankruptcy schedules with a corresponding exemption. The taxpayer owed money to the Arkansas Department of Workforce Services (“Government”) on the day the bankruptcy case was filed,  but failed to list the Government as a creditor holding a potential fraud claim.  Later, the Chapter 7 trustee entered a “no-asset” report indicating there were no assets for distribution to any unsecured creditors.  Ultimately, the court entered a discharge order.

The Government intercepted the tax return after the bankruptcy discharge had been entered, and refused to return the refund to the taxpayer.  The taxpayer responded by filing with the bankruptcy court a motion for contempt for violating the discharge injunction of 11 U.S.C. §524(a)(2).  Taxpayer argued that the Government was duty-bound to return the refund and later file an adversary to determine whether the Government’s debt was discharged. The Government opposed the motion for contempt and argued that the Government should have been notified of the bankruptcy filing and the lack of notice caused the debt to be rendered nondischargeable.

The Johnson court noted three key facts: (1) the Government had never received notice of the bankruptcy case before intercepting the refund; (2) the trustee had issued a “no-asset” report; and (3) the Government’s claim was based in fraud.  These facts triggered the applicability of 11 U.S.C. §523(a)(3)(B), which allows litigation to proceed at any time on the issue of fraud.  A creditor holding a fraud claim which was not notified of the bankruptcy filing is not restrained by the typical 60-day objection period of Bankruptcy Rule 4007(c).

Moreover, the Johnson court ruled that the bankruptcy court no longer had exclusive jurisdiction over the determination of dischargeability under §523(a)(2), (4) or (6).  Instead, the bankruptcy court shares jurisdiction with the state court. In short, the penalty to the taxpayer for failing to schedule the creditor holding a fraud claim is forfeiture of the right to enjoy exclusive federal jurisdiction and loss of the 60-day limitations period applicable in exclusive jurisdiction actions.

In short, the Johnson court rejected the taxpayer’s attempt to hold the Government in contempt for violating the discharge injunction.  Similarly, the court rejected the Government’s argument that the debt was rendered nondischargeable.  Instead, the court denied the motion for contempt and declined to hold the Government in contempt until a court of competent jurisdiction rendered a judgment on whether the Government’s claim for fraud was rendered dischargeable or nondischargeable by the bankruptcy discharge.

Practice Pointer:   Taxpayers should strive to list accurately all creditors by name and address. Taxpayers who fail to give a creditor proper notice could find those debts nondischargeable in a Chapter 13 case or an “asset” Chapter 7 case.  But, if a taxpayer discovers that a creditor holding a potential fraud claim was inadvertently omitted from an “no-asset” Chapter 7 bankruptcy case, then the taxpayer should file an adversary proceeding in the bankruptcy court seeking a determination that the claim was discharged by the bankruptcy.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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What Mental State is Required to be Guilty of Tax Evasion?

Some taxpayers do not pay taxes because of poor cash flow.  Other taxpayers employ elaborate schemes to evade paying taxes. A third category of taxpayers show an indifference to tax obligations and continue to live their lives without paying taxes—some of the latter taxpayers are very rich people!

The U.S. Court of Appeals for the Ninth Circuit determined what mental state is required to find that a taxpayers’s federal tax liabilities should be excepted from discharge under 11 U.S.C. §523(a)(1)(C) for willfully attempting to evade paying the tax.  In Hawkins v. Franchise Tax Board of California, 769 F.3d 662 (9th Cir. 2014), the Ninth Circuit concluded that “specific intent” to evade is required for the discharge exception to apply.

In Hawkins, the taxpayer enjoyed the trappings of wealth, including a private jet, expensive private schooling for the children, an ocean-side condominium in La Jolla, CA, and a large private staff.  Taxpayer was a successful capitalist who invested in tax shelters upon the advice of tax counsel.  The IRS audited Hawkins and challenged the validity of the tax shelters.  The IRS then disallowed the tax shelters and assessed taxes and penalties of $16 million.

Hawkins did very little to alter his lavish lifestyle after it became apparent that Hawkins was insolvent and their personal living expenses exceeded their earned income.  Later, Hawkins filed Chapter 11 bankruptcy and confirmed a liquidating plan of reorganization.  The IRS received over $3 million from the bankruptcy estate.  The plan provided for a discharge of all preconfirmation debts, but provided that Hawkins and the IRS could bring suit to determine if the tax debt was dischargeable by the bankruptcy.  Such a suit was filed.

The IRS’ argued that the tax debt should not be discharged in bankruptcy because Hawkins’ maintenance of a rich lifestyle after their living expenses exceeded their income constituted a willful attempt to evade taxes.  The bankruptcy court agreed, but the Hawkins court reversed and rejected the IRS’ broad interpretation of the word “willful” and adopted a narrow interpretation of “willful.” More specifically, the Hawkins court concluded that declaring a tax debt nondischargeable under §523(a)(1)(C) on the basis that the taxpayer “willfully attempted in any manner to evade or defeat such tax” requires a showing of specific intent to evade the payment of taxes.  Id. at 669.

The Hawkins court distinguished its ruling from the ruling of other circuits that have found income taxes nondischargeable if the taxpayer merely committed the evasive acts intentionally—even if taxpayer’s evasive acts were committed for a purpose other than evading the payment of taxes (e.g. payment of money to doctors for cancer treatment instead of paying IRS).  While the Hawkins court noted that other circuits used different semantics, the court noted  that most of the cases in the other circuits resulting in nondischargeability actually involved intentional acts or omissions designed to evade taxes.  Id. at 669.

The Hawkins court reversed the bankruptcy court and remanded for consideration of the facts in light of the new “intent to evade” standard.  Apparently the Hawkins court wanted the bankruptcy court to determine if Hawkins continuation of a lavish lifestyle after IRS assessment of $16 million was (a) an indifference to taxpayer’s duty to pay taxes, or (b) an attempt to evade paying the taxes.

Practice Pointer:   Some red flags indicating intent to evade paying taxes include: keeping double books, making false bookkeeping entries, destroying records, transferring assets to a third-party, and concealing assets.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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How Long Does a Bankruptcy Filing Stay on My Credit Report?

Some people say a bankruptcy filing stays on the credit record for 7 years and other say 10 years.  Who is right?  This issue was addressed by the U.S. Court of Appeals for the Seventh Circuit in Childress v. Experian Information Solutions, Inc., 790 F.3d 745 (7th Cir. 2015).  In Childress, the court found the Fair Credit Reporting Act requires a reporting agency to purge bankruptcy records 10 years after the bankruptcy filing date, but noted that the credit-reporting agencies voluntarily purge them after seven years instead.  Id. at 746-747.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can Bankruptcy Discharge Income Taxes Filed More Than 2 Years Before the Bankruptcy Filing?

Short Answer:  Yes, income taxes can be discharged in bankruptcy if the taxpayer satisfies all of the bankruptcy requirements.  One of the contested issues is whether tax liability relating to a late-filed return can ever be discharged.  Another issue is whether the paper filed with the taxing authority is deemed a “return” for bankruptcy purposes.  These issues were addressed in In re McBride, 534 B.R. 326 (Bankr. S.D.OH 2015).

Facts: The taxpayer filed multiple city tax returns for taxes imposed by the City of Kettering, Ohio (“City”).  Some returns were filed on a timely basis and at least one return was filed after the due date. The tax liability due on these returns was calculated in relation to the IRS tax liability.  This liability was dramatically understated as a result of the taxpayer’s scheme to minimize tax liability through a now discredited “abusive trust arrangement.”  The US Tax Court found taxpayer’s self-reported returns dramatically deficient and increased the tax liability substantially, which caused the City tax liability to be increased proportionately.

Argument: In response, taxpayer filed chapter 7 bankruptcy to discharge the tax liability more than 2 years after the original City returns were filed. Taxpayer then filed an adversary proceeding to determine the dischargeability of the tax and filed a motion for summary judgment to obtain a judgment.  City objected asserting that the taxes owed are nondischargeable under 11 U.S. C. §523(a)(1)(B)(i) because the taxpayer never filed qualifying “returns.”  City argued the documents filed do not constitute “returns” because one return was untimely and all of the tax documents significantly under-reported the taxpayer’s income.

Analysis: The McBride court was forced to resolve the issue. There, the court addressed the two competing arguments regarding whether a late filed return can ever be a “return” for bankruptcy purposes.  The McBride court noted that the hanging paragraph in §523(a)(*) attempts to define the term “return.”  However, the court found the statute’s definition unclear and begged the question “Is §523(a)(*) pointing to the definitional provisions in state or local tax law to define the term ‘return’ for §523(a) purposes or, instead, must the document satisfy all aspects of the relevant nonbankruptcy ta law, including filing requirements, in order to be a ‘return’?” (Emphasis added).

The McBride court considered and rejected City’s bright-line test adopted by the Fifth Circuit in McCoy v. Miss. State Tax Comm’r (In re McCoy), 666 F.3d 924 (5th Cir. 2012) and followed by the Tenth Circuit in Mallo v. Internal Revenue Service (In re Mallo), 774 F.3d 1313 (10th Cir. 2014) and the First Circuit in Fahey v. Mass. Dept. of Revenue (In re Fahey), 779 F.3d 1 (1st Cir. 2015).  This test looks strictly at the tax statute’s filing deadline and would render taxes nondischargeable if the return was filed even one day late.

Instead, the McBride court applied the simplest meaning to §523(a)(*)’s definition of “return” as it relates to the nondischargeability of income taxes. The court held that §523(a)(*) required the court to look to relevant nonbankruptcy law to determine what qualifies as an acceptable return under that law. The court believed that if a document filed with the federal, state, or local taxing authority meets the applicable tax code’s DEFINITION of an acceptable return, then it is a return under §523(a)(*) even if the document does not fully comply with all aspects of the relevant tax code.

When a formal definition of return in the applicable tax statute is absent, the court must look to another source for determining whether the taxpayer’s tax documents qualify as a return.  The Sixth Circuit applied a four-part test to determine whether a tax form qualifies as a tax “return” for bankruptcy purposes: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of the tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of tax law.  See Beard v. Commissioner, 82 T.C. 766 (1984) adopted by United States v. Hindenlang (In re Hindenlang), 164 F.3d 1029 (6th Cir. 1999).

The McBride court applied its analysis to the case and bar and concluded that questions of fact existed and these facts had to be determined before the Beard test could be applied.  Therefore, the court denied the taxpayer’s motion for summary judgment and allowed the parties to present evidence to determine if the tax returns filed with the City were “returns” for bankruptcy purposes.

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis.  Wait the two years after filing the tax returns (and meet all other requirements) before filing bankruptcy.  Then expect to battle the taxing authority if the returns were filed late or substantially understated the tax liability.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

How do I Sue the IRS for Taking Assets After my Taxes were Discharged in Bankruptcy?

A taxpayer can sue the IRS for collecting taxes eliminated in a Chapter 7 bankruptcy case—but not immediately.  So what are the rules and limitations?

That issue was addressed in In re Broos, 534 B.R. 358 (8th Cir. BAP 2015).  There, the taxpayer filed bankruptcy and obtained a bankruptcy discharge before the IRS levied the taxpayer’s assets and filed a Notice of Federal Tax Lien. The taxpayer filed an adversary lawsuit in the bankruptcy court and sought damages for violating the automatic stay and/or the bankruptcy discharge injunction. The IRS sought to dismiss the lawsuit because the taxpayer had failed to exhaust the “administrative remedies” before filing the lawsuit.

The Broos court agreed with the IRS. First, taxpayers can sue the IRS only to the extent the United States has waived its sovereign immunity per 26 U.S.C. §7433(a).  But, taxpayers may not bring a direct action for damages against the IRS until the taxpayer exhausts the administrative remedies provided in 26 U.S.C. §7433(d).  The Tax Code requires the taxpayer to adjudicate the issues before an administrative law judge and plead a case for damages; thus keeping the IRS out of court as much as possible.  There, the taxpayer can seek damages for the IRS’ willful violation of the bankruptcy automatic stay protections under 11 U.S.C. §362 and the bankruptcy discharge injunction under 11 U.S.C. §524.  See 26 U.S.C. §7433(e)(1).

What are the procedures for exhausting the administrative remedies?  The procedure a taxpayer must follow in order to exhaust the remedies under §7433(d) for violating the bankruptcy discharge is enumerated in 26 C.F.R. 301.7430-1 and 301.7433-2(e).  A litigant must file a written administrative claim for damages or for relief with the Chief, Local Insolvency Unit for the corresponding judicial district in which the bankruptcy petition was filed.  The claim must contain the taxpayer’s name, identification number, current address, current home and work telephone number, the location of the bankruptcy court in which the underlying bankruptcy case was filed, the case number of the bankruptcy case in which the violation occurred, a description of the violation and injuries, the dollar amount of the injuries, and the signature of the taxpayer or taxpayer’s representative.  26 C.F.R. 301.7433-2(e).  The taxpayer must then wait until the earlier of six months or the date on which the IRS has rendered a decision on the claim.

In Broos, the taxpayer failed to seek damages and administrative remedies before filing the adversary lawsuit in the bankruptcy court.  Therefore, the bankruptcy court dismissed the lawsuit against the IRS as premature.

Note that damages can never include punitive damages against the IRS for violating the automatic stay or bankruptcy discharge injunction.  Punitive damages are unavailable as a matter of law. 11 U.S.C. §106(a)(3).

Practice Pointer: Suing the IRS is very complicated.  The law forces claims to be addressed administratively within the IRS by an administrative law judge. Only afterwards can a taxpayer seek damages in the bankruptcy court for violating the Bankruptcy Code.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can I Sue IRS Employees for Collecting Taxes Eliminated in Bankruptcy?

IRS employees make mistakes like everybody else.  But the IRS employees have special protections that average citizens do not enjoy. So, what can a taxpayer do if the IRS wrongfully attempts to collect income taxes discharged in bankruptcy by levying assets or filing notices of federal tax liens?

That issue was discussed in In re Broos, 534 B.R. 358 (8th Cir. BAP 2015).  In Broos, the taxpayer filed bankruptcy and received a chapter 7 bankruptcy discharge long before the IRS attempted to levy the taxpayer’s assets and before the IRS filed a Notice of Federal Tax Lien.  The IRS was provided notice of the bankruptcy and presumably notice of the chapter 7 bankruptcy discharge.  Nonetheless, the IRS levied and liened.

The taxpayer filed an adversary lawsuit in the bankruptcy court and sought damages for violating the automatic stay and/or the bankruptcy discharge injunction.  The lawsuit named as party-defendants the individual IRS employees involved in the levies and liens.  The IRS opposed arguing that the employees should not be the named defendants and the IRS should be substituted as the proper party defendant.

The Broos court agreed with the IRS.  The court noted the general rule that a taxpayer may not sue the United States or any of its officers and employees without a waiver of sovereign immunity.  Congress provided such a wavier in 26 U.S.C. §7433(a) but only as to the United States and not as to its individual employees.  Individual federal employees may not be sued for actions taken in the performance of their official duties.  Any claims filed against the individual employees would be barred by sovereign immunity.  Thus, the court granted the United States leave to be substituted as the property party defendants because Congress had waived sovereign immunity as to it.

Practice Pointer: Name the United States, and not the “Internal Revenue Service,” as the proper party defendant.  Also, do sue the individual IRS employees who performed the objectionable acts because the employees are protected by sovereign immunity.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Will I Lose my Tax Refund if I File Bankruptcy?

Here’s a common fact pattern.  A taxpayer files bankruptcy in June of a tax year and receives an IRS tax refund in April of the following calendar year.  What happens to the non-exempt portion of the IRS tax refund?  The taxpayer would want to keep the refund, but the Chapter 7 trustee would want a turnover of the refund for the benefit of the unsecured creditors.

That issues was addressed in In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, the parties agreed that the taxpayer should be allowed to keep the portion of the tax refund representing income earned after the bankruptcy case was filed to December 31.  The IRS argued that the taxpayer should be allowed to keep the same percentage of the tax paid after filing bankruptcy to the total tax refund; so if 25% of the tax payments were tendered after filing bankruptcy, then the taxpayer would be allowed to keep the same 25% of the total refund.

The Mooney court, rejected the IRS’ approach and adopted a “pro rata by days approach.”  Id. at 428.  The court held that the refunds should be prorated to the date of filing based on the number of calendar days before and after the bankruptcy filing date.  So, since the taxpayer filed bankruptcy on the 177th day of the year with 188 days remaining, then the trustee would be allowed to seize the percentage of the total refund that reflects 177/366, or 48.49%.  Similarly, the taxpayer would be allowed to retain the percentage of the total refund that reflects 188/365, or 51.51%.

Practice Pointer:  File as early in the calendar year as possible if a taxpayer is expecting a large refund. An early filing preserves the argument that the income was earned after the bankruptcy filing and the maximum share of the tax refund would be protected by the taxpayer.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are Estimated Tax Payments Paid to the IRS Protected from Seizure in Bankruptcy?

Yes, estimated tax payments made to the IRS immediately before filing bankruptcy could be protected from seizure by the Chapter 7 trustee, according to In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, an individual taxpayer tendered to the IRS $36,700 in estimated tax payments two days before filing Chapter 7 bankruptcy.  The Chapter 7 trustee wanted to seize those payments and filed a motion for turnover pursuant to 11 U.S.C. §542(a), arguing that the estimated tax payments were credits against the future tax liability and constituted “credits” that are property of the bankruptcy estate which are subject to turnover.  The taxpayer opposed the turnover motion and argued that the tax payments/credits are not within the taxpayer’s “control” because those payments can only be refunded by the IRS after the payments are applied to taxes due for the year in which the payments were made, citing Rev. Rul. 54-149, 1954-1 CB 159-60.

The Georgia bankruptcy court noted that the Eleventh Circuit in which it sits has never published a decision on the issue. But, the court noted that the Ninth and Tenth circuits have published conflicting opinions.  So the bankruptcy court analyzed both approaches.

Adopting the reasoning of the Tenth Circuit in the case of Weinman v. Graves (In re Graves), 609 F.3d 1153 (10th Cir. 2010), the Mooney court started its analysis by finding the tax credits were property of the bankruptcy estate.  But, the court noted that the Chapter 7 trustee succeeded only to the title and rights in the tax credits that the taxpayer had at the time the bankruptcy case was filed, nothing more.  The Mooney court believed the trustee’s interest in the tax creditors were limited to the same extent as a taxpayer’s interest in the application of a prior year tax refund, by the strictures of 26 U.S.C. §6513(d), which makes a taxpayer’s refund application election irrevocable.  A taxpayer would have no right to any cash refund of the estimated tax payments until their current tax liability is determined and then only if they are entitled to a further refund.

Finally, the court held that the bankruptcy estate’s interest in the pre-payment is limited to the taxpayer’s contingent reversionary interest in the pre-payment attributed to pre-petition earnings.  Stated differently, if the taxpayer is entitled to a refund after their current year tax liability was satisfied, then the Chapter 7 trustee is entitled to demand turnover of any amount of such refund attributable to the prepetition earnings.

Practice Pointer:  Tendering estimated tax payments to the IRS for the current year (or applying a tax refund from a prior year) prior to filing bankruptcy is a clever strategy to deplete non-exempt assets that would otherwise be seized by the trustee and distributed to the unsecured creditors.  Step two of the strategy would be to minimize the tax refund in the current year since the Chapter 7 bankruptcy trustee would be entitled to demand turnover of any amount of the refund attributable to the prepetition earnings. Taxpayers receiving a paycheck could reduce their tax withholdings in an effort to minimize the tax refund.  Self-employed taxpayers could seek to minimize refunds by minimizing net income from delayed income recognition and expedited expense recognition.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Does a Criminal Conviction Prevent a Taxpayer from Discharging Tax Debt?

Criminals who have been convicted of tax fraud or other tax crimes typically have tax liabilities.  But not all tax crimes are the same.  Some crimes relate to filing fraudulent tax returns with the intent to evade paying taxes.  Other tax crimes relate to willfully submitting to the IRS false returns, statements, or other documents that may or may not relate to any intent to evade paying taxes.  From a bankruptcy point of view, these crimes are not equal.

The question arises whether a taxpayer convicted of willfully submitting to the IRS false “returns, statements, or other documents” pursuant to 26 U.S.C. §7206(1) can discharge the related tax liabilities by filing Chapter 7 bankruptcy.  This issue was addressed in U.S. v Parker, 578 Fed.Appx. 669 (9th Cir. 2014).  In Parker, the IRS filed a summary judgment motion seeking to reduce to judgment the taxpayer’s income tax liability after taxpayer received a bankruptcy discharge.  The taxpayer objected claiming there was a triable issue of fact that precluded the entry of a summary judgment on the issue of bankruptcy dischargeability, namely whether the taxpayer ever intended to evade paying the tax. Taxpayer asserted that the tax conviction (and tax liability) resulted from the embezzlement of funds to save a business from bankruptcy and not to evade paying IRS tax.

The 9th Circuit Court of Appeals began its analysis by noting that a taxpayer’s discharge in bankruptcy may be excepted “for a tax… with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. §523(a)(1)(C).  The government must demonstrate (1) a knowing falsehood; (2) an intend to evade taxes; and (3) an underpayment of tax.

The Parker court determined that the  26 U.S.C. §7206(1) criminal conviction proved conclusively that the taxpayer had satisfied the first and third element (“a knowing falsehood” and an “underpayment of tax”), but did not conclusively prove the second element (that the taxpayer had intended to evade the payment of taxes).  So the court denied the IRS’ motion for summary judgment because an intent to evade taxes creates a credibility determination that is prohibited at the summary judgment stage.  A trial is required to determine the taxpayer’s intent.

Practice Pointers: A tax professional must realize that not all tax crime convictions are the same.  The tax professional must review the specific elements of the crime committed.  Some criminal convictions necessarily would result in the denial of a bankruptcy discharge, while other crimes do not.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are IRS Tax Liens Removed by Filing Bankruptcy?

An IRS lien can be eliminated in a Chapter 13 bankruptcy case, but tax liens cannot be avoided by filing a Chapter 7 bankruptcy case.

A taxpayer unsuccessfully attempted to avoid the IRS’ tax liens by filing chapter 7.  In U.S. v Parker, 578 Fed.Appx. 669 (9th Cir. 2014), the court found that a chapter 7 case discharged the taxpayer of personal liability for old taxes, but the prepetition tax liens on the taxpayer’s property remained enforceable after the discharge—citing the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992).

Practice Pointers: A Chapter 7 bankruptcy case is designed to eliminate personal liability, but not the lien against real estate or personal property.  A chapter 13 case would be a better strategy if the goal is to strip or avoid a lien.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Spouse Who Signs a Joint Tax Return Without Reviewing it be Denied a Bankruptcy Discharge?

Sometimes one spouse takes the financial reins and handles all the financial aspects of a marriage (like banking, buying cars, preparing tax returns, etc.) while the other spouse handles the day-to-day family issues (like cooking, cleaning, children, etc.).  It is not uncommon for the non-financial spouse to sign a tax return without reviewing it.  It is a matter of trust.  The non-financial spouse trusts the other spouse to prepare an accurate tax return.

In In re Birkenstock, 87 F.3d 947 (7th Cir. 1996), the court was confronted with the issue of whether a wife who signs a joint tax return without reviewing it can be denied a bankruptcy discharge of tax liability for “willful attempt to evade” taxes.  The Birkenstock court had no problem finding the husband to be a chronic tax evader who took extraordinary steps to willfully attempt to evade paying the taxes. The husband’s taxes were excepted from the bankruptcy discharge and survived intact at the conclusion of the bankruptcy.

The Birkenstock court had a more difficult time deciding whether the wife also willfully attempted to evade paying the taxes.  The court noted that the only relevant evidence upon which the bankruptcy court had determined that the wife had acted willfully was the fact that she had signed the joint tax return.

The Birkenstock court set out the rules for non-dischargeability of tax liability in bankruptcy. The court noted that a Chapter 7 debtor is typically granted a general discharge of all debts owed as of the bankruptcy filing date.  However, 11 U.S.C. §523(a)(1)(C) creates an exception to the dischargeability of income taxes when the taxpayer makes “a fraudulent return or willfully attempts in any manner to evade or defeat” the tax.

So the question in the Birkenstock case was what constitutes “willfully attempts … to evade or defeat” the payment of taxes.  The 7th Circuit held that §523(a)(1)(C)’s exception comprises both a conduct requirement (that the taxpayer sought in any manner to evade or defeat his tax liability) and a mental state requirement (that the taxpayer did so willfully).  The court found that a “willful” determination requires a taxpayer’s attempt to avoid tax liability to be voluntary, conscious, and intentional.  In other words, the taxpayer must both (1) know that she has a tax duty under the law, and (2) voluntarily and intentionally attempt to violate that duty.  The willfulness requirement prevents the application of the bankruptcy discharge exception to taxpayers who make inadvertent mistakes, reserving nondischargeability for those whose efforts to evade tax liability are knowing and deliberate.

After reviewing the law and apply the law to the facts, the court ruled that the bankruptcy had erred in finding the spouse had willfully attempted to evade the tax liability.  The only evidence presented at trial regarding the wife’s willfulness was the fact that she had signed the tax returns.  Therefore, the bankruptcy court order was reversed and the wife was granted the bankruptcy discharge as to the tax liability.

 

Practice Pointers:  A spouse should consider not filing a joint tax return if the spouse has any reason to believe the other spouse may be filing a fraudulent return or may be willfully evading the tax liability.  Instead, a spouse should consider filing a separate tax return, especially if the spouse has little to no income as the spouse in Birkenstock.  The wife in Birkenstock would not have had any tax liability, because she did not work, had she filed separately.  The husband would have had all the tax liability and the wife would not have had to worry about any court ruling that her share of the tax liability was nondischargeable.  There are some tax disadvantages by filing separately, but none of the those disadvantages would compare to the disadvantage of the wife being held jointly and severally liable for the husband’s tax liability that could later be deemed nondischargeable in bankruptcy.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

What is the Effect of Crossing-Out the “Penalty of Perjury” Verification on an IRS 1040 Form?

The IRS 1040 Form concludes with a taxpayer’s obligation to sign the return under penalties of perjury, and to declare that the taxpayer has examined the return and accompanying schedules and statements, and state to the best of the taxpayer’s knowledge and belief, they are true, correct, and complete.

But what happens to a taxpayer who strikes or otherwise scratches-out the verification?  A taxpayer scratched-out the verification and suffered the consequences in United States v. Moore, 627 F.2d 830 (7th Cir. 1980).  In Moore, the taxpayer who scratched out the verification on tax returns filed over several years was indicted for tax evasion for failing to file income tax returns.  The IRS did not consider the unverified tax returns as tax “Returns.”

The court noted the taxpayer’s duty to sign a return that verifies its accuracy under penalties of perjury.  The Moore court found that debtor’s failure to verify the return under penalty of perjury resulted in the return not being deemed a “Return” for tax purposes. Id. at 834.

Practice Pointers: The best strategy is for the taxpayer to hand-deliver the tax returns to an IRS office and to have an extra copy hand-stamped “Filed” by the IRS representative.  A taxpayer should ask that both page 1 and page 2 of the Form 1040 be stamped so that the taxpayer has proof that the return was signed.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

What is the Effect of an IRS Lien During Bankruptcy?

This issue was addressed in In re Nomellini, 534 B.R. 166 (Bankr. N.D.CA 2015).  In Nomellini, a taxpayer filed a chapter 13 bankruptcy and listed the value of his allegedly underwater real property at $950,000 with a mortgage lien of $980,000. Taxpayer also listed personal property of $10,000.  The IRS accepted the valuations and filed a proof of claim consisting of a $10,000 secured claim and a $204,000 unsecured claim.  The chapter 13 plan stated that the “valuations shown above will be binding unless a timely objection to confirmation is filed.”  No objections were filed and the plan was confirmed.  The IRS ultimately was paid $10,000 for the secured claim.

Later, but before the plan was completed and discharge entered, the taxpayer sold the home for $2,175,000, which resulted in a $1,000,000 surplus after the mortgage obligation was paid in full.  The taxpayer argued that the IRS was only entitled to the $10,000 provided in the plan and that the IRS was limited by the confirmed plan and did not enjoy the rights of its lien.

The court phrased the issue as whether, under the provisions of the confirmed plan, the IRS was entitled to any of the proceeds of the sale of taxpayer’s real property based on the federal tax lien recorded, when the IRS has already been paid the full amount of its allowed secured claim as set forth in the confirmed plan.

The Nomellini court rejected the taxpayer’s argument believing the confirmed plan only affected the IRS’ “claim” against taxpayer and did not affect the IRS’ in rem rights established by the tax lien.  The court held that the IRS’ lien was not affected by the plan confirmation and the IRS had a valid lien against the property at the time of the sale because taxpayer never stripped or modified the IRS lien.

Practice Pointers: Taxpayer should have been more strategic.  Taxpayer should have filed a Rule 3012 motion to value the real estate soon after filing bankruptcy.  The IRS apparently would have agreed with the taxpayer’s valuation of the real estate.  Alternatively, taxpayer could have filed an adversary proceeding against the IRS and sought a valuation within the adversary and an order declaring the lien void upon issuance of the discharge.  Then, taxpayer should have paid off the case and received the discharge prior to selling the property.  Upon discharge, the IRS’ lien would have been void because the underlying debt would have been discharged. Thereafter, taxpayer could have sold the real property and kept the $1,000,000 surplus and paid nothing more to the IRS.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can an IRS Tax Lien be Eliminated or Reduced by Filing Bankruptcy?

The IRS has the statutory right to record a Notice of Federal Tax Lien against a taxpayer’s home, other real estate, and personal property.  See 26 U.S.C. §6323. Such a lien provides the IRS with the right to a taxpayer’s assets superior to any later recorded junior liens.  In the event of liquidation, the IRS would be paid in full prior to any junior lienholders receiving any money.

A taxpayer attempted to eliminate/void the IRS’ lien by filing Chapter 13 bankruptcy in Ryan v. United States, 725 F.3d 623 (7th Cir. 2013).  In Ryan, taxpayer failed to file taxes for the years 2006 thru 2010.  The IRS responded by filing a Notice of Federal Tax Lien against taxpayer’s real property and personal property. Subsequently, taxpayer lost his home for delinquent real estate taxes and did not own a bank account or vehicle when he filed bankruptcy.  In fact, debtor’s total assets were worth only $1,625 as of the bankruptcy filing date.

Taxpayer attempted to reduce the tax lien to the asset value of $1,625.  Taxpayer alleged that §506(a) allows a taxpayer to bifurcate the IRS’ claim between a secured claim component to the extent of any assets and an unsecured claim component for the remaining debt.  Then, taxpayer asserted that §506(d) of the Bankruptcy Code allowed a taxpayer to “stripdown” the lien to the value of the property, citing 11 U.S.C. §506(d).  The IRS agreed with the bifurcation, but objected to the lien being voided and argued that §506(d) does not authorize the bankruptcy court to void the federal tax lien to the extend it exceeded the value of the assets.

The Ryan court looked for guidance in the U.S. Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992).  In Dewsnup, the Supreme Court considered the proper interpretation of §506, and held that §§506(a) and 506(d) did not have to be read together, and that the term “allowed secured claim” in §506(d) was not defined by reference to §506(a). Instead, the Court determined that, consistent with preCode rules that liens pass through bankruptcy unaffected, the term “allowed secured claim” in §506(d) means a claim that is, first, allowed under §502 and, second, secured by a lien enforceable under state law, without regard to whether that claim would have been deemed secured or unsecured under §506(a).

Therefore, the Ryan court found that the IRS’ claim was secured by a lien enforceable under state law, and then held that the IRS’ claim could NOT be stripped down pursuant to §506(d). However, the Ryan court noted in dicta that the IRS’ claim could be stripped down pursuant to other sections of the Bankruptcy Code, including 11 U.S.C. §1325.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Did a Parent Willfully Evade Paying Taxes by Paying College Tuition Instead?

Section 727(b) of the Bankruptcy Code provides for the discharge of an individual chapter 7 debtor’s prepetition debts unless such debts are excepted from discharge pursuant to 11 U.S.C. §523. Section 523(a)(1)(C) excepts from discharge any debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The issue of willful evasion was addressed in In re Looft, 553 B.R. 910 (Bankr. N.D.GA 2015).  In Looft, an IRS audit resulted in the disallowance of partnership losses taken by an individual taxpayer on Form 1040. The IRS then assessed tax liability of approximately $319,000.  The taxpayer struck back by hiring attorneys to sue the tax professional who advised the taxpayer to include the partnership losses on the tax returns.  Taxpayer submitted a request for a collection due process hearing and filed a petition in the US Tax Court.  The IRS issued notice of intent to levy.  Taxpayer filed an offer in compromise to settle the tax liability.  Ultimately, taxpayer sought bankruptcy relief to discharge the tax liability.

The Looft court considered the taxpayer’s behavior after the IRS audit to determine if the taxpayer willfully attempted to evade paying the taxes.  On the negative side, and instead of paying the tax liability assessed, taxpayer paid more than $88,000 in college tuition so his child could attend the University of Virginia.  Taxpayer also purchased an $18,500 BMW for taxpayer’s daughter to use during college and another BMW for $9,800 when she graduated.  Taxpayer also gave cash gifts to his children and bought them cell phones and a laptop computer.  Taxpayer also spent $68,000 on his country club and more than $16,000 on trips and vacations.

On the positive side, the court noted the following about the taxpayer: (1) asserted he was victim of bad tax advice; (2) made voluntary payments towards the assessed taxes, including $2,500 obtained through a home equity loan; (3) took no action to stop the IRS from intercepting taxpayer’s refunds; (4) did not change tax withholdings to reduce future refunds; (5) withdrew money from a 401(k), paying tax penalties to do so, and paid $22,000; (6) took no effort to change bank accounts or withdraw money from bank accounts after receiving the IRS’ notice of intent to levy; (7) taxpayer continued to direct deposit his paychecks into the same bank account after the levy; (8) did not avoid keeping money in the bank account; and (9) timely-filed tax returns and timely-paid tax obligations relating to all tax years after the tax assessment resulting from the audit.

The Looft court noted that the IRS has the burden of proof and that exceptions to discharge are strictly construed in favor of the taxpayer. The Looft court identified IRS burden.  The IRS must show that taxpayer engaged in (1) evasive conduct with (2) a mental state consistent with willfulness.

Evasive conduct requires a showing that the taxpayer engaged in affirmative acts to avoid payment or collection of the taxes, either through commission or culpable omission.  The conduct requirement is not satisfied by mere nonpayment of taxes.

The 11th Circuit in Zimmerman v. IRS (In re Zimmerman), 262 Fed. Appx. 943, 946 (11th Cir. 2008) supported a finding of nondischargeability when the conduct included: (1) failure to timely-file tax returns: (2) failure to pay taxes; (2) intra-family transfers for little or no consideration; (3) titling a house solely in the spouse’s name while the debtor remains on the mortgage and makes all the payments; (4)  characterizing earnings so they are not subject to tax withholding; (5) making large discretionary expenditures; (6) failure to file tax returns while maintaining a luxury lifestyle. Other issues to consider are: (6) use income to pay off other burdensome debts; (7) behavior intended to prevent IRS from reaching taxpayer’s assets; (8) under-withholding of taxes from paychecks; (9) failure to pay estimated taxes; (10) failure to accrue assets by opting to lease assets instead; (11) dealing primarily in cash transactions; (12) excessive spending; and (13) discontinuance of direct deposit of wages into an account subject to a levy.

The Looft court considered all these factors as they related to taxpayer and found that the tax payer did not willfully attempt to evade paying the taxes.  Important to the court was the fact that the only steps the taxpayer took to prevent the IRS from collecting the tax liability were through official channels (i.e. offer in compromise, tax court, collection due process hearing). The court found that taxpayer’s actions were not consistent with an intentional failure to pay.

Practice Pointers: Whether a taxpayer willfully evaded paying taxes is a fact intensive analysis.  If in doubt, a taxpayer should establish a pattern of action that would support a conclusion that the taxpayer has the desire to pay without the ability to pay.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Who Has the Burden of Proof in a Tax Dischargeability Dispute Relating to Fraudulent Returns or Willful Attempt to Evade Paying Taxes?

Certain tax liabilities can be discharged in bankruptcy provided they are not excepted from discharge pursuant to 11 U.S.C. §523.  Section 523(a)(1)(C) excepts from discharge any tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

Taxpayers or the IRS can file an adversary proceeding in bankruptcy court seeking an order determining whether the taxpayer’s tax obligations are discharged.  The factual question in these cases is whether  a taxpayer filed a fraudulent return or willfully attempted to evade or defeat a tax.

Who has the burden of proof: the taxpayer or IRS?  That issue was addressed in In re Looft, 553 B.R. 910 (Bankr. N.D.GA 2015), citing Griffith v. United States (In re Griffith), 206 F. 3d 1389, 1396 (11th Cir. 2000). The Looft court found that the burden of proof is on the government to prove nondischargeability by a preponderance of the evidence. Exceptions to discharge are strictly construed in favor of the debtor.  In determining whether the government has met its burden, the court considers the totality of the circumstances.

Practice Pointers: The taxing authority has the burden of proof, but the analysis is fact intensive.  The bankruptcy court would be given wide discretion in determining whether the government met its burden.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer Eliminate Tax Debt if He Failed to File a Return Until After the IRS Assessed the Tax?

An old case is instructive for taxpayers who live in Illinois, Indiana, and Wisconsin.  See In re Payne, 431 F.3d 1055 (7th Cir. 2005).  This case is more than 10 years old and applies pre-BAPCPA law, but it is the only case addressing the issue issued by the US Court of Appeals for the Seventh Circuit. Other circuit courts have ruled on the issue. SEE BLOGS. Again, the 7th Circuit has not yet ruled on the issue for taxes due after the 2005 BAPCPA law was enacted.

In Payne, the taxpayer failed to file the 1986 tax return until 1991, which was one year AFTER the IRS had assessed tax liability for income tax due.  Taxpayer offered to compromise his tax debt in 1992, but the IRS rejected the offer.  Five year later taxpayer filed for Chapter 7 bankruptcy relief in 1997.

The court correctly noted that Section 523(a)(1)(B)(i) of the Bankruptcy Code forbids the discharge of federal income tax liability with respect to which a “return” was required to be filed but “was not filed.”  The taxpayer argued that the return filed in 1992 was a “return” as used in the statute, albeit filed six years late and after the IRS had gone to the trouble of figuring out what the taxpayer owed.  The IRS argued that an untimely post-assessment return is not a “return” within the meaning of the statute and that therefore taxpayer never filed a 1986 “return” and so cannot be discharged from liability for the taxes that the taxpayer owes for that year.

The Payne court noted that the Bankruptcy Code had not defined the term “return” pre-BAPCPA.  However, cases held that to be deemed a return, a document filed with the IRS must (1) purport to be a “return,” (2) be signed under penalty of perjury, (3) contain enough information to enable the taxpayer’s tax liability to be calculated, and (4) “evince[] an honest and genuine endeavor to satisfy the law.  Id. at 1057, citing United States v. Moore, 627 F.2d 830, 834-35 (7th Cir. 1980). The Payne court further declared that a purported return that does not satisfy all four conditions does not play the role that a tax return is intended to play in a system of self-assessment.  So while a “return” that satisfies the first three conditions comports with the literal meaning of the word, it does not comport with the functional meaning.

The whole dispute in Payne was whether the taxpayer satisfied the fourth prong of the test and “endeavored to satisfy the law” by filing the 1986 tax return in 1992.  The court rejected a line of reasoning used by other courts that the a late-filed return after the IRS assessed the tax does not serve the purpose of the filing requirement.  The Payne court expressly stated that the legal test is not whether the filing of a purported return has some utility for the tax authorities, but whether it is a reasonable endeavor to satisfy the taxpayer’s obligations.  So the bankruptcy courts should not look through the eyes of the IRS to determine usefulness; rather, the court should look through taxpayer’s eyes to determine if the taxpayer’s efforts constituted a reasonable endeavor to satisfy the taxpayer’s obligations.

The majority of the Payne court reversed the lower court and found that the taxpayer had not reasonable endeavored to satisfy the taxpayer’s obligations.  Hence the tax debt was excepted from discharge.  However, a persuasive counter argument was asserted in a dissent by Circuit Judge Easterbrook, who argued that the return was a “return” for bankruptcy purposes.  The judge believed taxpayer’s failure to timely file the return was distinct from the definition of “return.”  Instead, the judge believed motive may affect the consequences of a late-filed return, but not the definition of “return.”  Motive was an issue relating to Section 523(a)(1)(C) and whether taxpayer “willfully attempted… to evade or defeat” the tax.  Remember, however, this case relates to pre-BAPCPA law established in 2005.  Judge Easterbrook, in dicta, suggested the result would be different if the BAPCPA law was applicable.

Practice Pointer:  This is an old case and several circuit courts have recently ruled that a late-filed return does NOT constitute a “return” for bankruptcy purposes.  So file those returns on time.  The Seventh Circuit has yet to issue a ruling, but a future circuit court panel could agree with Judge Easterbrook’s dissent.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Can a Taxpayer who Files a Tax Return After the IRS Assesses the Tax Eliminate the Tax Debt in Bankruptcy?

A Chapter 13 debtor could discharge the tax debt by paying the tax liability through the repayment plan.  However, most people are interested in the dischargeability of the tax debt in a Chapter 7 bankruptcy case without any payment to the IRS.

In In re Mallo, 774 F.3d 1313 (10th Cir. 2014), the taxpayers filed a Chapter 7 bankruptcy case to discharge tax debt relating to an IRS assessment made prior to the taxpayers filing the bankruptcy petition.   The taxpayers failed to file the returns for 2000 and 2001.  The IRS issued statutory notices of deficiencies pursuant to 26 U.S.C. §§ 6212 and 6213 for those years.  The IRS began collection efforts in 2006.  In response, the taxpayers filed joint Form 1040s for the missing years in 2007.

The Mallo court defined the issue as follows: whether an untimely 1040 Form, filed after the IRS has assessed the tax liability, is a tax return for purposes of the exceptions to discharge in 11 U.S.C. §523(a)(1)(B)(i) of the US Bankruptcy Code. The Court began its analysis by examining the Bankruptcy Code’s definition of “return,” which states a return “means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”  Id at 1318.

Second, the Mallo court noted that prior to the BAPCPA amendments of 2005  most courts determined whether a document qualified as a tax return by following the four-pronged test approved in Beard v. Commissioner, 793 F.2d 139 96th Cir. 1986).  This Beard test consisted of: (1) there must be sufficient data to calculate tax liability; (2) the document must purport to be a return; (3) there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) the taxpayer must execute the return under penalties of perjury. The majority of courts have held that tax forms filed after the IRS assesses the taxpayer’s liability have no valid purpose and therefore cannot satisfy the 3rd prong of the Beard test— there being no honest and reasonable attempt to satisfy the requirements of the tax law.  See In re Payne, 431 F.3d 1055 (7th Cir. 2005).

The Mallo court side-stepped the Beard test and held that 11 U.S.C. §523(a)(*) of the US Bankruptcy Code excludes late-filed Form 1040s from the definition of “return” because the “applicable filing requirement” includes filing deadlines—and late-filed returns do not satisfy applicable filing deadlines.  The court rejected the taxpayers’ argument that the “applicable filing requirements” refer not to the filing time, but to whether a tax form qualifies as a return upon form and content per the Beard test.  Apparently, the Mallo court would hold that no late-filed tax returns would ever be deemed a “return” for bankruptcy purposes.

Consequently, the Mallo court held that the taxpayer’s liability was excepted from the general Chapter 7 discharge order after finding the taxpayers’ Form 1040s were not “returns” for bankruptcy purposes of 11 U.S.C. §523(a)(1)(B)(i).

Practice Pointer: File all tax returns and perform all other filing obligations on a timely basis. There appears to be a growing trend to side-step the Beard test and find that late-filed tax returns can never be deemed a “return” and therefore can never be discharged in a Chapter 7 bankruptcy case.  The US Court of Appeals for the Seventh Circuit has not ruled on this issue directly. But read In re Payne, 431 F.3d 1055 (7th Cir. 2005).  The 7th Circuit covers all of Illinois, Indiana, and Wisconsin.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.