• Attorney Andrew Steiger

Tax Debt in Bankruptcy - Case Alert

Taxpayers with unpaid tax balances are often times concerned with how to pay back the IRS. For taxpayers with substantial tax debts and other debts, the question is often whether filing for bankruptcy can provide tax relief as part of the fresh start that bankruptcy provides debtors. Tax debts pose special problems and opportunities for debtors because the IRS may provide tax relief outside of bankruptcy, but bankruptcy may not provide a discharge of certain tax debts. This alert provides some background on when a tax debt may be discharged in bankruptcy, and a recent case where the debtor was denied a discharge because of willful evasion of paying tax debts.

When are Tax Debts Dischargeable in Bankruptcy?

Filing bankruptcy provides certain debtors and taxpayers a discharge of tax debts, meaning those tax debts will not have to be repaid after bankruptcy. This applies to both IRS tax debts and state and local tax debts. The general focus is on both whether and when tax returns were filed for the tax debts listed in the bankruptcy filing. For debtors who have not filed tax returns, those unpaid taxes would not be discharged in a bankruptcy. Instead, those tax debts would ride through bankruptcy and taxpayers would have to work out a solution for repayment or abatement after completing the bankruptcy filing. Debtors must provide the bankruptcy trustee with a copy of tax returns in both Chapter 7 and Chapter 13 filings, so if a taxpayer has failed to file tax returns this will be problematic.

The structure of the bankruptcy code is such that it gives the IRS time to review filed tax returns and assess taxes against taxpayers who either filed returns late or did not file returns. Further, the bankruptcy laws provide the IRS time (in theory) to collect unpaid taxes prior to a taxpayer using bankruptcy to discharge the taxes.

Recently Filed Tax Returns

The first tax debt that is not dischargeable in bankruptcy is recent income tax debt. Specifically, if the income tax debt relates to a return that is due within three years of the bankruptcy filing date. These types of tax debts are not dischargeable even if the IRS does not file a claim.

Recently Assessed Tax Debts

For income taxes that were assessed within 240 days of the bankruptcy petition, these tax debts would not be discharged. Importantly, for taxpayers seeking other routes to settle or reduce their unpaid tax balances through an IRS offer in compromise, the time when an offer in compromise was pending, which can be many months, would be excluded from the calculation. So for example, if the IRS assessed a tax and the taxpayer filed an offer in compromise that was pending for 300 days, the IRS would look back 540 days, plus an extra 30 days under the statute to see if a tax was assessed during that period. If it was, then that tax would not be dischargeable. There is a similar rule for cases where a debtor filed a prior bankruptcy and the automatic stay prevented the IRS from collecting taxes.

Taxes Assessable After the Bankruptcy Case is Filed

A third type of income tax that is not discharged is an income tax that was not assessed prior to the bankruptcy filing, but is assessable after the filing and does not relate to either an unfiled tax return or late filed returns during the two years prior to the bankruptcy filing. This also excludes returns that were fraudulent or where the taxpayer willfully attempted to evade taxes. The time limit for this type of income tax could relate to a significant understatement of tax where the IRS has six years to assess additional tax, penalties and interest against the taxpayer instead of the usual three year statute of limitations applicable to income tax returns.

Common Taxpayer Behavior When Faced With Unpaid Tax Debt

Many taxpayers who fall behind in their taxes are afraid of IRS enforcement, which may include liens, levies and wage garnishment. For taxpayers who do not have the current means to pay taxes, many decide to delay filing tax returns to avoid the stress of IRS enforcement. Unfortunately, this strategy only leads to additional penalties and interest. Further, once taxpayers miss filing deadlines, they will usually continue to delay filing returns until they have the financial means to pay the unpaid tax debt. At this point, many are very surprised at the total balance awaiting repayment.

An important concern is whether unpaid taxes will lead to criminal penalties. For most taxpayers, the IRS will not pursue criminal prosecution. The IRS has limited resources, but more importantly, the IRS looks at the motivation for the unpaid taxes. Many taxpayers do not have the means to pay their taxes, and this leads to failure to file returns and pay the taxes. Most will ultimately file returns late and either sign up for a payment plan or seek an offer in compromise. The IRS accepts this reality. Problems arise for taxpayers who have the means to pay taxes, know they have to pay taxes, and either fail to file returns and pay taxes or (more likely) willfully underreport income.

While the IRS provides options for repayment (or settlement in certain circumstances), if taxpayers have other debts accumulating including medical debt, student loan debt and general credit card debt, bankruptcy may look like a good option to reduce the debt. Unfortunately, if the tax returns were not filed, bankruptcy will not provide a discharge of those debts. To get the clock started for tax debts, taxpayers must first file their tax returns.

For taxpayers who do file their returns on time, there is a waiting period for discharge of debts under the bankruptcy process. For late filed returns, the returns must have been filed before the two years prior to filing the bankruptcy. Taxpayers who need to file bankruptcy to eliminate other types of debt may need to wait if they file tax returns late. Despite all this, the IRS may not get very far in the collections process before the debt may be discharged.

Bankruptcy Court's View of Unpaid Tax Debt

For debtors who have filed tax returns late, but at least two years before the bankruptcy filing, and that were due before three years before the bankruptcy, these debts are likely to be discharged. The one catch-all that will trip up a taxpayer every time, however, is tax evasion. The bankruptcy trustee will review taxpayer's tax debts, along with the IRS, to determine if the taxpayer willfully attempted to avoid payment of taxes.

Willful Attempt to Evade Taxes

Tax evasion is nothing new, even for the bankruptcy court. In a recent case in the 6th Circuit, a willful attempt to evade taxes was reviewed for both the taxpayer's conduct and intent. The trickier aspect of this standard is the intent or mental state requirement. The government must provide facts sufficient to prove both the conduct and intent to evade taxes.

For the conduct part of the test, the taxpayer must engage in acts of omission or acts of commission related to an attempt to evade taxes. This requires an analysis of the taxpayer's behavior related to the failure to file tax returns and payment of the taxes due or show to be due in light of the circumstances surrounding the taxpayer. In the recent case, the taxpayer was an attorney who earned substantial income but filed the tax returns years after they were due and failed to pay the taxes due. After filing late, the taxpayer continued to fail to pay the past due taxes while spending lavishly on personal items. Given the fact that the taxpayer had means to pay but did not, the government satisfied this requirement.

Standard of Review for Tax Evasion

For the mental state requirement, the government has to prove the taxpayer (1) had a duty to pay taxes; (2) knew he had such a duty; and (3) voluntarily and intentionally violated that duty. It is difficult for taxpayers to prove they did not know of a duty to pay taxes when owed, and the taxpayer in this conceded this point. The remaining issues then was whether the non-payment was voluntary and intentional. The IRS must prove that the taxpayer has the financial means to pay the outstanding tax liabilities, but makes a conscious decision not to apply these financial resources toward the tax debt.

To prove this element, the court focused on the lifestyle of the taxpayer at the time the tax debt was outstanding. During this time, the taxpayer spent lavishly on restaurants, luxury gifts for his wife, driving an expensive car, going on vacations, and spending a large amount of money monthly on other discretionary items. The court found that the taxpayer could have paid the taxes due during the years at issue. Also, the court noted that the 6th circuit (applicable for debtors filing bankruptcy in Michigan) does not require the government to prove that the taxpayer spent the money on personal items specifically to avoid paying the taxes. Unlike other circuits, the 6th circuit does not require this specific proof which would be much more difficult for the IRS or bankruptcy trustee to prove. Therefore, the debtor lost this case and the substantial tax debts were not discharged in the bankruptcy.

Contact Detroit Bankruptcy Lawyer Andrew Steiger

If you need assistance handling tax debts, contact Detroit bankruptcy attorney Andrew Steiger for a free consultation. He can assist you in determining the best course of action to resolve your tax debts and can provide advice regarding whether bankruptcy is an option that may address your financial situation. Contact him at (248) 259-6367 or provide your email information here.

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