April 2003

Income Tax Liabilities in Bankruptcy

By Robert S. Barnett, Esq., counsel to Capell & Vishnick LLP

In certain instances, the Bankruptcy Code permits debtors to obtain discharge of certain federal income tax liabilities. Discharge is generally available if the applicable income tax return was filed more than two years before the date of filing of the bankruptcy court petition [11 USC section 523(a)(1)(B)(ii)], if taxes have been assessed for more than 240 days [11 USC section 507(a)(8)(A)(ii)], and if the last date for filing the return without penalty was over three years before the petition [11 USC section 507(a)(8)(A)(i)]. No bankruptcy discharge is available for fraudulent returns or for cases where the debtor willfully attempted to evade or defeat the tax. When a debtor files for bankruptcy, income taxes for the last three taxable years (or those for which the statute of limitations was extended) are not dischargeable.

The purpose of these provisions is to afford the IRS sufficient time in which to institute collection proceedings against the debtor and to avoid surprise and unfair advantage. The requirements are designed to allow sufficient notice so that the IRS can act and obtain payment.

Care must be taken in analyzing a taxpayer’s financial situation before deciding that bankruptcy is a suitable option. Often, the central issue involves whether the taxpayer has properly filed the requisite income tax returns. Several recent court decisions have discussed what is sufficient to afford the taxpayer a discharge in bankruptcy once the requisite waiting periods have been met.

When taxpayers fail to file returns, the IRS often files substitute returns based on the data on file. In William C. Hindenlang [U.S. v. Hindenlang, 164 F.3rd 1029, 1033 (6th Cir. 1999)], the Sixth Circuit held that tax returns filed by a debtor after the IRS prepared substitute returns were not sufficient returns under 11 USC section 523(a)(1)(B). Hindenlang failed to file returns for several years, and the IRS prepared substitute returns and issued deficiency notices thereon. The taxpayer eventually filed income tax returns that were substantially the same as the substitute returns prepared by the IRS. The appeals court concluded that the taxpayer’s returns were filed too late, did not serve any tax purpose, and did not represent an honest and reasonable attempt to meet the requirements of tax law.

A four-part test can determine whether the return is sufficient to provide for bankruptcy discharge. The return must: purport to be a return; be executed under penalty of perjury; contain sufficient data to allow calculation of tax; and represent an honest and reasonable attempt to satisfy the requirements of the tax law. A return filed after the IRS has filed a substitute return will fail the fourth requirement. The Hindenlang court concluded that although the first three requirements may have been met, the return as filed served no purpose at all under the IRC and, as a matter of law, did not satisfy the fourth test.

New York State

New York State Bankruptcy Court decisions have been consistent with the analysis provided by the Sixth Circuit. In Shrenker v. United States [87 AFTR 2d, para. 2001-513 (February 9, 2001)], the Bankruptcy Court for the Eastern District of New York followed Hindenlang and held that untimely tax returns were not sufficient to meet the tests for dischargeability.

Taxpayers must also be aware that New York bankruptcy courts look at various factors in determining whether tax debts are dischargeable. For example, an unsigned tax return has been held nondischargeable, as have returns which failed to disclose all information from which tax liability could be computed. In addition to untimely filing, the failure to report income provides sufficient basis for the bankruptcy court to deny discharge relief to the taxpayer.

Bad conduct may also influence the court’s decision and may increase the likelihood that the IRS will challenge a bankruptcy discharge. In Haesloop v. U.S. [86 AFTR2d, para. 2000-5366 (August 30, 2000)], the U.S. Bankruptcy Court for the Eastern District of New York found that the taxpayer had engaged in conduct in order to willfully evade his tax obligations. Haesloop failed to timely file tax returns for 1990, 1991, and 1992 and also failed to make estimated tax payments. When the returns were filed, full payment was not made. The court found that the taxpayer had paid other personal obligations, including his daughter’s college education and taxes owed by his wife. The court agreed with the IRS that the taxpayer had the resources to pay his taxes but willfully chose to pay other creditors instead. The court also found that the taxpayer had deliberately structured his affairs and his assets to prevent the IRS from collecting the tax debt. Therefore, the taxpayer’s petition was held to be in bad faith, and the taxpayer was denied a discharge of his tax debt.

A taxpayer’s conduct may affect whether a court will be sympathetic. If the court senses deliberate manipulation and bad faith, the taxpayer will find it impossible to obtain a discharge. A bright-line test does not exist, making professional judgment crucial.

Taxpayers should timely file their returns even if they do not have funds to make full payment. Any actions by delinquent taxpayers to transfer or otherwise reduce their assets will be closely scrutinized by the IRS and may result in the denial of a bankruptcy discharge.

Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

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