Discharge of Unfiled Taxes under the Bankruptcy Abuse Prevention and Protection Act of 2005 (BAPCPA). No More “Super” Discharge?

by Stephen Kass on August 21, 2012

The basic concept of a chapter 13 bankruptcy filing historically was to allow
individual debtors to reorganize their finances. The policy of giving the debtor a chance
to have a fresh start was foremost behind Congress’ intent to provide the debtor with a
broad discharge of his/her debts incurred through false representation, fraud or recent
consumer debt.(1) The term of art used in dealing with a discharge of this type of liabilities
was called a “super” discharge.
History
As explained by Thomas E. Ray, in his 1994 analysis of the complex evolution
of the “super” discharge provision of the Bankruptcy Code, the “original version of the
Code did not have a liberal provision with respect to the discharge of the debts listed in
§523 (a)”.(2) Only in 1978, did Congress recognize that based on the concept of a “fresh
start”, the debtor should be allowed to discharge debts which were not “innocently”
incurred. (3) Subsequently, Congress’ policy turned away debtors. In 1984, Congress
added §1325, a “disposable income” provision in which debtors needed to repay in order
to get a confirmation of their chapter 13 plan. (4) In 1990, Congress further amended the
Code to disallow discharges of student loans, injuries arising from drunk driving and
criminal-restitution payments.(5)
The development of the “super” discharge provision was always controversial.
There was always a struggle between allowing the discharge of the debts mentioned in
§523 of the Code and protecting innocent and honest debtors. It appears that the urge to
protect honest citizens prevailed over intentionally incurred dishonest obligations.
Although Code §1325(a)(3) already had a good-faith requirement that protects
the system from manipulative filings, Congress concluded that it needed to help the judge
in determination of good faith with a strict provision that outlaws the discharge of dishonest obligations. (6)
Congress finally outlawed a ‘super” discharge provision with the adoption of BAPCPA.
This article will concentrate on the discussion of the dischargeability of income
tax debts under the new law after briefly summarizing the general rules.
New Law for Handling Old Liabilities
Since BAPCPA went into effect on October 17, 2005, bankruptcy practitioners
dealing with tax debt discharges have had to find new ways of dealing with their clients’
“unfiled old”(7), late filed or “substantial old” tax liabilities.
According to the “old” law, debtors with income tax debts that were not
completely dischargeable under chapter 7 were able to deal with them by filing chapter
13 bankruptcy. Some chapter 13 bankruptcies were filed solely to deal with unfiled
income tax liabilities or for substantially old income tax liability.
Three Part Test for a Tax Liabilities Discharge under Chapter 7
Pursuant to 11USC § 523(a)(1) a tax debt discharge was allowed -and still is
possible- if the tax debt satisfies a three part test. All three parts of the test have to be
satisfied.
The first test is known as a “three year rule” meaning that the income taxes on
the gross receipts had to be due three or more years before the filing date. The second
part of the test is known as a “two year rule”, meaning that the debtor had to file the
return at least 2 years before filing for bankruptcy. The third part of the test is called a
“240 day rule”, meaning that taxing authorities must have assessed the tax at least 240
days prior to filing for bankruptcy with the addition of all the applicable stays.(8)
For these rules to apply, the tax return had to be filed by the debtor himself and not by the IRS after
assessment.(9)

Chapter 13 Option for Debtors with Unfiled Taxes (Old Law)
An interesting technique that bankruptcy and tax practitioners were able to do is
to discharge within the life of the chapter 13 Plan unfiled taxes. Under Code §1328(a), a
discharge was granted to all debts properly provided for in the plan, with the exception of
claims for which the last payment is due after the final payment under the plan as well as
claims relating to alimony, maintenance and child support.(10) Interpreting this section, if
the debtor’s plan properly provides for the payment of income taxes owing, the taxes
were discharged, regardless of the age of the tax claims owing or other status, as long as
the three-year rule as stated above is passed. In order for a discharge to apply the plan had
to provide (1) for the full payment of taxes entitled to priority and 2) for payment of the
value of all assets to which a filed federal tax lien has attached as of the filing date of the
bankruptcy.(11)
The bankrupt taxpayer who followed all the above-mentioned rules regarding the
treatment of priority taxes in order to discharge taxes as a general unsecured claim paid
as little as 10 cents on the dollar in chapter 13 to discharge such tax liabilities. Of course,
in cases where a federal lien was filed, the plan had to provide for its repayment. All
secured claims had to be repaid in full. (12)
Chapter 13 Option for Clients with the Intent to Evade or Defeat the Tax or Clients
with the Recent Tax Debt (Old Law)
Section 1328(a) of the old Code allowed debtors to discharge their tax liabilities
even for fraudulently filed tax returns or with an intent to evade or defeat such tax, as
well as recent tax debts that could be included in the repayment plan. Chapter 13 in this
sense was a very convenient harbor for those “irresponsible” tax “nonpayers” and “non
filers”. Indeed as Oct. 17, 2005, was approached, many debtors rushed to file their
chapter 13s just for the sole purpose of dealing with the income tax debt on unfiled tax
years in question or for taxes that might be deemed to be fraudulent.
BAPCPA Provisions and Practical Advice
Under the new law, a discharge of unfiled taxes, late taxes or fraudulently filed
taxes is no longer available to debtor taxpayers. Section 1328 (a) specifically references
§523 (exceptions to a discharge) and prohibits a discharge of any unfiled tax debt as well
as debt for fraudulently filed returns.

A taxpayer with this problem today can address it by filing a chapter 7 bankruptcy
and then, while it is pending, file an adversary proceeding against the taxing authorities.
IRS officials want attorneys who deal with tax debt over $100,000.00 to commence an
adversary proceeding because for them, a presumption arises that the taxpayer had intent
to evade or defeat the tax. Because of this presumption the IRS officials want debtors to
argue their position in court and let the judge decide if the tax debt was incurred
intentionally and whether or not it is dischargeable.
One practical problem that will arise is that, according to§1324 of BAPCPA, the
confirmation hearing must be held within 45 days of the meeting of creditors. Section
1324 specifically reads that:

“the hearing on confirmation of the plan may be held not earlier that 20
days and not later than 45 days after the date of the meeting of creditors
under §341(a), unless the court determines that it would be in the best
interests of the creditors and the estate to hold such hearing at an earlier
date and there is no objection to such earlier date.”

The problem with that provision is that with the adversary proceeding usually
being usually lengthy, you never know when the chapter 13 trustee’s patience will run
out and he/she will bring a motion to dismiss the case. For example, in New York, it was
always hard even without adversaries pending to get adjournments for over six
months.(We are talking about situations when the attorney is working on the settlements
of taxing authorities’ claims, for example). Getting adjournments for the confirmation
hearings for years would seem to be really problematic.
Another practical problem is that a chapter 13 with an adversary proceeding
within will become very expensive for the client debtor. Many people might be better off
filing an Offer in Compromise (OIC) with the taxing authorities instead of filing chapter 13.
To help a taxpayer with the tax liabilities under the new law, the attorney for the
debtor needs to:

a) urge a client to file his tax returns for the years in question;
b) make sure that the tax owed is old enough to qualify for a discharge under the two
year rule, the 240 day rule and of the three year rule, which always applied in chapter
13. Here, of course, if the client is filing his tax return after he came to a consultation
with an attorney, the debtor will have to wait for at least two years to file any chapter
13 petition. The question that might arise is this: what if during these two years the
taxing authorities assess the tax? Some good advice can be to enter into an installment
agreement during these two years. If you do that, it will stop any assessment
proceedings that the taxing authorities might take; (c) deal with the liabilities outside
the bankruptcy court and file an OIC with taxing authorities.

Conclusion

The intent behind BAPCPA was to encourage debtors with disposable income to
file for Chapter 13 in lieu of Chapter 7. With respect to debtors with tax liabilities, this
might not be the result. A few examples will illustrate this (assume for all the examples
no assets and some disposable income):

1) the debtor has $90,000.00 of unsecured debt, $50,000.00 of priority debt .
Under the old law, the debtor was able to file chapter 13 and pay 100
percent of priority debt and 10 percent of unsecured debt. Under
BAPCPA, the debtor can file chapter 7 and qualify under the means test
because priority taxes are deducted over five years and then file an OIC
with taxing authorities;
2) the debtor has $100,000.00 of unfiled unsecured taxes and $25,000.00 of
priority taxes. Under old law, the debtor was able to file chapter 13 and
pay 10 percent of unsecured debt and 100 percent of priority liabilities.
Under BAPCPA, the debtor might disappear off the tax roll or file an OIC
after filing the returns;
3) the debtor has $225,000.00 of unsecured tax debt and $0 priority debt.
Under the old law, the debtor would file chapter 7 and commence an
adversary proceeding. Under BAPCPA, the debtor might have to file
chapter 13 if he/she fails the means test and file an adversary within the
chapter 13. This means that the confirmation hearing might have to be
adjourned for years and attorney for the debtor will have to make a fee
application to be paid within a five-year plan. Another issue arises here if
the debtor will have to show sufficient income to support the plan with
huge legal fees in an adversary; more disposable income will lead to a
higher settlement of adversary, which would lead to increased plan
payments and more disposable income needed.

 

1 See 11 USC §523(a)(2). Also see §523 (a)(1), §523(a)(3), §507(a)(8)(C).
2 Thomas E. Ray, “Demise of the chapter 13 “super” discharge?” 13-5 ABIJ 16 (1994).
3 Id.
4 See Id.
5 See Id.

6 11 U.S.C.S 1325(a) includes a requirement for the confirmation of the plan that the Plan has to be
proposed in good faith. In determining good faith the Court needs to look at the totality of the
circumstances test”. Circumstances taken into consideration are: percentage of the proposed payment,
debtor’s financial situation, debtor’s honesty in representing facts and other relevant facts that go to the
core of the understanding of whether there was an abuse of Chapter 13 in proposed plan. Of course each
judge has his/her guidelines for determining the good faith in filing of the Plan. See also In Re Elsie L.
Herndon, 218 B.R. 812; 1998 Bankr. LEXIS 310.
7 “Old” or “substantially old” taxes means here that the taxes are more then 3 years old from the date they
are due, more then 2 years old from the date they were filed and 240 days old from the time they were
assessed, with all the applicable stays. See §507(a)(8)(A)(ii).
8 The following activities on the Debtor’s account stay the running of a 240 day period: the number of days
the Offer in Compromise (OIC) was pending, the number of days the prior Bankruptcy was pending after
the tax return due date with the valued extensions plus 30 days for each applicable Offer in Compromise
plus 6 months for each applicable Bankruptcy proceeding. As per BAPCPA the stay period in now for the
duration of OIC plus 30 days, and for the duration of the prior Bankruptcy plus 90 days. See
§507(a)(8)(A)(ii).
9 In Re Gushue 126 BR 202, also see In re Nolan, 1997 Bankr.Lexis 622, 79 A.F.T.R. 2d (RIA) 2670
(Bankr. E.D. Tenn.1997). The Bankruptcy Court ruled in favor of IRS stating that the Return prepared by
the IRS is not a return for the bankruptcy purposes. Under new BAPCPA 2005 §523(a) tax returns filed
under section 6020(a) of the Internal Revenue Code (IRC) are considered properly filed and returns filed

under section 6020(b) of the IRC are not considered property filed. Section 6020(a)of the IRC states that
“…if a person consents to a disclosure of all the information necessary for the preparation of the tax return,
and the Secretary prepares such a return and the person signs such returns, it can be considered as a return
of such person.” Section 6020(b) of the IRC states “… if a person fails to prepare a return … or prepared a
fraudulent return…the Secretary should make a return from his/her own knowledge …”.
10 11 USC § 1322(b)(5).
11 11 USC § 1322 (a)(2),1325(a)(5), See also Arthur H. Boelter, “Represent Bankrupt Taxpayer”, Tax
Practice Series, West Group, Chapter 9-8.20,04/2000.
12 USC § 1225 (a)(5). See also In Re Deutchman, 192 F3d 457. Even after the plan was confirmed, the IRS
secured interest was not extinguished, although the secured claim was not filed by the IRS.

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