Dischargeability of Taxes in Bankruptcy

Many clients, lawyers and accountants have called us regarding the discharge of taxes in bankruptcy filings. In these difficult economic times, the IRS and New York State have stepped up their auditing of individuals and businesses.

Many kinds of “old” state and federal income taxes are dischargeable in bankruptcy. In the case of income taxes, they are dischargeable in Chapter 7 if all of the following criteria are met:

1. The tax is for a year for which a tax return is due more than 3 years prior to the filing of the bankruptcy petition;
2. A tax return was filed more than two years prior to the filing of the bankruptcy petition;
3. The tax was assessed more than 240 days prior to filing of the bankruptcy petition;
4. The tax was not due to a fraudulent tax return, nor did the taxpayer attempt to evade or defeat the tax;
5. The tax was not assessable at the time of the filing of the bankruptcy petition; and
6. The tax was unsecured.

Section 507(a)(8) of the Bankruptcy Code provides that:

Income taxes: (i) for tax years ending on or before the date of filing the bankruptcy petition, for which a return is due (including extensions) within 3 years of the filing of the bankruptcy petition; (ii) assessed within 240 days before the date of filing the petition; (iii) not assessed before the petition date, but were assessable as of the petition date, unless these taxes were still assessable solely because no return, a late return (within 2 years of the filing of the bankruptcy petition), or a fraudulent return was filed, withholding taxes for which a person is liable in any capacity, an employer's share of employment taxes on wages, salaries, or commissions (including vacation, severance, and sick leave pay) and excise taxes on transactions occurring before the date of filing the bankruptcy petition are all not dischargeable in bankruptcy.

As part of our bankruptcy intake process, we analyze a client’s state and federal tax transcripts to determine whether or not their tax debts (if any) are dischargeable or not.

However, some of the taxes that would ordinarily be dischargeable because of their age may not be, if the Bankruptcy Court determines that the debtor has acted in “bad faith” with respect to their non-payment of taxes. Section 523 of the Bankruptcy Code (which governs exemptions to discharge) provides in Section 523(a)(1)(C) that:

“A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

However, Section 523 does not define what constitutes a “willful attempt to evade or defeat” a tax. To interpret this language, the Bankruptcy Court adopted the three-part test applicable under Section 6672 of the Internal Revenue Code, which imposes civil penalties on any taxpayer “who willfully attempts in any manner to evade or defeat any . . . tax or the payment thereof.” Under that test, a willful attempt to evade or defeat a tax is established if the debtor (1) had a duty to pay the tax, (2) knew of that duty, and (3) voluntarily and intentionally violated the duty. Numerous courts have adopted this test as the standard for willful evasion under Section 523.

With respect to the attempt to avoid or evade taxes, the IRS takes the position that if a well-to-do individual (doctor, investment banker, or attorney) pays creditors other than the IRS, when they have available assets, this is “an attempt to avoid or evade taxes.”

In Lynch v. United States, 299 B.R. 62 (Bankr. S.D.N.Y. 2003), the debtor, Christine Carter Lynch, brought an adversary proceeding under chapter 7 of the Bankruptcy Code seeking a discharge of the claims of the Internal Revenue Service, totaling approximately $600,000 as of the time of trial, with respect to her tax liability for two groups of tax years -- for tax years 1980, 1981 and 1982, totaling approximately $542,000 (the “1980s Taxes”), and for tax years 1993, 1994 and 1995, totaling approximately $55,000 (the “1990s Taxes”). The IRS opposed her request for relief, with respect to both groups of tax years, contending that she is subject to the statutory exception to discharge of §523(a)(1)(C).

The Court noted that the caselaw applying §523(a)(1)(C) has consistently held that its requirements are satisfied in situations where the debtor -- even without
fraud or evil motive -- has prioritized his or her spending by choosing to satisfy other obligations and/or pay for other things (at least for non-essentials) (emphasis added) before the payment of taxes, and taxes knowingly are not paid.

Here, with respect to each of the 1980s Taxes and 1990s Taxes, the Court had to determine whether that latter principle applies under the facts here. Assuming it did, the Court had to also determine, with respect to the 1980s Taxes, to what extent it applies when if the Debtor not acted in that manner, she could not have paid all of the tax debt anyway.

After hearing the evidence, the Court found that Ms. Lynch - among other things, spending money on a Central Park West Apartment at a cost of more than $6,000 per month; eating dinner in restaurants four days a week; traveling considerably, to California, China and Paris; running up credit card bills; and making huge gratuitous transfers to her church, all ahead of payment of the back taxes due -- of the same type that has been held to constitute a willful attempt to evade the payment of taxes in earlier cases. And the Court further found that, but for her spending priorities, Ms. Lynch could have paid the majority of the 1980s Taxes -- even after payment of the 1990s Taxes, which plainly could have been and should have been paid in full.

The Court held that Ms. Lynch’s extravagant lifestyle was a factor in her failure to pay both the 1980s Taxes and the 1990s Taxes, stating:

“By electing to make discretionary expenditures on the incremental cost of a Central Park West apartment, the restaurant dining, the credit card purchases and payments, the travel, the tuition and the ‘tithing,’ Ms. Lynch evidenced exactly the kind of conduct that resulted in nondischargeability in Wright, Haesloop, Angel, and the other discretionary spending cases.” Lynch at 65.

Because Ms. Lynch elected to spend her money elsewhere and not to satisfy her tax obligations -- especially when she had the ability to easily pay them in full -- the Court held that she willfully evaded her 1990s Taxes.

At the same time, the Court conceded that the IRS was unrealistic in expecting Ms. Lynch to be able to pay the entirety of her 1980s Taxes without a reduction, and criticized the government’s conduct in the case. However, the Court found that Ms. Lynch could have easily paid her 1990s Taxes without a drastic adjustment in her lifestyle.

Anyone who has questions concerning the discharge of taxes should contact Jim Shenwick.