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Government Working Group Proposal No. 14 addresses the state taxing authorities' concerns regarding the debtor's obligation to disclose and report information to the state when there is a federal audit or assessment altering the debtor's income tax liability as originally reported on his or her income tax return. State income tax liabilities are often calculated based upon the adjusted gross or taxable income properly reportable for federal income tax purposes. When a taxpayer's federal income is changed due to an audit, state statutes generally require the debtor to inform the state of such changes. The Internal Revenue Service ("IRS") also provides copies of the revenue agent's report ("RAR") of the audit results to the state. Upon receiving either the RAR from the IRS or the information from the taxpayer, the state assesses the additional tax owed based upon the change in income. Government Working Group Proposal No. 14 is concerned with the state not receiving notice or receiving notice late of a debtor taxpayer's adjusted tax liability. In such case, the state is concerned that its claim may be barred because the discharge occurs before the audit is completed and after any applicable bar date.
Commission Track Number 218. The Government Working Group proposes that the Commission should submit to the Advisory Committee on Bankruptcy Rules of the Judicial Conference ("Rules Committee") a recommendation that Federal Rule of Bankruptcy ("Bankruptcy Rule") 1007 require a debtor to disclose on schedules when initially filed whether or not any tax audits are pending, and to file amended schedules and statements as necessary, with written notice thereof to state and local taxing authorities, to provide adequate notice to state taxing authorities and other creditors of a federal tax audit. Additionally, Government Working Group Proposal No. 14 recommends that Bankruptcy Code Section 523(a) be amended to provide that failure to substantially comply with Bankruptcy Rule 1007 renders nondischargeable a state or local government claim associated with a debtor's noncompliance.
The Task Force agrees with the proposed amendment to Bankruptcy Rule 1007. However, the Task Force opposes the proposed amendment to Bankruptcy Code Section 523(a) excepting from discharge a state or local government claim associated with a debtor's noncompliance with Bankruptcy Rule 1007. This amendment is unnecessary, given that these claims are already nondischargeable under section 523(a)(1)(A) as a priority tax falling under section 507(a)(8)(A)(iii) which covers taxes that are not assessed as of the date of the petition but are still assessable. If the states are concerned about the tax being discharged in a Chapter 13 case where the state fails to file a timely claim, then the appropriate remedy is to amend section 1328.
Although Proposal No. 14 only encompasses state taxes arising from federal audits in progress at the time the bankruptcy petition is filed, the Commission should also consider the broader issue of the dischargeability of state taxes arising out of prepetition federal audits where the federal tax has already been assessed prior to the filing of the petition. As discussed above, once the federal audit becomes final, the states require that the taxpayer report the changes in income. Some states require that the taxpayer file an amended return, while others merely require that the taxpayer provide the state with a copy of the RAR. Most states require the change in income be reported within 30 to 90 days. If the taxpayer either fails to provide the report or provides it late, it is unclear as to whether the tax is dischargeable. There have been several conflicting cases on this issue.
A state tax resulting from a federal audit should be dischargeable even if the taxpayer failed to provide the state with a copy of the RAR or amended return. Because the IRS furnishes the state with the information necessary for the state to determine the additional tax due, the state should be required to assess the tax within a reasonable period of the federal assessment, such as 180 days. Thus, a state tax resulting from a federal audit would be dischargeable 420 days (180 days plus the 240 days provided in section 507(a)(8)(A)(ii)) after the federal assessment.
In order to encourage the debtor to comply with the reporting requirements, the debtor should be able to shorten this period by filing an amended return or providing the report. Often, even when the debtor timely files the report, the state does not promptly assess the tax. Once a debtor provides the state with the report or amended return, 30 days is a reasonable time for the state to assess the tax. Thus, if the debtor complies with the state law and provides the state with a report or an amended return, the state tax resulting from the audit would be dischargeable 270 days from the date the return is filed (30 days plus the 240 days provided in section 507(a)(8)(A)(ii)).
The Task Force recommends that section 523(a)(1)(B) be amended to clarify that neither an amended return nor a report is a "return" for purposes of that provision (as well as for purposes of section 507(a)(8)(A)(i)). Section 507(a)(8)(A) should be amended by adding the following subparagraph:
(iv) a state or local income tax assessable due to an increase in income as a result of an Internal Revenue Service audit of the debtor's income as reported on the federal tax return filed by the debtor shall be deemed assessed for purposes of subparagraph (ii) of this paragraph on the earlier of (1) 30 days after the date on which an amended return or report was filed with the state, or (2) 180 days after the date on which the federal tax was assessed.
The information requested regarding pending audits is reasonable and necessary for the state to protect its potential claim in the bankruptcy. Although the additional information will require paperwork by the debtor, this burden is not unreasonable when compared to the prejudice to the state if it does not receive notice of the audit.
Government Working Group Proposal No. 14 includes an amendment to section 523(a) providing that failure to comply with Bankruptcy Rule 1007 will result in the state's claim being nondischargeable. This amendment is unnecessary because such claims are already denied a discharge under section 523(a)(1)(A), which exempts from discharge any tax specified in section 507(a)(8). Under section 507(a)(8)(A)(iii) a tax that is not assessed but is still assessable at the time the petition is filed is a priority nondischargeable tax. If the state is able under state law to assess the tax once the audit is final, the additional state tax resulting from the audit falls under section 507(a)(8)(A)(iii) and is thus nondischargeable under section 523(a)(1)(A).
The state may be concerned that if it is unaware of the claim, the tax may be discharged in a Chapter 13 case. Although priority taxes must be paid in full in a Chapter 13, section 1328 provides that a debtor is discharged of all claims provided for in the plan. If the state is unaware of its claim and fails to file a proof of claim, even a priority tax may be discharged. The remedy to protect the state is to amend section 1328, not section 523(a).
As discussed above, all states that have an income tax require the taxpayer to report a change in federal income to the state. The method and time to report the change vary from state to state. Twenty five states require a taxpayer to file an amended return and a copy of theRAR to report the change in income (fn. 98). The remaining states that impose an income tax either permit the taxpayer to choose to amend its return or to merely provide a copy of the RAR, or they use a form to disclose the change. One state, Hawaii, has no reporting requirement.
Because the states use a wide variety of reporting methods, there are conflicting cases regarding whether a tax assessed by the state more than 240 days prior to the date the petition was filed was dischargeable where the debtor either did not file an amended return or filed late. Several courts in states where an amended return was required held that the amended return was a required return for purposes of section 523(a)(1)(B) and thus the tax was nondischargeable if the debtor failed to file a return or filed late and the petition was filed within two years of the date the late return was filed (fn. 99). These cases generally state that an amended return is a "return" without any analysis.
There are many cases finding that an amended return is not a "return". At least one bankruptcy case, In re Arenson, (fn. 100) has held that where a taxpayer files an amended return in response to a substitute return filed by the IRS for the taxpayer, the amended return does not constitute a return within the meaning of section 523(a)(1)(B)(i). Arenson relied upon Supreme Court decisions holding that an amended return is not a new "return," but merely a change in the original return, for purposes of the statute of limitations (fn. 101). By holding that the amended return was not a return, the court denied the debtor a discharge for the federal tax claim.
Another bankruptcy decision, In re Lamborn (fn. 102), held that an amended return is a return for purposes of section 507(a)(8)(A)(i) and thus a tax resulting from the amended return is not dischargeable for three years. The court distinguished In re Greenstein and all of the Supreme Court cases holding an amended return is not a return. In finding that the amended return is a return, again the court denied the debtor a discharge.
Where the state merely requires a report, and not an amended return, courts have generally found that a report is not a required return (fn. 103). These cases generally state that section 523(a)(1)(B) must be interpreted liberally in favor of the debtor. Additionally, the purpose of section 523(a)(1)(B) is to deny a discharge to a debtor who has engaged in a "wrongful act" by not filing any return and has thwarted the government's attempt to determine the liability owed. These cases concluded that the state, by requiring successive returns, should not be able to deny the debtor a discharge. Further, the courts stated that based upon the plain meaning of the statute, a return is not "required" if the debtor may choose to file a copy of the RAR instead of amending the return. Thus, not every requirement to provide information to a taxing authority rises to the level of a required return. Last, the courts found that where the IRS already provides the information to the state necessary for the state to determine the tax owed, the information required from the debtor is not necessary. In consequence, the state does not need the protection of section 523(a)(1). Only one case, In re Blutter, (fn. 104) has held that a "report" is a required return.
Because there are so many conflicting cases regarding whether an amended return is a "return" and whether a report is a "return," Congress should resolve the issue. The better rule is that an amended return and a report should not be considered a "return" for purposes of either section 507(a)(8)(A)(i) or section 523(a)(1)(B). An amended return is not a new return but a change in a previously filed return. Section 523(a)(1)(B) is meant to deny a discharge where the debtor has committed a "wrongful act;" it should not be construed to prevent a discharge where a debtor is innocently mistaken in reporting his or her income. If the debtor is not innocently mistaken as to the appropriate income, the courts could use section 523(a)(1)(B)(iii) to deny a discharge if the taxpayer has willfully attempted to evade the tax or has committed fraud.
The case is more compelling regarding states requiring amended returns or reports. First, the state receives the information from the IRS and the amended return does not provide any different information. Thus, the state has the relevant information to make an assessment. Many debtors can not afford to pay an accountant to provide them with tax advice. In consequence, they will frequently not comply with the requirement to file the return, not out of a desire to willfully fail to comply with the state law, but because they are unaware of the requirement or the time in which to comply. They also may be misled by the fact that the IRS informs them that it will notify the state. Ironically, the federal tax resulting from the audit will be dischargeable 240 days after the federal assessment while the state tax that "piggybacks" off the federal tax will be nondischargeable. Thus, the state will frequently get a windfall because of its requirement to file an amended return.
Additionally, states that require an amended return will receive more preferential treatment than those states that make it easier for the taxpayer to comply by simply providing a copy of the RAR to the state. Some states may change their state statute to require an amended return. One of the major complaints about the state and federal tax systems is that compliance is often difficult. Thus, the bankruptcy law should not encourage states to adopt more difficult compliance procedures by rewarding the states that require the most returns and punishing the states that make the process easier for the taxpayer.
In light of the above discussed concerns, the Task force recommends that all state taxes that piggyback off of federal audits should be treated uniformly under the Bankruptcy Code regardless of the state reporting requirements. The rule adopted should allow the state ample time to assess the tax, but should essentially place the state tax on an equal basis with the federal tax. The Task Force proposal accomplishes these goals.
The Association of the Bar of the City of New York opposes requirements to notify state tax authorities of pending federal audits.
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fn. 98: See chart "Time Limits for Reporting Adjustments and Filing Responses to Determination Letters," Aspen Publishers, Multistate Corporate Taxation.
fn. 99: See, In re Jones, 158 B.R. 535 (Bankr. N.D. G.a., 1993); In re Greenstein, 95 B.R. 583 (Bankr. N.D. Ill. 1989); In re Haywood, 62 B.R. 42 (Bankr. N.D. Ill. 1986); In re Cohn, 96 B.R. 827 (Bankr. ND Ill 1988).
fn. 100: 134 B.R. 934 (Bankr. D NE 1991), aff'd, 145 B.R. 310 (D NE 1992).
fn. 101: See Badaracco v. Comm'r, 464 U.S. 386 (1984); Zellerbach Paper Co. v. Helvering, 293 U.S. 172 (1934); and National Paper Products Co. Helvering, 293 U.S. 183 (1934).
fn. 102: 181 B.R. 98 (Bankr. N.D. Okla. 1995), aff'd, 1997 Bankr. Lexis 98.
fn. 103: In re Olson, 1994 Bankr. Lexis 1364 (Bankr. N.D. N.D. 1994); and In re Balckwell, 115 B.R. 86 (Bankr. W.D. V.a. 1990); cf., In re Dyer, 158 B.R. 904 (Bankr. W.D.N.Y. 1993).
fn. 104: 177 B.R. 209 (Bankr. S.D.N.Y. 1995).
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Last updated June 1, 1997