NONASSESSED TAXES AS PRIORITY/NONDISCHARGEABLE DEBTS

(COMMISSION TRACK NUMBER 314)

Present Law

Unsecured tax claims in Chapter 7 can be divided into three types as follows:

Type 1 - priority/nondischargeable

Type 2 - nonpriority/nondischargeable

Type 3 - nonpriority/dischargeable

>From the perspective of a Chapter 7 debtor, Type 1 can be good or bad depending on whether assets exist to pay the tax. More often than not, they are bad because assets are not available to pay the tax. Type 2 is bad because there is no payment priority and the tax is not discharged. Type 3 is good because the taxes are discharged.

Although Chapter 13 has its own separate discharge rules, the Chapter 7 classification scheme has useful application in Chapter 13. This is because priority taxes, i.e., Type 1, are paid in full in Chapter 13 while nonpriority taxes, i.e., Types 2 and 3, can be satisfied with "best efforts" payments. The commission proposals focus on this disparate treatment between Type 1 and Type 2 taxes in Chapter 13.

Section 507(a)(8)(A)(iii) makes any tax that has not been assessed but is still assessable a priority tax. Any tax that can be assessed by the I.R.S. after an audit fits here. Thus, taxes in section 507(a)(8)(A)(iii) can be called "audit risk" taxes. As section 523(a)(1)(A) makes priority taxes nondischargeable, audit risk taxes are priority/nondischargeable or Type 1.

Carved out of the priority treatment created by section 507(a)(8)(A)(iii) are unassessed taxes related to nonfiled returns, returns filed late within two years of the petition date, fraud returns, and taxes where the debtor willfully attempted in any manner to evade or defeat tax. These carved-out taxes are nonpriority/nondischargeable or Type 2. They are the only Type 2 taxes.

Two ancillary holdings should be noted. If a debtor executes a Form 872-A, open-ended extension of statute of limitations on assessment, and the Form 872-A is not terminated, any audit risk tax covered by the Form 872-A will be nondischargeable regardless of age. See, Blake, Jr. v. United States (In re Blake, Jr.), 154 B.R. 590 (Bankr. M.D. Ala. 1992).

If the audit risk tax at issue is a state tax, one looks to state law to determine whether the tax is still assessable. See, Vitaliano v. Cal. Franchise Tax Bd. (In re Vitaliano), 178 B.R. 205 (9th Cir. B.A.P. 1995).

Proposals Before the Commission

Commission Track Number 314. Commissioner Shepard proposes that (a) all unassessed taxes be treated as priority taxes, i.e., Type 1; and (b) the four carved-out items, i.e., Type 2 taxes, must be paid in full in Chapter 13. See Santa Fe Discussion Issues p.12, item II.C.3.

The Justice Department proposes that the four carved-out items, i.e., Type 2 taxes, must be paid in full in Chapter 13. Justice Proposal, p. 91-92.

The Internal Revenue Service proposes that (a) all unassessed taxes be treated as priority taxes, i.e., Type 1; and (b) the four carved-out items, i.e., Type 2 taxes, must be paid in full in Chapter 13. See IRS Proposal, p. 44.

Task Force Position

Present law should not be changed.

Reasons for Position

The Task Force believes that the availability of Chapter 13 to debtors should not be constricted. Under the Commission Track Number 314 proposals, Type 2 taxes would no longer be dischargeable with a best efforts payment in Chapter 13 (fn. 111).

The effect of these proposals on nonfilers (one of the Type 2 taxes) would be particularly devastating. Currently, it is possible for nonfilers in Chapter 13 to file returns post-petition, stay current, pay three years of back taxes, which is not easy, and reenter the system. If the proposals were adopted, it would take little effort on the part of the I.R.S. to eliminate bankruptcy relief for nonfilers.

As a matter of administrative practice, before beginning collection activity, the I.R.S. often files substitutes for returns for a nonfiler's unfiled tax years. See I.R.C. Section 6040(b). No notice is given. Once the I.R.S. files a substitute for return that tax year is forever considered a nonfiled year. Bergstrom v. Untied States (In re Bergstrom), 949 F.2d 341 (10th Cir. 1991). Thus, if the proposals were adopted, by creating a substitute for return, the I.R.S. would make the nonfilers's tax obligation forever nonpriority/nondischargeable in Chapter 7 and payable in full in Chapter 13.

Commission Track Number 314 must be read in conjunction with proposals to expand the list of nondischargeable taxes in Chapter 13 to include taxes that are nondischargeable in Chapter 7, see Commission Track Number Track 213, and current case law interpreting the phrase "willful intent to evade or defeat" tax so that any nonpayment of tax results in the underlying obligation being nondischargeable. See, Toti v. United States (In re Toti), 24 F.3d 806 (6th Cir. 1994) (taxpayer had wherewithal to file his return and pay taxes, but he did not fulfill his obligation; held, tax liability nondischargeable), cert. denied, 115 S.Ct. 482 (1994); Bruner v. United States (In re Bruner), 55 F.3d 195 (5th Cir. 1995) (agreed with analysis in Toti); and see our response to Commission Track number 602, infra. In combination, bankruptcy relief for taxpayers would be lost, thereby losing sight of the need to help good people, who otherwise are without remedy, reenter the system.

Constricting the availability of Chapter 13 is particularly myopic. Chapter 13 is the government's most economical method for collecting tax debts. Constricting Chapter 13 may be a revenue negative proposal. Chapter 13, as currently drafted, works well in bringing disenfranchised taxpayers who are currently outside of the system, e.g., nonfilers and tax protesters, back into the system.

Beyond the size of collections, Chapter 13 provides an inexpensive system for the government to collect tax debt. Instead of paying a revenue officer to collect the tax, the Chapter 13 trustee enforces collection. Furthermore, instead of the government paying the revenue officer's salary, the taxpayer pays the trustee a fee.

****************************FOOTNOTES*******************************

fn. 111: See also our position with respect to Commission Track Number 213, supra.

Questions, comments or suggestions? kbercik@taxcounsellor.com

Last updated June 1, 1997