DISCHARGEABILITY OF PENALTIES RELATED TO NONDISCHARGEABLE TAXES

(COMMISSION TRACK NUMBER 331)

Present Law

Section 523(a)(7)(A) ("Subparagraph "A") of the Bankruptcy Code is generally viewed as a codification of the pre-Code position of the government regarding the dischargeability of penalties, i.e. that all non-compensatory (i.e. punitive) penalties are dischargeable only if the related tax is dischargeable (fn. 130). However, Congress went further and made an additional category of tax penalties dischargeable under section 523(a)(7)(B) ("Subparagraph (B)"). Subparagraph (B) provides for a discharge of a tax penalty "imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition."

Courts addressing the interpretation of the interaction of the two subparagraphs have held that Subparagraph (B) as enacted is unambiguous as a matter of statutory construction and can discharge certain penalties even if the underlying tax is not discharged, thus overriding the general approach of Subparagraph (A) (fn. 131). The analysis continues by addressing what is the "transaction or event" which begins the running of the three year period of Subparagraph (B). Courts have variously held that the "transaction or event" is the due date or the filing date of the return. Such "events" can easily pre-date a bankruptcy petition filing by more than three years, making penalties related to such tax years dischargeable (fn. 132). This is of particular interest where there is a long-standing dispute with the IRS ending in an assessment of tax which is non-dischargeable but which relates to a year in which the due date or filing date precede the petition filing date by three years.

Proposals Before the Commission

Commission Track Number 331. Under a draft proposal before the Government Working Group, Bankruptcy Code Section 523(a)(7) would be amended to provide that a penalty computed with reference to a tax liability is discharged only when the underlying tax is also discharged. The draft cites one particular situation as the source of its concern. In a case of civil fraud, although the underlying tax is not dischargeable, the civil fraud penalty would be discharged if the event giving rise to the penalty is more than three years old. Unnumbered Government Working Group Proposal.

The Department of Justice proposes that section 523(a)(7)(B) be clarified to provide that it is not triggered by the filing of a return and that any penalty that is calculated in reference to a tax liability cannot be discharged unless the underlying tax is discharged.

The Department of Justice cites that as a result of several courts' interpretation of section 523(a)(7)(B), filing penalties including fraud penalties may be discharged even before the liability for tax is determined (fn. 133). Justice Proposal, p. 94.

IRS proposes that a penalty computed with reference to a tax liability is discharged only when the underlying tax is also discharged and proposes amending Subparagraph (B) to limit its application to penalties which are computed without reference to a tax (e.g. preparer penalties). IRS Proposal, p. 49.

Task Force Position

The Task Force supports the proposal as to fraud and failure to file penalties, but otherwise opposes it.

Reasons for Position

The Task Force believes that the current language of section 523(a)(7)(B) is not merely a Congressional drafting error. Under the present structure, the government has three years from the due date or filing date of the return to the petition filing date to assess and collect a penalty before the penalty becomes dischargeable. Generally, allowing the government three years to assess and collect a penalty (other than fraud and failure to file as discussed infra) related to a specific tax year before it becomes dischargeable is an adequate amount of time to prevent prejudice to the government in a bankruptcy context.

It is important to remember that the government is a well-protected creditor with respect to the underlying tax and prepetition interest, both of which are typically priority claims and non-dischargeable. The real issue is whether a bankrupt individual should have continuing personal liability for a penalty on top of the underlying tax and interest. The Task Force believes that, generally, personal liability for tax and interest is sufficient to make the government whole and balance its interests against the fresh-start principles of bankruptcy.

However, the Task Force acknowledges the problems of fraud and failure to file penalties, both of which are cases in which a debtor's actions have frustrated the abilities of the government to reasonably pursue assessment and collection efforts and in which there is demonstrable wrongdoing by the debtor (fn. 134). In these cases, a policy of post-discharge personal liability for such penalties is warranted. Therefore, the Task Force would agree with the draft proposal solely as it relates to fraud and failure to file. Fraud and failure to file penalties would be dischargeable only when the underlying tax is dischargeable. In cases of fraud, no such discharge of tax would ever occur due to section 523(a)(1)(C), which exempts fraud from discharge. In the case of a taxpayer who never files a return (as opposed to late filing), no discharge of tax would ever occur due to section 523(a)(1)(B)(i).

The Task Force wishes to express some concern, however, about the prospect that this may create an incentive to more aggressively pursue allegations of fraud when there is already a view among some debtor's counsel that the government has expanded the willful attempt to avoid or evade and fraud positions to a level which has become unreasonable.

Perhaps a constructive approach to the area in general should be undertaken which will result in a reasonable and balanced approach to both the issues of dischargeability and fraud and "willful attempt to evade" cases. See our response to Commission Track Number 602. The Task Force believes that a more detailed analysis and discussion is required in order to evaluate all of the effects of the proposed amendment on the whole penalty structure and its treatment under the Bankruptcy Code. The Task Force's main concern is to facilitate a position which would be equitable to the government's revenue collection efforts, and yet be reasonable in light of bankruptcy policy.

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

fn. 130: Thus, Subparagraph (A) generally links the discharge of a penalty to the priority provisions of Section 507(a)(8) so that if an income tax is priority and non-dischargeable, then related penalties are also non-dischargeable. It also makes non-dischargeable those penalties related to non-filed returns or late-filed returns under the two-year filing rule of Section 523(a)(1)(B)(ii). Additionally, penalties related to fraud or willful evasion of tax under 523(a)(1)(C) are also made non-dischargeable because the underlying tax would not be dischargeable.

fn. 131: McKay v. United States, 957 F.2d 689 (9th Cir. 1992); In re Roberts, 906 F.2d 1440 (10th Cir. 1990); In re burns, 887 F.2d 1541 (11th Cir. 1989).

fn. 132: However, the tax may be non-dischargeable because it is subject to the two year rule of Section 523(a)(1)(B)(ii) and the 240-day assessment rule of Section 507(a)(8)(A)(ii).

fn. 133: For example, the statute of limitations on prosecution of the crime of tax evasion is six years under 26 U.S.C. Section 6531. Fraud penalties imposed after a criminal prosecution for tax evasion would inevitably be discharged under these decisions even though the related tax is excepted from discharge by reason of Bankruptcy Code Section 523(a)(1)(C).

fn. 134: The Task Force also acknowledges the somewhat inequitable and counter-intuitive result of the following situation. Although Internal Revenue Code Section 6531 provides a six-year statute of limitations for criminal fraud prosectuion, there is no statute of limitations in the case of civil fraud under I.R.C. Section 6501(c)(1). However, if the government wanted to assert a civil penalty after a criminal prosecution, the current three-year rule of Subparagraph (B) would typically discharge such penalties..

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Last updated June 1, 1997