Report of the American Bar Association Tax Section Task Force on the Tax Recommendations of the National Bankruptcy Review Commission

DEFINITION OF "WILLFULLY" FOR PURPOSES OF SECTION 523(a)(1)(C) OF THE BANKRUPTCY CODE

(COMMISSION TRACK NUMBER 602)

Present Law

Bankruptcy Code Section 523(a)(1)(C) provides that a tax claim based on a fraudulent tax return or "with respect to which the debtor . . . willfully attempted in any manner to evade or defeat such tax" is nondischargeable.

Proposals Before the Commission

Commission Track Number 602. This proposal.

Task Force Position

The Task Force proposes that the Code should be amended to provide that the term "willful" as used in Bankruptcy Code Section 523(a)(1)(C) be defined in a manner consistent with the criminal standard for willfulness under Internal Revenue Code Section 7201, such that a finding of "willfully attempted to . . . evade or defeat such tax" must be supported by such affirmative act or acts as evidence a wrongful intention to avoid paying a lawful tax.

For purposes of this section, evidence of intent merely to defer payment, failure to file a lawfully required return when due, or to pay a lawful tax when due, shall not, without further evidence of affirmative misconduct evidencing an intent not to pay the tax, justify a finding of willful attempt to evade the tax.

Such a definition is consistent with the rulings of several recent cases holding that mere omission is not enough to constitute willful evasion. Thus, the Task Force proposes to codify the rule in Haas v. Internal Revenue Service, 48 F.3d 1153 (11th Cir. 1995) (fn. 222).

Reasons For Position

The Task Force proposes that the definition of "willful" be clarified in order to resolve a split in case decisions, and to bring the treatment of this issue closer to congressional intent. Failure to resolve the split in authority creates lack of uniformity in application of the laws, and continuing uncertainty among bankruptcy courts and professionals as to the rights and duties of debtors.

Some courts have interpreted "willful" to mean any act or omission evidencing failure to report or pay taxes when due. Thus, some courts have held taxes nondischargeable merely because the debtor failed to file tax returns or pay taxes, even in the absence of any affirmative conduct evidencing a bad purpose, or deliberate intention to avoid paying the tax (fn. 223).

The Task Force believes that the better rule is that only affirmative misconduct, and not merely passive omissions (such as failure to file or pay) should be considered sufficient to support a finding of "willful" within the meaning of Section 523.

Existing law under the Code provides for the discharge in bankruptcy of, among other things, "stale" income taxes, together with the concomitant interest and penalties as may have accrued in connection with such taxes (fn. 224).

This privilege is intended to benefit the "honest but financially unfortunate debtor," and not "to create a tax evasion device" or to benefit a taxpayer who ". . . had otherwise attempted to evade" a tax (fn. 225). The purpose of the discharge privilege is to permit . . . an industrious debtor to reestablish himself as a productive and taxpaying member of society" (fn. 226).

The Bankruptcy Code currently permits discharge of personal income taxes where the taxpayer may have filed his or her return late, but at least more than two years prior to the filing of the bankruptcy (fn. 227). And, separate language in the section provides that the tax is dischargeable if the tax return in question was not fraudulent, and with respect to which the debtor had not ". . . willfully attempted in any manner to evade or defeat such tax" (fn. 228).

Accordingly, the Code contemplates that a taxpayer may have failed to file a return on time, but as long as he or she eventually files it the failure to file it in a timely manner would not by itself render the tax excepted from discharge.

The Code also obviously contemplates that a taxpayer may have failed to pay all or a portion of a lawful tax liability; the mere failure to pay the tax would seem to be insufficient by itself to render such tax nondischargeable, or else the whole portion of section 523 dealing with tax discharge would seem to be pointless; why provide for the discharge of unpaid taxes, and in the same breath provide that if one owes taxes he or she must be guilty of tax evasion, and therefore not eligible for discharge of the taxes?

This notion is similar to the argument that merely filing bankruptcy to escape a tax is, by itself, evidence of a willful attempt to evade the tax; such arguments have been raised in the past, and rejected by the courts. For example, the court in In re Peterson stated:

Seeking bankruptcy relief as soon as debts for taxes are arguably dischargeable is not per se evidence of a willful attempt to evade the taxes. If it were, then it would effectively negate the provisions of the Bankruptcy Code which make debts for taxes generally dischargeable (fn. 229).

In a similar vein the court in In re Williams rejected the argument that mere failure to pay the tax constituted willful evasion. Were mere failure to pay sufficient to constitute willful evasion, said the court, ". . . no debtor who owes taxes to the government would be entitled to the protection of the general bankruptcy discharge" (fn. 230).

Certainly, a pattern of failing to file returns or pay taxes, when considered along with the totality of circumstances, may indicate a bad intention by the debtor; such evidence, for example, is often cited in cases of tax protesters. However, typically, tax protesters perform other affirmative conduct making their lack of intention to pay the taxes quite clear.

The argument that mere failure to file a timely return by itself, or pay the tax when due by itself constitutes willful evasion, spreads the "evasion" net so widely as to scoop the vast majority of delinquent taxpayers into the nondischargeable category. An empirical study would probably demonstrate that a great many, if not a vast majority, of delinquent taxpayers who seek a fresh start in bankruptcy fall within the "honest but financially unfortunate debtor" who deserves bankruptcy protection. These are, after all, individuals and families who produced taxable income; else how could they owe taxes? They produced taxable income by being, or trying to be, productive participants in the economic life of the nation.

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fn. 222: See also In re Gathwright, 102 B.R. 211 (Bkrtcy. D. OR 1989); In re Fuller, 189 B.R. 352 (Bkrtcy. W. D. Pa. 1995).

fn. 223: In re Cox, 189 B.R. 214 (D. M.D. Fla) 1995); In re Toti, 24 F.3 806 (6th Cir. 1994).

fn. 224: See, generally, S.R. No. 1158, 89th Cong., 2d Sess., May 12, 1966; Jack F. Williams, Rethinking Bankruptcy and Tax Policy, 3 Am. Bankr. Inst. L. Rev. 153 (Spring 1995); Morgan D. King, Discharging Taxes in Bankruptcy (4th ed. KingsPress 1995); Robert E. McKenzie, Representation Before the Colleciton Division of the IRS (Clark, Boardman).

fn. 225: S.R. No. 1158, supra.

fn. 226: Id.

fn. 227: Bankruptcy Code Section 523(a)(1)(B)(i), (ii).

fn. 228: Bankruptcy Code Section 523(a)(1)(C).

fn. 229: In re Peterson, 160 B.R. 385 (Bkrtcy. D. Wyo. 1991). See also Carlen v. U.S., 1991 WL 424977 (N.D. Indiana 1991), 1991 Bankr. LEXIS 1469.

fn. 230: In re Williams, 164 B.R. 352 (Bkrtcy. M.D. Fla. 1994).

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