Section 523(a)(1) of the bankruptcy code distinguishes the nondischargeable taxes from those that may be discharged in bankruptcy.
In most cases, the analysis is pretty simple. Generally, nondischargeable taxes are those where the return was due less than three years ago, where the return was actually filed less than two years ago, or where the tax was actually assessed less than 240 days ago (assuming the debtor is filing a bankruptcy petition today). This is, in the end, numerical.
If the debtor made a “fraudulent return,” the taxes are not dischargeable. This is also very easy to determine: did the IRS assert the fraud penalty and win? It’s a rare case when a debtor files a bankruptcy petition and the first allegation of fraud comes when the debtor wants to discharge taxes.
But there is one phrase that invites interpretation, and that can trip up the most conscientious practitioner: 523(a)(1)(C) says that “A discharge . . . does not discharge an individual debtor from any debt for a tax with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”
There are two main functions to the IRS: audit and collection. Audit determines how much tax you owe; collection ensures that you actually pay it. This subsection implicates both functions, and they have very different standards of bad behavior.
Because the subsection starts with the “fraudulent return” element, it’s a reasonable assumption to believe that fraudulent intent extends to the element of “willful attempt to evade or defeat tax.” Not so.
“Willful evasion” includes both a conduct element (an attempt “in any manner”) and a mental state element (“willful” means “voluntary, conscious, and intentional”). The conduct may be an affirmative act, such as transferring property to another family member for no consideration while tax debts hang over the owner’s head, or an omission, such as failure by a law partner’s failure to tell the accounting gal to withhold taxes.