Discharging tax debts when the debtor has evaded collection

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.

The mental state is satisfied where the taxpayer had a duty to pay tax, knew he had that duty, and voluntarily and intentionally violated that duty. Did your taxpayer pay $3,000 to help his son’s college tuition one year while he owed $100,000 in tax? That payment would suffice for evasion in “any manner.”

This issue can arise at the last minute in a case. A good bankruptcy practitioner will file an adversary proceeding, that is, a separate lawsuit in the bankruptcy, to get a judgment stating that the debtor’s taxes are discharged. The IRS may never say anything about dischargeability of these taxes until it answers the lawsuit. I had a case where the bankruptcy specialist told me she would discharge the debtor’s taxes “according to the formula,” suggesting she would only look at the three-year, two-year, and 240-day rule mentioned above, but then the IRS answered the dischargeability proceeding by denying dischargeability and showing me the 100-page history from the collection department.

Is there any way to estop the government here? After all, the government employee suggested she wouldn’t oppose dischargeability, but then she did. Unfortunately, no. It is almost impossible to estop the government (and I don’t think estoppel would work even against a private party on these facts, because there is a missing element of reliance). There are cases from the federal judiciary saying that one can assume that government employees are incompetent; and because it would be unfair to allow one litigant to get a benefit from the incompetence of a government employee, but another gets tripped on the same facts with a sharper employee, estoppel should be hard to get against the government.

I don’t suggest that the average governmental employee is incompetent – most are very professional. In my case, the employee indicated how she was leaning, but then simply changed her mind on the issue before the last moment when the government needed to make its decision.

If the government says that the tax is not dischargeable, the debtor can continue to prosecute the action and hope that the judge will render a decision in his favor. That litigation will cost tens of thousands of dollars, however. The debtor can also get out of bankruptcy and submit an offer in compromise to the IRS; that contract between the IRS and the debtor can deal with taxes and penalties due to fraud, and also taxes that the now-compliant taxpayer tried to evade in the past. Sources tell me that this program has gotten much easier in the last six months, as well.