When discharging taxes, I have always thought that it is the best practice to seek a judgment from the bankruptcy judge that the taxes are discharged. That’s because unlike many other nondischargeable debts (fraud, malicious tort, etc.), the debt may remain in force with no further word from the court. The IRS or the FTB could come back five years after the discharge and just start collecting on taxes where it wasn’t made explicitly clear that the tax was discharged. A declaratory judgment gets rid of this ambiguity.
I’m changing that stance now.
Up until now, I have operated on a simple procedure: I file an adversary proceeding for a declaratory judgment stating that the taxes are discharged, the IRS either stipulates that they are, thereby ending the issue, or it doesn’t stipulate and the parties go through a trial to determine dischargeability. Section 523 gives six exceptions to dischargeability: the assessment is from a tax return due less than three years before the bankruptcy petition; the assessment is from a tax return actually filed less than two years before the bankruptcy petition; the assessment occurred less than 240 days before the bankruptcy petition (think of an audit assessment); the tax return was never filed; the assessment is from a fraudulent return; or the taxpayer willfully attempted to “evade or defeat” the tax (some of these clocks can be tolled under circumstances such as offers in compromise or prior bankruptcies, but that’s a discussion for another day).
The first five exceptions are very easily determinable: either the number of days or the filing exist, or they don’t.
It is not always so easy to determine whether the taxpayer “evaded” tax. The tax authority merely needs to prove that the taxpayer knew about the tax liability and did something (or failed to do something) to avoid paying the tax. This could be as small as paying $3,000 for a kid’s tuition, or a trip to Las Vegas with a fine dinner and some casino time while learning to play with real money slots, during a period when tax was owed.
Here are some cases on evasion:
Dalton v. IRS, 77 F.3d 1297 (10th Cir. 1996)
In re Fegeley, 118 F.3d 979 (3rd Cir. 1997)
U.S. v. Jacobs, 490 F.3d 913 (11th Cir. 2007)
While the burden is on IRS to prove evasion, the evidentiary standard is low, and yet the IRS very rarely asserts this exception. In 10 years as an attorney practicing bankruptcy law within the IRS, I never saw this exception asserted.
Recently, the Department of Justice changed its policies on stipulating to dischargeability of tax. The local US Attorney’s Office no longer stipulates to dischargeability across the board. It requires the taxpayer-debtor to stipulate that the United States may later rely on the evasion exception if it uncovers evidence. That somewhat defeats the point of the stipulation: the IRS could administratively determine, five years after the discharge, that the debtor had actually evaded the payment of tax, and open collection proceedings. Our clients could first learn about this when the IRS files a notice of federal tax lien against them. The client’s recourse is to then re-open the bankruptcy case and prosecute another adversary proceeding against the IRS.
In other jurisdictions, the United States has started to move to dismiss these declaratory adversary proceedings on grounds of ripeness or nonjusticiability. The IRS argues that there is no controversy: it will admit that the tax is dischargeable under five out of the six tests, that it has administratively abated the tax, and that it is not threatening to collect the tax. No controversy, no need for a judicial decision. Midwestern courts agree. See, for instance, In re Mlincek, 350 B.R. 764 (Bankr. N.D. Ohio 2006), or In re Erickson, Case No. 12-59165, Adv. Pro. No. 12-05546 (Bankr. E.D. Michigan 2013). (The IRS hasn’t yet succeeded in dismissing these cases in California).
So what do I advise now? Today, I cooperate with what the IRS wants us to do here: get your discharge, then call the bankruptcy specialist to ask what tax years are discharged. If you agree with the IRS’s answer, leave it alone. If you disagree, ask why the IRS analyzes it differently than you, and take a deep breath before filing suit to get a declaration of dischargeability.
Why the deep breath? Because the lawsuit may well become more expensive than the taxes being discharged. Your adversary in bankruptcy court will be a Special Assistant U.S. Attorney, directed by the Tax Division of the Department of Justice in Washington, DC, answering to Eric Holder. My experience of the Tax Division is that it is staffed by very intense and driven attorneys living in a cocoon who see their patriotic duty as expanding the law in favor of the government; it will often require its attorneys to argue cases that the IRS itself (answering to Jack Lew) is willing to concede.
This strikes me as unsatisfactory, but I must defer to practicality. We represent taxpayer debtors. At the moment when they get their discharge, they have, by definition, few assets. They cannot bankroll a lawsuit against the Department of Justice when it is willing to throw highly-trained bodies from across the country in the service of vindication of a highly esoteric point of law.
