Almost all bankruptcy debtors are affected by tax liabilities and the Internal Revenue Service is the most feared creditor, if not the most frequent creditor, listed on bankruptcy clients' schedules. The Internal Revenue Service, however, is one of the slowest creditors to act to protect its collection rights. Congress compensates for the government's slowness by providing it with the most aggressive collection tools and remedies.(1) Normally, by the time a client makes a decision that filing for protection in bankruptcy is the only remaining remedy to stay creditors from pursuing their claims, the client is destitute. Prior to the bankruptcy, the client probably will have a history of first paying the most persistent creditor, or the creditor with the most immediate remedy, rather than paying the government's tax liability.
The government has recently objected to the client's discharge of tax liabilities in certain bankruptcy cases under Bankruptcy Code [sections] 523(a)(1)(C)(2) if the client knew of a tax liability and yet paid other creditors ahead of the government. The Fifth and Sixth Circuits have accepted the government's argument and have held that when a client has paid any creditor ahead of the government, the client has "willfully attempted in any manner to evade or defeat a tax liability" and, therefore, is not entitled to a discharge of tax debt.(3) In contrast, the 11th Circuit will not deny the client a discharge of tax debt on an omission of duty only, but additionally requires the government to prove that the client committed an affirmative act of fraud with regard to the tax debt. Depending on the circuit, every client who has paid a non-government creditor ahead of the government creditor puts his or her ability to discharge an otherwise dischargable tax liability in bankruptcy in jeopardy. The author's opinion is that the Fifth and Sixth Circuit's position is demonstrablY at odds with the intentions of drafters of the Bankruptcy Code.
Chapter 7 Compared to Chapter 13
An individual, or a married couple, choose between two primary chapters in bankruptcy. The clerk's office for the Middle District of Florida, Jacksonville Division, reported that in 1996, 6,089 Chapter 7 ("liquidation") cases and 1,967 Chapter 13 ("wage earner plan") cases were filed in its division, which represents an approximate 26 percent increase from the prior year. The two bankruptcy chapters must be considered in all cases where possible tax liabilities are in issue since each chapter affects the client's discharge differently.
A bankruptcy under Chapter 7, 11, or 13(4) is commenced when a client files a petition in the bankruptcy court. Financial schedules are attached to the petition that show the client's creditors, assets, liabilities, income, expenses, and brief financial history. Once the court enters the "order of relief," which is usually the same day the client's petition is filed, the creditors are enjoined from pursuing further collection of their debts outside of the bankruptcy. Also upon filing the petition, the client's nonexempt assets become part of the bankruptcy estate subject to either liquidation under Chapter 7 or administration under Chapter 13 by a court-appointed trustee.(5)
A creditor may object to the debtor's discharge of a particular debt, or to the discharge generally.(6) If no creditor is successful in objecting to the client's bankruptcy discharge in whole or in part, the court enters an order granting the client's discharge and imposes a permanent injunction against most pre-petition creditors from attempting to ever collect the debt or hold the client liable for the debt,(7) including certain tax debts, as will be discussed hereafter.
A Chapter 13 bankruptcy differs from a Chapter 7 bankruptcy in both its procedures and its effect on the client's discharge. In a Chapter 13 bankruptcy, the client proposes a payment plan with a duration of three to five years, rather than a liquidation of assets.(8) The client will make monthly payments as set forth in the court-approved plan to a Chapter 13 trustee,(9) who in turn distributes the funds to creditors as set forth in the plan. Upon completion of the plan, the court enters an order of "superdischarge,"(10) which discharges the debtor of the debts provided for in the plan, including certain federal and state tax liabilities. A superdischarge may be granted regardless of a [sections] 523(a)(1)(C) challenge.(11) A lesser discharge is available under [sections] 1328(b) and is not referred to as a "superdischarge."
A number of clients are not eligible to file a Chapter 13 petition(12) or are not able to propose a feasible plan under Chapter 13 and, therefore, must file for bankruptcy protection under Chapter 7. Before filing the bankruptcy petition, the attorney must consider which chapter will be able to provide the client with a possible discharge of tax indebtedness.
This article addresses how the "willfully attempting in any manner to evade or defeat a tax" language of [sections] 523(a)(1)(C) of the Bankruptcy Code will be applied by a court to the facts of a government's tax claim and what standard of willfulness will be used to except a tax liability from a Chapter 7 or Chapter 11 bankruptcy discharge. If the court allows the government to prove willfulness with the slight standard used by the Fifth and Sixth Circuits, many clients will lose the opportunity to obtain a "fresh start" when they are not able to discharge what are otherwise dischargable tax liabilities in bankruptcy.(13)
Standard under [sections] 523(a)(1)(C)
The courts that have interpreted [sections] 523(a)(1)(C) agree that there is no definition of evasion or willfulness under the Bankruptcy Code or the Internal Revenue Code.(14) The interpretation of the willfulness requirement under the second prong of [sections] 523(a)(1)(C) has prompted debate among the courts. The similar language of "willfully...