Archive for the ‘ Nondischargeable ’ Category

Declaratory Judgments for Dischargeability

When discharging taxes, I have always thought that it was 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, 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.

You file bankruptcy to get rid of debts you can’t afford to pay and to get the fresh financial start in life that you so desperately need. But remember … not all debts can be wiped out in your bankruptcy.

The Bankruptcy Code lists several types of debts that can’t be discharged in bankruptcy. These are things like:
•    Child support payments
•    Spousal support
•    Most student loans
•    Certain tax debts
•    Injuries caused by driving under the influence
•    Debts which are the subject of a divorce judgment

•    Civil penalties from government entities

Traffic tickets and parking tickets fall under the last category, “civil penalties.”

Chapter 7 Bankruptcy

523(a)(7) forbids the discharge of civil penalties or criminal fines. Therefore, in a Chapter 7 bankruptcy government fines aren’t wiped out.

Chapter 13 Bankruptcy

Ahhh … Good News! (Maybe).

Bankruptcy Code 1328(a)(3) allow a Chapter 13 debtor to discharge non-criminal government fines if he completes all the court approved plan payments.

What is included in these “civil penalties” or “civil infractions”? This can be minor offenses such as speeding, failing to stop at a stop sign, or parking tickets. These claims are places with the rest of the unsecured creditors in a Chapter 13 plan. They are paid over the next 3 to 5 years from what is affordable to the debtor. Whatever isn’t paid through the 3 to 5 years plan is discharged at the end.

One more practical pointer … Even if you have a criminal fine that isn’t wiped out by bankruptcy, you can include it in a Chapter 13 plan. This stops the creditor (which is usually the government) from collecting from you during the course of the Chapter 13 bankruptcy. And that means the State Government is stopped from taking your drivers license or sending you to jail for non-payment of this fine. Yes, at the completion of the 3 to 5 year Chapter 13 plan the balance due remains due and the State Government can then collect from you. But you are safe during the time the chapter 13 bankruptcy is in effect.

So …
•    If the fine is for a criminal action, it’s not wiped out in either a Chapter 7 or a Chapter 13 bankruptcy.
•    But if your fine is a civil penalty it’s not wiped out in a Chapter 7 bankruptcy, but it can be discharged in a Chapter 13 bankruptcy.
•    And even if can’t be discharged in either a Chapter 7 or a Chapter13 bankruptcy, you can get protection from revocation of drivers license or being sent to jail for non-payment while the Chapter 13 proceeds.

Credit: Stephen Brittain of Victorville

My client (“Wolfgang”) ran a small construction business in the summer of 2007. He hired an attorney (“Attorney David”) to help him foreclose on mechanics’ liens he had recorded, because one of his customers didn’t pay him $50,000 for a construction job. The attorney helped him, but the litigation turned very ugly: the customer countersued for $250,000 in completion damages.

The legal bills mounted. From May 2007 to November 2007, Attorney David charged more than $100,000 in attorney fees. Wolfgang settled the countersuit by paying $40,000. He never expected that result: he had hoped to collect $50,000, not pay $40,000.

The recession hit too. Construction started to tank in the San Gabriel Valley in the spring of 2007; by the summer of 2007, Wolfgang had no new jobs, and realized he needed to sell his house and take other financially-protective actions. The bills that Attorney David was piling up? Wolfgang couldn’t keep up with them, but kept promising he’d pay Attorney David.

He and his wife discussed the situation over the fall. If we’re going to sell the house and move, his wife said, I want to go back to Luxembourg (where she came from) with the children.

His wife moved back to Europe in January 2008. Wolfgang sold his house the next month. He had also invested in a Pollo Loco franchise, and he tried to keep that going. He moved in with his mother in Calabasas for five months, then moved to Luxembourg to be with his wife and children.

Attorney David felt betrayed. Stiffed. Resentful. He sued Wolfgang for the fees and interest, now more than $150,000. Not finding Wolfgang in the US, Attorney David found an attorney and process server in Luxembourg. Wolfgang didn’t answer the lawsuit, and Attorney David figured out how to garnish Wolfgang’s Luxembourgish wages.

Somehow Wolfgang found me. I filed a bankruptcy case for him, and got him discharged of his debts. Even though Wolfgang lived in Luxembourg, there was enough reason to have the case administered in Southern California. The discharge would extend to the debt to Attorney David.

But Attorney David had other ideas: he sued Wolfgang in the bankruptcy court for nondischargeability of the debt, now more than $200,000. Specifically, he claimed that Wolfgang had defrauded him; he alleged that Wolfgang had misrepresented himself and case at the time he hired Attorney David, and had never intended to pay the attorney’s fees. A debt for services procured by fraud is not dischargeable under 11 USC Sec. 523(a)(2).

Attorney David’s case was weak. Wolfgang clearly breached the contract, but contract breach isn’t fraud. Fraud requires elements of knowledge (Attorney David would need to prove that Wolfgang knew he couldn’t or wouldn’t pay at the time he hired the attorney) and reliance (Attorney David would need to prove that he justifiably relied on Wolfgang’s promises). Nonpayment of fees is an occupational hazard for attorneys; we guard against this hazard by asking for fee deposits and making it clear that nonpayment is grounds to withdraw. Jay Foonberg, a coach for attorneys, memorably holds that it’s better to not work and not get paid than it is to work and not get paid, so don’t get stuck in the latter; he calls this “Foonberg’s Rule.”

Wolfgang was going to win, but the process could take months if not years. To try to settle the case, we went to mediation.

In mediation, a neutral party – here, another bankruptcy attorney – meets with both sides and tries to see if there is any ground on which to resolve the case. The case only settles if both sides agree to the terms of the settlement; otherwise, they leave the mediation and continue on to trial.

Attorney David made the first presentation in mediation: he reiterated the same settlement demand he had made six months earlier – payment of $5,000 a month for 20 months, a total of $100,000. My client rejected it out of hand because he could not commit to the payment schedule. I pointed out to the mediator that he had a tough job: Attorney David didn’t have a fraud case, and Wolfgang didn’t have assets. Wolfgang had little incentive to find a lot of money to pay for settlement, because he expected to win; and even if he lost, then Attorney David would be left with a piece of paper saying he was owed $200,000 or more, but no way to collect more than a fraction of that money.

Wolfgang did not display a compromising mindset. He found it unjust to pay one red cent to end the litigation: the truth was that he had not defrauded Attorney David.

Many people think that the justice system exists to find the truth, and then to act on it. Not so. The justice system exists to resolve disputes; it is a beautiful thing when our system of justice reaches a just and true result, but it’s entirely unnecessary that it do so.

If the justice system exists to resolve disputes, someone who is in a legal bind should recognize that he needs to think strategically and not expect the judge to find truth and vindicate him. Strategic thinking is as useful, if not more so, in a legal setting as in any other life interaction.

Wolfgang had a difficult situation: he had few assets to fight with. He had me, but my willingness to team up with him would evaporate when I had used up the $12,000 retainer I held in my trust account. His opponent was a retired attorney who showed himself willing – like Javert in Les Miserables – to follow Wolfgang back to the Old World. “Justice” doesn’t enter into the equation.

While he was dogged, Attorney David also showed himself to be a poor negotiator. After his presentation, he said that he was busy, and really wanted to settle this case because he had more important work to do than prepare for this trial. Not a good idea to back himself into a corner.

The parties ultimately settled for a payment of $20,000 by Wolfgang: half on signing the settlement agreement, and two payments of $5,000 each in 12 and 24 months.

Had the case gone to trial, it could have cost Wolfgang at least $20,000. He really faced the question of whom to pay: his attorney to defend him, or his former attorney turned tormentor. I have worked for clients who lived by the motto “millions for defense, not a cent in tribute.” However, when you are bankrupt, that motto is generally unhelpful.

Attorney David will need to question whether his effort was worth it. He spent untold hours attempting to get paid, drove Wolfgang into bankruptcy, and ended up with less than 10 cents on the dollar. That doesn’t look like a win to me.

On the other hand, Wolfgang had to pay up to get out of an almost frivolous lawsuit after filing bankruptcy. That does not look like much of a win to me, either.

Debtor’s often have Notices of Federal Tax Liens outstanding at the time they file bankruptcy. How are these handled?
First, a properly-noticed lien survives bankruptcy. It continues to attach to any property owned at the time of the bankruptcy. It does not attach to any property acquired after the petition date.
1. Lien on real property. If the bankrupt debtor owns a house and the IRS has filed a Notice of Federal Tax Lien against the debtor’s real property (in the county records), the IRS will generally keep that notice in place after bankruptcy. The house may be underwater and the IRS lien thus worthless, but if the house appreciates in value, the IRS is entitled to the new value.
If, however, the debtor acquires a new piece of land after filing bankruptcy and discharging his taxes, the IRS lien won’t attach to the new piece of land.
2. Personal property. If there is a Notice of Federal Tax Lien filed against personal property, it attaches to everything the debtor owns on the day of the bankruptcy petition. Once the debtor discharges the underlying tax, the IRS still has the right to seize all your personal assets (even those exempted) to satisfy its lien, but it just won’t. Imagine: you, as a debtor, file for bankruptcy, go through the entire process, get your debts including your tax debts discharged, and then they send the Asset Recovery Team to your house to seize your car and sofas – for which it could get how much at auction? Also, the lien doesn’t attach to newly-acquired property, so it would need to investigate whether the bracelet it proposes to seize and sell came from Aunt Tammy as a birthday gift after the bankruptcy petition was filed. The IRS long ago figured out that the PR and legal problems here are huge, so they’ll go ahead and release the lien.

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.

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.

The tenant who wanted her rent back

My client was a landlady who rented her three-unit house not far from the beach in Ventura. The county came by one day and put yellow tags on two of the units, calling them “substandard” and evicting the tenants that day. Why “substandard?” Mostly because the area was zoned for one unit only: there was no way to have three units on the lot legally. But there were other, fixable, health and safety issues; the building was not the Ritz-Carlton.
Three months later, the landlady had demolished the units, short-sold the remaining house, and filed for bankruptcy protection.
The tenant in the middle unit didn’t want her to get off so easy. She filed an adversary proceeding, a lawsuit, in the bankruptcy asserting a nondischargeable debt: she claimed she was entitled to a refund of all the rent she had paid, since the unit was illegal the entire time and California law says you can’t collect rent on an illegal or uninhabitable unit. She claimed that the debt was nondischargeable, that is, the landlord should still owe it despite getting bankruptcy protection, because the landlord had collected each rent check by fraud, or because the act of renting the unit was a “willful and malicious” tort.
My client refused to settle: she didn’t see any reason she should refund rent for a period of time (three and a half years) when the tenant actually occupied the apartment without an express complaint. The tenant demanded a five-figure lump-sum payment to drop the case.
So we went to trial. Trials in bankruptcy court are blessedly short: no juries, just the judge, the parties, and the testifying witness. Not much chance to argue: the judge knew the law, and we had submitted briefs beforehand.
The tenant testified that she developed some questions about the legality of the units, and visited the city’s planning department. She discovered that the units were indeed illegal. “You didn’t bring this to the landlady’s attention then, did you?” “No,” the tenant admitted. “I was scared of her, and besides, I didn’t want to jeopardize the place where I was living, the benefit of my tenancy.”
The tenant also testified that she knew, from her first phone conversation with the landlady, that the unit she would rent had some issues. She took it anyway because she was desperate.
At the end of the trial, right after we finished our [short] closing arguments, the judge made findings of fact from the bench. No fraud, no willful and malicious tort, judgment for defendant. My landlady client was able to walk away from her debts, including this frivolous one.
Facts win cases; bad lawyering can lose them. Here, the facts spoke for themselves. Without a lawyer, however, the landlady would have been lost in the morass of procedures and evidence objections (who but a lawyer really knows what “hearsay” is?).
Even more so than other clients, bankruptcy clients need to make a cost-benefit analysis. Had the landlady not fought the case, she would have left her bankruptcy with a nondischargeable judgment of around $50,000. Her defense cost around $15,000. She might have settled for $15,000 before trial, but negotiations broke off. It’s up to the client to determine when to settle or go forward; the landlady went forward because of principle, but later regretted not just writing a check to settle. But who knows? Had she settled early on, she might have regretted that course of action too.
If you face a similar situation, a bankruptcy in Ventura or Los Angeles counties where someone wants to make sure you don’t get your discharge, we can help you at Faucher & Associates.

Getting rid of taxes in bankruptcy

People often believe that they cannot discharge income taxes through bankruptcy. Wrong! It is more difficult to discharge income tax than other debts, but debtors can sometimes meet the requirements for dischargeability. First, the income tax must be from a period where the tax return was due more than three years before the bankruptcy filing. Second, the debtor must have actually filed the tax return more than two years prior to the bankruptcy filing. Third, the tax cannot have been assessed within the last 240 days before the bankruptcy filing (this might occur if the debtor had an audit determining more tax due than reported).
These rules give the I.R.S. a chance to collect from the debtor before the bankruptcy. As an example: You file your return for the 2010 tax year on April 15, 2011. The IRS then has three years to try to collect the taxes that are due from that return. But say that you file your return late. If you file you 2011 return in 2013, then the IRS has 2 years from the date you filed to collect, and then you can discharge it in bankruptcy. Finally, if the IRS does an audit and assesses a higher amount of tax on your 2010 return, then it has 240 days to collect the taxes before you file bankruptcy and discharge taxes.
(As an aside, I try to use the term “tax year” as opposed to the vacuity appearing in the Internal Revenue Code: “taxable year.” The government taxes income, not time.)
Additionally, your return cannot be fraudulent, and you cannot have “willfully” attempted to evade payment of the tax. If a court determines that you owe a fraud penalty on your taxes, then you cannot discharge the penalty nor the underlying tax. This rule gives citizens yet another incentive – in addition to avoiding jail time, a 75 percent civil penalty, and other harsh treatments – to file an honest tax return.