Epilogue A Concluding Discussion on Tax Compliance in Consumer Cases
Consider the situation in which a debtor files chapter 13 with a number of delinquent individual income tax returns.4 Several, if not all, of the unfiled periods relate to taxes that would otherwise be dischargeable because the tax returns in question were due more than three years prior to the petition date.5 The Internal Revenue Service (IRS) dutifully files a proof of claim listing the periods as unliquidated and estimates the amount of the taxes due under one of two approaches: The IRS attempts to estimate the amount of the taxes due based on what the debtor owed in prior years (a difficult task where there is no prior history of tax filings) or, in a coercive measure, estimates the amount of the taxes at an amount that exceeds the anticipated tax due in an attempt to force the debtor to file the return, liquidate the claim and reduce the amount of the tax due.6 The United States does not file an objection to the confirmation of the debtor's chapter 13 plan, instead relying on its proof of claim as the basis for payment. Further, characteristic of most chapter 13 plans, the plan is a percentage payout with potentially many unsecured creditors. The debtor demonstrates feasibility and the plan is confirmed, many times at a base rate of less than 10 percent distribution to unsecured creditors.
As a result, there are several consequences to this sequence of events. First, the debtor does not file his/her tax returns. Second, the IRS does not ever liquidate its claim. Third, the distribution to unsecured creditors may be adversely affected by the IRS's inflated, unliquidated claim.
Consumer lawyers that would comment on this scenario would correctly note that the periods in question may be so old that it is not possible for the debtor to prepare the delinquent tax returns. Further, given that the periods are going to be discharged upon plan completion, whether the returns are filed or not does not change the end result that the taxes will be discharged.
The chapter 13 trustee is put in a dilemma; the plan can be administered and claims paid, but at an unknown cost to unsecured creditors. Because the chapter 13 trustee is charged with ensuring that the debtor maximizes distributable income for the benefit of all creditors by paying only valid claims, a tension exists between moving a case forward to completion and protecting unsecured creditors that are many times unrepresented.
Corrective Actions that May Be Taken
The IRS, if monitoring cases with unfiled returns, has at least three methods in addressing the problem. First, the IRS can ask a bankruptcy court to compel the filing of the returns so that the IRS's claim is liquidated. That said, nothing in the Bankruptcy Code grants the IRS the ability to compel the filing of tax returns. See In re Ferrell, 241 B.R. 348, 349 (Bankr. M.D. Pa. 1999). Further, as a basis for the motion to compel, the IRS may have to show that the debtor is either able to file accurate returns, uncooperative in providing information so that the IRS cannot prepare the returns,7 or not subject to prosecution for failing to file the returns. Id.; see, also, In re Galarza Pagan et al, 279 B.R. 43 (D. P.R. 2002).
In this context, the burden is on the IRS to show why the debtors have not filed their returns. Moreover, the IRS will have to focus on the debtor's ability to file accurate returns because the prospect of preparing the debtor's returns is limited by the availability of tax information. The IRS has the statutory authority to prepare the delinquent returns, but is not statutorily mandated to do so.8 Moreover, the IRS's preparation of a §6020(b) return cannot be used to make "lawful the failure to file a return despite the command of [26 U.S.C.] §7203."9
The substitute for return (SFR) program was developed to deal with taxpayers who do not file voluntarily and for whom the IRS has income information available to substantiate a significant income tax liability.10 SFRs are adjusted to reflect income reported on information returns (Forms W-2 and 1099) and other sources of income, and a tax liability is proposed to the taxpayer in the form of a statutory notice.11 In the context of the average chapter 13 case, the IRS does not have the ability to generate the needed information because the debtor's filing history is either non-existent, or the debtor may have been self-employed and has no demonstrable sources or reporting income—W-2s or Form 1099s.
Second, the IRS could argue that the debtor's case should be dismissed on the basis of bad faith for failure to file tax returns. See Greatwood v. United States (In re Greatwood), 194 B.R. 637 (9th BAP 1996). This argument loses credence because the court could consider a motion to dismiss on the basis that the failure to file the returns has acted as an unreasonable delay in confirming a chapter 13 plan (§1307(c)(1)). If the debtor accepts the IRS's unliquidated proof of claim as filed, there will be no delay. As such, the IRS will have to articulate that the failure to file the returns is bad faith. See Hopkins v. United States (In re Hopkins), 201 B.R. 993, 994 (D. Nev. 1996) (none of the provisions of the Bankruptcy Code exempt the debtor from the requirements of the Internal Revenue Code that an individual must file tax returns). The court and the IRS will then be faced with the Hobson's choice of getting the debtor's case dismissed and the IRS pursuing a summons enforcement action in federal district court to compel the debtor to provide tax information, or delaying confirmation for several months pending preparation of the returns and IRS review of the returns.
Third, the IRS could object to the debtor's chapter 13 plan confirmation. In some jurisdictions, this approach is made effective by the advent of local rules that specifically require the filing of tax returns as a predicate to confirmation of a chapter 13 plan. See, e.g., In re Koval, 205 B.R. 72, 76 (Bankr. N.D. Tex. 1996).12 Absent a local rule governing a requirement to file tax returns before confirmation, however, the confirmation process will be plagued by delay until a debtor can muster the resources to prepare the return. Meanwhile, other creditors must wait for their distribution pending resolution of the IRS's claim.
Conclusion and Solution
A number of commentators to bankruptcy reform have acknowledged the difficulties posed by delinquent pre-petition tax returns. As such, they have argued a fairly bright-line rule of requiring that pre-petition tax returns for the six years prior to the petition date be filed before the first setting of the §341 meeting as a sensible means of forcing the debtor to file tax returns as a condition of confirmation. This would cover both priority and non-priority tax periods. Further, these commentators suggest that failure to file the returns by a specific date—i.e., the §341 meeting—is grounds for dismissal under §1307(c) before the case proceeds to confirmation. This solution would result in getting all priority periods liquidated and the three most current non-priority periods filed. Moreover, the debtor would be relieved of the burden of going back seven years or more to obtain tax information. While such an approach should apply to individual income tax liabilities, such a measure would not excuse the filing of business tax returns,13 regardless of age, given the fact that by definition business taxes are non-dischargeable. As such, a chapter 13 debtor would still have to file all pre-petition business tax returns so that the IRS's priority claim will be fully liquidated.
4 The proliferation of consumer cases with tax issues is a consequence of several factors: IRS lax collection efforts in the filing of liens, levies and writs of entry; a reduction in the IRS workforce; and the chilling effect of the Tax Reform Act of 1998 that subjected IRS employees to individual lawsuits for perceived harassment of taxpayers during collection and enforcement activity. Return to article
5 See Turner v. United States (In re Turner), 182 B.R. 317 (Bankr. N.D. Ala. 1995); In re Daniel, 170 B.R. 466 (Bankr. S.D. Ga. 1994) (tax liabilities for periods in which tax returns are unfiled and were due more than three years prior to petition date are not excepted from discharge under §507). Return to article
6 Even though the proof of claim reflects tax periods that are unliquidated, the IRS should file a proof of claim because failure to do so could result in the taxes being discharged if the debtor provides for the liability in the chapter 13 plan. See Dixon v. Internal Revenue Service (In re Dixon), 218 B.R. 150, 154 (10th BAP 1998) (citations omitted). Return to article
8 See In re Martin, 180 B.R. 90 (E.D.N.C. 1994) (courts have consistently found that although the IRS has the authority to file a return for the taxpayer, it is not required to do so); In re Rank, 161 B.R. at 409 (§6020(b) does not supplant the taxpayer's obligation to file nor does it relieve the taxpayer from criminal liability for failure to file). Return to article
11 26 U.S.C. §6212(a) (RIA ed. 2001) provides that if the secretary of the IRS (or his/her subordinates) determines that there is a tax deficiency, the secretary is authorized to send such notice to the taxpayer. Return to article
12 Local Rule 3015(g)(5) for the U.S. Bankruptcy Court of the Western District of Texas requires that all delinquent pre-petition tax returns be filed as a condition of confirmation. Return to article
13 Business taxes includes payroll or "FICA" taxes as defined under 26 U.S.C. §§3402-3405; 6051 (RIA ed. 2001); unemployment or "FUTA" taxes under 26 U.S.C. §§85(b) and 6050B (RIA ed. 2001). Other "business" taxes might include partnership taxes or highway-use taxes for trucking businesses. 11 U.S.C. §507(a)(8) (West 2002) provides that business taxes are exempt from discharge. Return to article