Illinois Survey of Tax Non-filers in Chapter 13 Shows Non-compliance
Notwithstanding the statutory provisions requiring most individuals to file income tax returns, a significant number fail to do so. The Illinois Department of Revenue (IDR) has conducted two surveys of individuals filing chapter 13 petitions in the Northern District of Illinois, Eastern Division (Chicago) to determine the scope of the problem. The purpose of this article is to discuss the results of the surveys, the problems that the non-filing of income tax returns creates for taxing authorities in the chapter 13 context, and certain legislative proposals that have been made to address the problems. The article concludes with the author's views on the appropriate methods to address the problems.
In December 1994, the IDR conducted a survey of all debtors filing chapter 13 petitions in Chicago during a one-week period. The survey was conducted by comparing the debtors' social security numbers with the IDR's records to determine whether the debtors had filed returns for the pre-petition tax years. Based on this comparison, the IDR determined that of the 97 debtors filing chapter 13 petitions during the survey period, 41 had one or more "open" years for which they had not filed Illinois income tax returns—a 42.3 percent non-compliance rate.
Since 1994, the number of chapter 13 filings has increased dramatically, both within the Northern District of Illinois as well as nationally. According to the latest figures from the Administrative Office of the U.S. Courts, the number of chapter 13 petitions filed nationwide during the year ending June 30, 1997, totaled 387,521, a 22.6 percent increase over the prior year. In the Northern District of Illinois, there were 10,417 chapter 13 petitions filed for the same period.
In March 1997, the IDR conducted a more extensive survey to determine the accuracy of its prior findings and to better understand the scope of the problem. Its follow-up survey confirmed the prior results. The findings were as follows:
- Number of chapter 13 petitions filed in Chicago during March 1997: 822
- Number of petitions in which IDR was listed as a creditor: 75
- Total number of petitions in which IDR was not listed as a creditor: 747
Of the 747 cases where the IDR was not listed as a creditor, the survey showed a substantial number where the IDR already had liquidated liability and an even larger number where there was no liquidated liability but for which there were "open" pre-petition tax years. The figures are as follows:
- Number of petitions where IDR had liquidated liability but was not listed as a creditor: 147 (This category also includes some debtors who also had "open" tax periods for which liability had not been liquidated.)
- Number of petitions where IDR did not have liquidated liability but for which there were "open" pre-petition tax years: 294
These figures show that in 19.7 percent of the cases in which the IDR was not listed as a creditor, it already held a liquidated income tax claim against the debtor. And in 39.5 percent of the cases in which the IDR was not listed as a creditor and did not have liquidated liability, the IDR's records showed "open" pre-petition tax years.
In reviewing these figures, it should be noted that the IDR does not know at this time what percentage of the debtors in the surveys were not required to file returns, either because their income was below the threshold level or because they did not reside in Illinois during the taxable years in question. For several reasons, the IDR estimates that the number of debtors from its surveys who were not required to file returns is small. First, in order for an individual to file chapter 13, he/she must havea regular source of income. 11 U.S.C. §109(e). Second, most debtors filing chapter 13 petitions do so to protect significant assets such as automobiles or homes that would indicate that they have more than a de minimis level of income. Third, the venue provisions require a debtor to file in the district in which he has resided, had a principal place of business or holds his principal assets during a majority of the 180 days prior to filing. 28 U.S.C. §1408. Finally, in the limited number of cases covered by the survey where the IDR has been able to conduct an in-depth investigation, it has yet to find a case where the debtor was not under a duty to file. Even assuming that the IDR's survey results of non-filers should be lowered somewhat to reflect those debtors who were not required to file returns, it appears that the number of debtors with "open" tax years filing chapter 13 petitions is still very substantial.
Problem Caused by the Non-filing of Tax Returns
The non-filing of income tax returns creates substantial problems for taxing authorities in chapter 13 cases because of the scope of the discharge available under 11 U.S.C. §1328(a) and because of difficulties in liquidating income tax liabilities for "open" tax years and filing timely claims in the large number of chapter 13 cases filed each year in which this situation exists.
An individual debtor obtaining a discharge in chapters 7, 11 or 12 as well as a chapter 13 debtor receiving a "hardship" discharge pursuant to §1328(b) will not be discharged of taxes with respect to which he has failed to file a return as the provisions of §523(a)(1) are applicable in those situations. See §§727(b), 1141(d)(2), 1228(a)(2) and 1328(c)(2). An individual receiving a discharge pursuant to §1328(a), however, is discharged of "all debts provided for by the plan or disallowed under §502" with certain limited exceptions which are not generally applicable to taxes. Case law has interpreted the requirement that a claim be "provided for" to mean that the claim must be "dealt with" or "referred to" in the plan. Matter of Gregory, 705 F. 2d 1118, 1122 (9th Cir. 1983). With respect to a priority tax claim, as long as the taxing authority has knowledge of the bankruptcy case, the claim can be "provided for" if the plan provides for proper treatment of priority claims, even if the taxing authority is not listed as a creditor. In re Ryan, 78 B.R. 175 (Bankr. E.D. Tenn. 1987); but see In re Trembath, 205 B.R. 909 (Bankr. N.D. Ill. 1997) (Holding that where a debtor conceals his connection to a corporation with trust fund tax liability, he is not discharged of the responsible officer claim even where the IRS had notice of the case.) This is also true even if the tax claim is contingent or unliquidated, or if the debtor has failed to file a tax return. In re Leber, 134 B.R. 911 (Bankr. N.D. Ill. 1991); In re Owens, 84 B.R. 361(E.D. Pa. 1988). Therefore, if a taxing authority has knowledge of a chapter 13 case, if the plan "provides for" that type of claim and if the debtor completes the plan, the tax claim will likely be discharged if a timely claim was not filed even in cases where the taxing authority was not listed as a creditor or where returns were not filed. The only certain way to avoid having a tax claim discharged is to file a timely claim.
While there should be no reason why taxing authorities cannot timely file claims where returns have been timely filed and the tax liabilities liquidated pre-petition, there are a number of problems in filing timely claims where debtors have failed to file tax returns. Where a taxing authority receives notice of a chapter 13 filing and has "open" pre-petition periods, it has several options under current law, none of which are totally satisfactory. First, it can audit the debtor, issue a Notice of Deficiency and file a claim for the liability determined by audit. In light of the large number of cases where debtors have "open" pre-petition tax years, this option is not feasible. In addition, given the fact that the calculation of state income tax is generally based on the federal income tax return, in order for a state to perform a state income tax audit it would also have to perform a federal income tax audit for the same period unless the federal return had already been filed, which is unlikely. Most state revenue departments are simply not equipped to do so.
Second, the taxing authorities can file estimated claims for the "open" tax years. The problem with this approach is that it is extremely difficult to estimate income tax liability with any degree of accuracy. Absent the filing of a return or the completion of an audit, the estimation of income tax liability is, at best, a guess. In addition, taxing authorities that have instituted a procedure of filing estimated claims for personal income tax in chapter 13 cases where their records show "open" pre-petition years have been sanctioned under Rule 9011 of the Federal Rules of Bankruptcy Procedure. See In re McAllister, 123 B.R. 393 (Bankr. D. Ore. 1991) (Oregon Department of Revenue sanctioned where it adopted the practice of filing estimated claims for "open" years in chapter 13 cases, sent letter to debtors' counsel advising of estimated claim and requesting information to allow it to amend or withdraw claim and withdrew claim promptly after being advised that debtor did not reside in state during year in question.) The IDR also has been sanctioned for engaging in a similar practice. The problem also would not be fully resolved by the filing of an unliquidated claim listing the "open" years as the amount of the claim must still be liquidated in order for the trustee to pay the claim, and the only effective way to liquidate income tax liabilities in the large number of chapter 13 cases with "open" years is to have returns filed.
Finally, taxing authorities could file objections to confirmation in all cases where its records show "open" periods, most likely on the basis of lack of "good faith" or on the basis that feasibility of the plan cannot be determined since the amount of the pre-petition tax claims is unknown. This option is also not satisfactory because it would require the taxing authority toprepare objections and appear at the confirmation hearings in each of the large number of chapter 13 cases where the non-filing problem exists merely to compel the debtor to do what should have been done in the first place—file the returns.
The tax system as it currently exists in this country depends on voluntary compliance to function properly. One of its central requirements is the requirement that taxpayers file timely and honest returns. As the surveys point out however, the level of non-compliance by individuals filing for chapter 13 is high. Because of the difficulties that taxing authorities have encountered in liquidating liability and filing timely claims in the large number of chapter 13 cases with "open" pre-petition tax years, many debtors are able to discharge taxes for which they have never filed returns without making any payment. Meanwhile, where a debtor has timely and properly filed his/her tax return, it is likely that taxing authorities will have filed timely claims and the debtor will have to pay the tax claims in accordance with the plan in order to obtain a discharge. In effect, the dishonest debtor who fails to file tax returns has a better chance of not having tax claims timely filed and therefore of being able to discharge those claims without making any payments than does the honest but unfortunate debtor who files returns but is unable to pay. This result certainly undermines the integrity of the tax system.
Several proposals have been made to the National Bankruptcy Review Commission (NBRC) to address the problems. One of the proposals is that a debtor seeking to proceed in chapter 13 be required to establish that he has filed all pre-petition tax returns. While there has been little opposition to the concept that debtors should have to file tax returns as a condition to obtaining relief under chapter 13, there has been some debate as to what the "look-back" period for which a debtor would have to establish that all required returns were filed should be. The NBRC recently adopted the recommendation of the Tax Advisory Committee that debtors in chapter 13 be required to establish that they have filed all required returns due during the six-year period prior to the filing date.
The more controversial proposals have dealt with the issue of whether the superdischarge available under §1328(a) should be limited and to what extent. Debtors' attorneys have argued for retention of the current chapter 13 discharge. The Internal Revenue Service has argued for the incorporation of all exceptions to discharge found in §523(a)(1). In essence, this proposal would make the discharge available under §1328(a) correspond with the discharge available to individuals in chapters 7, 11, 12 and individuals receiving a "hardship" discharge in chapter 13. A number of states have proposed a more limited exception to discharge for taxes with respect to which a debtor filed a fraudulent return or engaged in affirmative acts in an attempt to wilfully and fraudulently evade payment of the tax. To date, the NBRC has not adopted any of the proposals. The vote on the third proposal advanced by a number of states resulted in a 4-4 tie. It remains to be seen what action may be taken in the future and what recommendations will be made in the final report to be submitted to Congress this fall or what Congress will do once it receives the report.
When Congress enacted the Bankruptcy Reform Act of 1978, it required that priority taxes be paid in full over the term of a chapter 13 plan but allowed for the compromise and discharge of non-priority tax claims without full payment. See §§1322 and 1325. What Congress did not anticipate, however, was the large number of individuals filing for chapter 13 who have "open" tax years and the difficulty that the taxing authorities would have in liquidating the tax liability, especially income tax liability, and filing timely claims. Because of this situation, chapter 13 debtors who have failed to file income tax returns frequently are able to discharge their tax liability without the necessity of making any payments.
Enactment of a requirement that debtors establish that they have filed all required returns for the six years prior to filing for bankruptcy in order to proceed in chapter 13 would have a major impact in addressing the problem. In the author's view, however, §1328(a) should also be amended to include an exception to discharge for taxes for which a return was not filed and an exception for taxes for which the debtor filed a fraudulent return.
The exception for unfiled returns is needed to cover those situations where a debtor misrepresents to the bankruptcy court that all required returns for the past six years have been filed. In addition, while it is unlikely that the taxing authorities will regularly seek to audit taxpayers who have "open" periods outside the six-year "look-back" period, there will undoubtedly be exceptional cases where the taxing authorities should audit non-complying taxpayers for those tax periods. If an individual wanted to make sure that all tax years were covered by the discharge, he could do so by filing honest returns for all pre-petition years, which is what the law already requires. Any income tax liability for years for which returns were due more than three years prior to the petition date would probably not be entitled to priority and could be compromised and discharged along with the other general unsecured claims.
The exception for fraudulent returns is needed because many debtors will be filing tax returns in conjunction with their chapter 13 filings if filing is made a condition to proceeding in chapter 13. It is doubtful whether taxing authorities will have the time to conduct anything more than a precursory review of those returns prior to the bar date and hearing on confirmation.
Finally, there does not appear to be a valid reason why an individual in chapter 13 should be able to discharge taxes for which he did not file a return or filed a fraudulent return when an individual in chapter 11 or 12 who is likewise required to confirm reorganization plan to pay back creditors would not be able to do the same.
It should be noted that the incorporation of these two exceptions to discharge into §1328(a) would not alter the discharge currently available to a chapter 13 debtor who files honest and timely returns but lacks the money to pay. If honest returns have been filed, the taxing authorities will have to file claims and participate in the bankruptcy and will be bound by any discharge entered. It is only the debtor who refuses to file or who files fraudulent returns who will be denied the full discharge which is available under current law. Bankruptcy policy should be to afford a fresh start to the former and not to the latter.
 The views expressed herein are those of the author and do not necessarily reflect the views of the Office of the Illinois Attorney General or of the Illinois Department of Revenue.[RETURN TO TEXT]
 The scope of the surveys was limited to debtors who failed to file state income tax returns in chapter 13. While the problems caused by non-filing debtors also occurs in cases filed under other chapters of the Code, the problem is most significant in the chapter 13 cases because of the number of chapter 13 cases filed, the scope of the chapter 13 discharge and the difficulties in filing timely income tax claims as is discussed infra.[RETURN TO TEXT]
 According to the Administrative Office of the U.S. Courts, the number of chapter 11 filings nationwide for the year ending June 30, 1997, dropped 13.2 percent to 11,159. Chapter 12 filings dropped 5.4 percent to 1,006.[RETURN TO TEXT]
 Section 1328(a)(3) excepts from discharge criminal restitution and fines. To the extent that criminal restitution or fines are entered as part of a sentence in a criminal tax case, they would be excepted from discharge.[RETURN TO TEXT]
 While most taxing authorities do not receive notice of every bankruptcy filing at the present time, it is likely that within the near future with the introduction of electronic noticing, federal and state taxing authorities will receive notice of every filing.[RETURN TO TEXT]
 In order to confirm a chapter 13 plan, priority claims, including priority tax claims, must be paid in full although the payments can be deferred and the payment of post-petition interest is generally not required. Section 1322(a)(2). Non-priority tax claims can usually be compromised (to the same extent that other general unsecured claims can be compromised) provided that the plan meets the requirements of §§1322 and 1325. Upon completion of the plan, any unpaid balance of the general unsecured tax claims will be discharged. Section 1328(a).[RETURN TO TEXT]
 Line 1 of the Illinois return (Form IL-1040) is the adjusted gross income from the federal return. The calculation of income taxes in most other states likewise depends on the proper calculation of income for federal income tax purposes.[RETURN TO TEXT]
 Some debtors who have been subject to withholding or who have made estimated payments may even be entitled to refunds if a return is filed. If a refund is due, it is property of the estate and should be paid by the taxing authority. Whether a refund is due cannot be determined, however, unless a return is filed.[RETURN TO TEXT]
 In light of the fact that approximately 19 percent of chapter 13 debtors from the second survey who did not list the IDR as a creditor in their signed schedules owed liquidated income tax liabilities, it is reasonable to question whether they will accurately represent whether they have filed all required pre-petition tax returns for the prior six years. In addition, one of the common themes of tax protesters is that the tax statutes were not legally enacted and they are therefore not under a duty to file returns or pay taxes.[RETURN TO TEXT]