Developments in the Dischargeability of Tax Liabilities

By: Andrew G. Lizotte

One of the principal benefits for an individual filing for bankruptcy (a “debtor”) is the entry of a discharge, or forgiveness of debts arising prior to the bankruptcy filing.  Section 727 of the Bankruptcy Code provides circumstances under which a debtor may have their discharge denied in its entirety.  Section 523 of the Code, in turn, provides for a set of circumstances where a particular creditor may have their debt due from the debtor declared nondischargeable.

Recent decisions from the First Circuit Court of Appeals and the Bankruptcy Court for the District of Massachusetts have expounded on the question of whether an individual debtor’s tax liability is dischargeable in bankruptcy.  Under the First Circuit’s holding, the tax liability of debtors who file late returns will not be discharged in Chapter 7, while the Bankruptcy Court then held that the penalties associated with such tax liabilities may be dischargeable.

Section 727 of the Bankruptcy Code provides the debtor a discharge, relieving the debtor from all debts that arose prior to the petition date.  The discharge is subject to certain exceptions enumerated in Sections 523 and 727.  See 11 U.S.C. §§ 523, 727.  Section 523(a)(1) excepts from the discharge any debt for a tax with respect to which a return, or equivalent report or notice, if required- (i) was not given; or (ii) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and within two years of the date of the filing of the petition.  Accordingly, any taxes which require a return to be filed, and for which the return was filed late and within two years of the date of the bankruptcy filing, will not be discharged in bankruptcy.  The issue set forth in two recent cases is whether tax liabilities, and associated penalties, should be discharged where the returns were filed late but more than two years prior to the petition date.

In In re Fahey, 779 F.3d 1 (1st Cir. 2015), the First Circuit Court of Appeals consolidated four cases in which the Massachusetts Department of Revenue (the “DOR”) had challenged the dischargeability of tax debts where the debtors filed the tax returns late, but more than two years prior to their bankruptcy filings.  The question for the Court was whether the late filed tax returns qualified as “returns” under Section 523(a)(1).  If they were returns, then the taxes would be discharged, since the exception to discharge only applies to late returns filed within two years of the petition date.  Prior to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “BAPCPA”), “return” was defined by case law as a document which (i) purported to be a return, (ii) was executed under penalty of perjury, (iii) contained sufficient data to allow calculation of the subject tax; and (iv) represented an honest and reasonable attempt to comply with tax law.   Beard v. Commissioner, 82 T.C. 766 (1984).  Under this test, many courts struggled with whether late-filed returns represented honest and reasonable attempts to comply with the tax law, and should therefore be treated as ‘returns’.  Compare In re Payne, 431 F.3d 1055, 1059 (7th Cir. 2005) (focusing on whether return was filed before tax was actually assessed) with In re Colsen, 446 F.3d 836, 841 (8th Cir. 2006) (focusing on whether the tax forms were filled out in good faith and with accurate information).

The BAPCPA, however, added a definition of “return” to the Bankruptcy Code, defining it as “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”  In Fahey, the majority held that the filing deadline of April 15 set forth in Mass Gen. Laws ch. 62C § 6(c) constitutes an “applicable filing requirement.”  Therefore, any return filed after the deadline does not qualify as a “return” under the Bankruptcy Code and the underlying tax liability is not dischargeable pursuant to Section 523(a)(1).

Against this backdrop, the Bankruptcy Court for the District of Massachusetts was recently called upon to decide whether tax penalties associated with tax liabilities for which returns were filed late are dischargeable under Section 523(a)(7) of the Bankruptcy Code. In re McCarthy, No. 13-30959-HJB, 2016 WL 3866622, at *1 (Bankr. D. Mass. July 11, 2016).  Section 523(a)(7) provides that a tax penalty is discharged if the tax to which it relates is discharged or if the transaction or event giving rise to the penalty occurred more than three years prior to the filing of the bankruptcy petition.  See Burns v. United States (In re Burns), 887 F.2d 1541, 1544 (11^th Cir. 1989).

In McCarthy the debtors filed income tax returns late and more than three years prior to their bankruptcy filing.  Since the underlying taxes were not dischargeable under Section 523(a)(1) and Fahey, at issue was whether the event giving rise to the penalty occurred more than three years prior to the filing of the petition, in which case the penalties would be discharged.  The DOR argued that the “event” giving rise to the penalty was a continuing event, since Mass Gen. Laws ch. 62C § 33(b) provides that the penalty accrues for each month during which the failure to pay the taxes continues. Therefore, the DOR argued, for the purposes of Section 523(a)(7), the event occurred within three years of the petition date, and the penalties were not dischargeable.  The Court disagreed with the DOR and held that the “event” giving rise to the penalty occurs on the deadline to file and pay the taxes, which, in this case, occurred more than three years before the petition date.  Therefore, the penalties were dischargeable.

Explicit in both the Bankruptcy Court’s decision in McCarthy and the strongly-worded dissent in Fahey was the “well-settled” principle that exceptions to discharge should be construed narrowly in favor of the debtor, as a furtherance to the policy goal of affording debtors in bankruptcy a fresh start.  This precept and policy goal were not sufficient, in the Fahey majority’s view, to overcome the text of the BAPCPA’s definition of “return.”  Similar appeals to the text of Mass Gen. Laws ch. 62C § 33(b), providing for the monthly accrual of penalties, were advanced by the DOR, but were not accepted by the Bankruptcy Court.  It is, however, conceivable that if and when the First Circuit considers the dischargeability of penalties with respect to non-dischargeable taxes, it could disagree with McCarthy’s holding. Those advising prospective debtors should remain aware of this possibility.

Debtors filing for bankruptcy with outstanding taxes need to carefully review the foregoing provisions to evaluate the prospect for discharging unpaid taxes and associated penalties.