Category Archives: Dischargeability of Debts

Ninth Circuit Court of Appeals Upholds In re Hatton Test Regarding Definition of Return in Martin Smith Appeal


The issue in these cases is the effect of the Internal Revenue Service or other taxing authorities filing a Substitute Filed Return (“SFR”) and then the taxpayer voluntarily files their own tax return after that. Does the subsequent honest, accurate and voluntary filed tax return by the tax payer satisfy the definition of a “return” under the Bankruptcy Code and Section 523(a)(1)(B)(i)? A SFR is filed by a taxing authority (Internal Revenue Service or Franchise Tax Board) when a taxpayer fails to timely file their tax return on their own. A SFR is created and filed by the taxing authority. If a taxpayer has a SFR for a tax year and owes taxes for that year, and then files for bankruptcy protection the taxes owed for the SFR year, if normally dischargeable, are exempt from discharge (not discharged) given any debt for a tax with respect to which a return was not filed is nondischargeable pursuant to § 523(a)(1)(B)(i). But this is the bankruptcy world and not the real world. The Bankruptcy Code changes creditors rights to try and treat all parties fairly when the debtor has limited resources or no resources to pay their debts as the come due or at all.

Like many laws Congress passes certain terms that are extremely important are not defined within the law. I wish this was not so common and the undefined terms regularly are extremely important to interpreting the law. The Bankruptcy Code is no different. A “return” was not defined sufficiently and still is not even though Congress in the 2005 BAPCPA reforms amended Section 523(a) to include [For purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements)]. Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.] So the argument is a return filed after the SFR is a tax return that satisfies the requirements of applicable nonbankrutpcy law and the taxes for that year should therefore be dischargable.

As background, and you probably know this, any time a return is filed a form is used like 1040EZ or 1040a. So after a SFR is filed by a taxing authority the person that did not file their return uses the pre-printed form provide by the taxing authority. So for bankruptcy purposes and after the 2005 BAPCPA amended Section 523(a) to include for purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law the use of a preprinted form provided by the taxing authority meets this requirement. It apparently does not.

In the Martin Smith v. United States Internal Revenue Service [] case Mr. Smith and his Bankruptcy Attorneys attacked the fourth prong of the Hatton test and tried to argue Mr. Smith’s voluntary filed tax return filed after the SFR is a “return,” therefore the underlying taxes owed are dischargeable and not governed by § 523(a)(1)(B)(i). While the original bankruptcy court agreed, unfortunately the District Court and now the Ninth Circuit Court of Appeals disagreed.

In Hatton in 2000, pre-2005 BACPA, the Ninth Circuit Court of Appeals developed a four prong analysis as to what a “return” is pursuant to § 523(a)(1)(B)(i) and the Bankruptcy Code. See In re Hatton, 220 F.3d 1070 (9th Cir. 2000) The test for a “return” under Hatton is: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law. The 9th Circuit Court of Appeals noted that a number of sister circuits have agreed with the Hatton case. See In re Ciotti, 638 F.3d 276,280 (4th Cir. 2011); In re Justice, 817 F.3d 738, 740–41 (11th Cir.2016) The Ninth Circuit Court of Appeals also noted that the Tax Court has not wavered. See Estate of Sanders v. Comm’r of Internal Revenue, 144 T.C. 63 (2015) Wait, Congress changed Section 523 and added: for purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). So is this non-hanging parentheses language why there was no analysis of the Section 523 language change in 2005? Was Mr. Smith’s late filed return not in compliance with applicable filing requirements?

From my perspective a SFR does not meet the Hatton test. The taxing authority more or less makes up the numbers based upon what they have and not real world numbers. So while requirements 1-3 are met in the Hatton test, again we are left with prong 4. Does a SFR represent an honest and reasonable attempt to satisfy the requirements of the tax law? Subjectively yes. The Internal Revenue Service takes 1099’s or other documents provided by employers and does its best to put together a return on behalf of the tax payer who does not timely file their return. At the same time the tax payer subjectively believes when they do file their return after a SFR is filed they also make an honest and reasonable attempt to satisfy the requirements of the tax law. It would seem both parties are making a an honest and reasonable attempt to satisfy the requirements of the tax law. The courts have analyzed this issue objectively though.

Mr. Martin’s Bankruptcy Attorneys argued that the Smith facts were different then the Hatton facts and therefore distinguishable and I have to agree. I have not read all of the pleadings, but Mr. Martin filed his 2001 tax return seven years after it was due. Mr. Smith reported a higher income than the IRS used in their SFR which increased his tax liability. One issue that is not up for argument is whether the increased tax liability above the amount due on the SFR is dischargeable. The increased tax liability evidenced by Mr. Smith’s actual late filed return is dischargeable. So the late filed return is a partially recognized “return” under the Bankruptcy Code then? Just not the entire return? In Smith, Mr. Smith unfortunately falls prey to the holding in Hatton that belated acceptance of responsibility was not an honest and reasonable attempt to comply with the tax code. I have to disagree with this analysis in Smith. Not only did Mr. Smith file a return, but he honestly listed his income and deductions so that his tax liability increased and subjectively made an honest and reasonable attempt to satisfy the requirements of the tax law. So what if it was seven years after the actual taxes were due. Where is there any temporal requirement in the Hatton test or the new language in Section 523(a) resulting from the 2005 BAPCPA? The Hatton test is not even the law, but another appellate case and a created test prior to the statutory change in Section 523(a) to help define the term “return.” Statutory interpretation/construction requires a court take the plain meaning of the words used within their context. The court must focus on the language of the statute. Must give each word its ordinary meaning unless the statute or the context requires otherwise, and must interpret not only the individual words, but also the provision as a whole along with related provisions. See Lamie v. U.S. Tr., 540 U.S. 526, 534 (2004); Friedman v. P+P, LLC (In re Friedman), 466 B.R. 471, 479 (9th Cir. BAP 2012); Foxgord v. Hischemoeller, 820 F.2d 1030, 1032 (9th Cir. 1987) The court must interpret not only the individual words, but also the provision as a whole along with related provisions. United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 371 (1988) Where is the analysis of how Mr. Smith’s accurate, honest, reasonable, partially relied on and tax liability increasing return does not meet the requirements of applicable nonbankruptcy law (including applicable filing requirements)? The Hatton case was decided in 2000 and before the 2005 BACPA which became effective in 2005.

Unlike Mr. Smith, Hatton merely met with the IRS and capitulated into an installment agreement with the IRS without making any affirmative action to honestly and reasonably comply with the tax code. Mr. Smith clearly did honestly and reasonably not only make the effort, but did comply with the tax code and then filed a return that met the requirements of applicable nonbankruptcy law (including applicable filing requirements) by increasing his tax liability. Mr. Smith should have been rewarded for filing his tax return upon seeking bankruptcy protection under the Bankruptcy Code. An honest debtor deserves a discharge under the Bankruptcy Code. I believe this and believe the holding in the Smith case sends the wrong incentive and message to debtors and their attorneys.

So, somehow the Internal Revenue Service is allowed recognize the validity of a late filed return regarding the increased taxes owed while at the same time arguing the late filed return is not actually a “return” for purposes of §523(a)(1)(B)(i) as the late filed return does not meet the requirements of applicable nonbankruptcy law. I suppose the only reason to file a return after a SFR is to decrease the alleged tax liability in the SFR, but the return is still not a “return” for bankruptcy purposes. The Hatton case and now Smith decision more or less provide a penalty for not voluntarily filing a tax return within a certain amount of time. Well, then what is a reasonable time frame in which the fourth prong of the Hatton Test can be satisfied? One year? Two years or days after the SFR is filed? Some arbitrary time limit after the SFR is filed that if you are a day over you cannot discharge the taxes when filing bankruptcy? I still want to know how a return filed after a SFR does not satisfy the requirements of applicable nonbankruptcy law (including applicable filing requirements). I am going to have to dig deeper into these two cases……….

The Oral Arguments Before the Ninth Circuit Court of Appeals

Wow, what a pressure cooker. After listening to the oral arguments before the three judge panel I still believe the decision here is wrong as the law and Bankruptcy Code are written. It is about interpretation though and past decisions. The Ninth Circuit Court of Appeals just could not get over that the debtor filed the 1040 tax return so late after the IRS had given him so many chances to file his own return. The debtor in this case did not actually file his own return until after the IRS spent the time to file the Substitute Filed Return. I will assume the application of the Hatton test was the correct choice even with the addition to Section 523(a) of a definition of a “return” under the Bankruptcy Code. So we are stuck with the IRS and Ninth Circuit Court of Appeals somehow telling us the tax return filed by a debtor after a Substitute Filed Return is a “return” as to the amount the debtor filed return increases the assessed taxes from what the Substitute File Return assessed, but that same “return” is not a “return” as to the previously assessed taxes owed from the Substitute Filed Return. The Smith case did not nothing to explain how a portion of a “return” can be an honest and reasonable attempt to satisfy the requirements of the tax law and part of a “return” not be at the same time.

The Smith case really just ignores the issue of what the definition of what a “return” is under the Bankruptcy Code or what an honest and reasonable attempt to satisfy the requirements of the tax law (including applicable filing requirements). The Court just took the IRS position that since the IRS filed the SFR then a debtor in this case, Martin Smith, under the circumstances in his case could never subsequently file a return and have the portion of the taxes owed according to the SFR discharged in a bankruptcy case. Mr. Smith just waited far too long to file his “return” that by every measure was complete and accurate. In theory there can still be a set of facts in which a court can determine a return filed by the debtor after a SFR is in fact a “return” and discharge all of the taxes assessed for that year. This case was just not it. What is troubling is the Hatton case represented a debtor that made no good faith effort to file a “return” unlike in the Smith case. Mr. Hatton filed a late return in which he provided true and accurate information resulting in his tax obligation given his tax liability increased from the Substitute Filed Return the taxing authority created. That is by definition a honest and reasonable attempt to satisfy the requirements of the tax law (including applicable filing requirements). What does “including applicable filing requirements” even mean? We still do not know. It would have been nice for the Smith case to have gone this direction and helped to define how to apply the actual words of the Section 523(a) of the Bankruptcy Code.

So, the moral of the story really is to timely and honestly file your tax returns and not let a taxing authority file a return on your behalf. Do not ignore the letters a taxing authority sends in the mail to file your returns and this will never be a problem.

Was The Chapter 13 Petition and Plan Filed in Good Faith?


In a Chapter 13 reorganization case there are a number of requirements that a Chapter 13 Plan must meet to be confirmed or approved by the bankruptcy court. Section 1325, Confirmation of Plan, of the Bankruptcy Code provides the requirements that must be met. Section 1325(a)(3) and 1325(a)(7) provide the bankruptcy petition and chapter 13 plan must be proposed in good faith. This issue has been framed as a petition or plan is in bad faith. What you are trying to prove though is lack of “good faith.” Prove that the petition or plan were not filed in good faith. The word bad faith does not appear anywhere. The term “good faith” is not defined by the Bankruptcy Code so case law is all we have to go on.

Good Faith Pursuant to Section 1325 of the Bankruptcy Code

Again, the debtor will argue the petition and plan were filed in good faith. Lack of good faith can be shown by considering: (1) whether the debtor misrepresented facts in his/her petition or plan, unfairly manipulated the Bankruptcy Code, or otherwise filed his/her chapter 13 petition or plan in an inequitable manner; (2) the debtor’s history of filings and dismissals; (3) whether the debtor only intended to defeat state court litigation; and (4) whether egregious behavior is present. See Leavitt v. Soto (In re Leavitt), 171 F.3d 1219, 1224 (9th Cir. 1999) (internal quotation marks and citations omitted); see also Drummond v. Welsh (In re Welsh), 711 F.3d 1120, 1132 (9th Cir. 2013).

Mendez, Appellant v. Harwood, Appellee

In a recent decision by the Ninth Circuit Bankruptcy Appellate Panel the issue of good faith based upon an objection to confirmation filed by judgment creditor Ronald Mendez. According the court records, Mr. Mendez was a former client of the bankruptcy filer Sterling V. Harwood. Mr. Mendez paid Mr. Harwood a total of $18,000. At some point Mr. Mendez was dissatisfied with Mr. Harwood’s services and requested his money back. Mr. Harwood refused and from prison Mr. Mendez sued Mr. Harwood in Santa Clara Superior Court for breach of contract and fraud. Mr. Harwood did not respond to the lawsuit and a default judgment was entered against him for approximately $26,000. After five months Harwood tried to have the default judgment vacated for improper service of the summons and complaint. The Superior Court of California ruled Harwood’s motion to vacate the default judgment was not timely and that personal service of Harwood was proper. The default judgment stood.

Harwood’s Chapter 13 Bankruptcy Cases

Mr. Harwood filed a skeleton Chapter 13 bankruptcy petition to stop garnishment of his wages to satisfy the state court judgment of Mr. Mendez. A skeleton petition describes the filing of the basic documents to start a Chapter 13 bankruptcy case. The rest of the petition must be filed within 14 days or the case will be dismissed. There are almost no successful Chapter 13 reorganizations without the assistance of bankruptcy lawyers. Mr. Harwood’s first case was dismissed.

Harwood’s Second Chapter 13 Bankruptcy Filing

This first case was dismissed for failing to complete the credit counseling course or complete the bankruptcy petition. After retaining a bankruptcy attorney Mr. Harwood filed a second Chapter 13 bankruptcy case. To be fair Mr. Harwood has plenty of reasons to reorganize his debts. In addition to the Mendez judgment for $29,000, Mr. Harwood was behind on this mortgage payments and needs to obtain a loan modification to keep the his home, he is also behind on his property taxes, he has another judgment entered against him in San Mateo Superior Court totaling $5,837.90 owed to another attorney, Donald S. Tasto, Esq. Attorney Tasto unfortunately passed away while Mr. Harwood’s second bankruptcy filing was pending. Mr. Harwood also has $112,219.87 in general unsecured debts. Mr. Harwood listed his income from employment as a professor as $3,336 a month and business income of $25,362 a month in Schedule I (total monthly gross income after deductions is $26,452.84) and monthly expenses of $26,286 in Schedule J. With a gross income of over $26,000 a month there is only $166 to make the Chapter 13 Plan payment. Most of Mr. Harwood’s expenses are business related. Mr. Harwood’s wife does not work or have income.

The first filed Chapter 13 Plan proposed to pay $165 a month for 60 months. The only debt being paid through the Chapter 13 Plan are attorneys’ fees of $7,400 and the trustee fee to administer the plan. No actual creditors received any distribution through the first chapter 13 plan filed. There is authority to support an argument that filing a Chapter 13 Plan that pays nothing to creditors was not filed in good faith. This is a litigated issue though. An argument is how can someone reorganize their debts when they are not paying any of their debts back? What debts are reorganized? A Chapter 13 plan that pays nothing to creditors is more or less a Chapter 7 then, a complete discharge of eligible general unsecured debts. So the argument goes the actual reason a Chapter 13 plan like this is filed must be for some improper purpose or unfair manipulation of the Bankruptcy Code.

The First Amended Chapter 13 Plan proposed to pay $165 for 24 months then $365 for the remaining 36 months of the 60 month plan. Total plan payments would equal approximately $17,100 over the life of the plan. Mr. Harwood’s attorneys also increased their attorney fees to $8,800 or about half of the proposed plan payments. The second filed Chapter 13 Plan also proposed to reject an advertising contract with a radio station, avoid the judgment lien of deceased attorney Donald Tasto, Esq., and provide language about seeking modification of their first mortgage on his primary residence. Mr. Mendez objected to confirmation of this plan arguing it was not filed in good faith.

The Third Amended Chapter 13 Plan filed by Mr. Harwood proposed to reduce the plan payments to $165 for 24 months then $360 for the remaining 36 months. The Second Amended Chapter 13 Plan also included the following special provisions: “By April 30th of each year during the pendency of the case, the debtor shall provide the Trustee with a copy of all Federal income tax returns required to be filed; or, if an extension has been obtained, a copy of the extension and the tax return within ten (10) days of filing the return but no later than ten (10) days after the expiration of the extension date The debtor shall file a declaration on January fifteenth and July fifteenth of each calendar year, beginning July 15, 2014, which states what the status is of his law office in Vietnam and outlines the average monthly income and expenses for the business. The debtor shall file a declaration on January fifteenth and July fifteenth of each calendar year, beginning July 15, 2014, which states what the status is of the malpractice case against his spouse’s former bankruptcy attorney.”

Mr. Mendez’s Argument For Lack of Good Faith

Mr. Mendez argues the petition was not filed in good faith given Harwood misrepresented the nature of the debt owed to Mr. Mendez. Harwoods’s Amended Schedule F describes Mr. Mendez’s judgment claim as: “Incurred: 2013 Consideration: Alleged breach of contract Debtor disputes any liability to this individual. A default was taken based on improper service.” Mr. Mendez argues that the Santa Clara Superior Court ruled that service was proper and there is no alleged debt, Mr. Mendez obtained a valid judgment against Mr. Harwood. Whether true of not the description of the nature of a debt is a minor issue in the big scheme of things and does not really change the treatment of Mr. Mendez’s claim under the Bankruptcy Code. Minor discrepancies in the petition will not rise to the level of not having good faith. While the description of the claim owed to Mr. Mendez in Schedule F is arguably not correct, the bankruptcy court found that the description was adequate under the circumstances and the description is not evidence of trying to mislead the court or manipulate the Bankruptcy Code.

Mr. Mendez next argues the first filed case and Chapter 13 Plan were not filed in good faith given it was filed for the stated purpose of avoiding wage garnishment and frustrate the enforcement of the state court judgment of Mr. Mendez. This argument is not a good one absent some additional facts. A very high percentage of bankruptcy cases filed involve some sort of state court lawsuit. Filing bankruptcy to stop a wage garnishment, bank levy or foreclosure of a home is perfectly normal. If the state court case was at the eve of trial or some other additional circumstance this argument could work.

The bankruptcy court agreed and held that Mr. Harwood was well within his rights to file for bankruptcy protection under Chapter 13.

Mr. Mendez next argues that Mr. Harwood is seeking to discharge in Chapter 13 his judgment that would not be discharged in Chapter 7 and therefore Mr. Harwood has unclean hands. This is a tough argument given that Mr. Mendez’s judgment for fraud against Mr. Harwood is arguably not dischargeable in both Chapter 7 and Chapter 13 if proven pursuant to Section 523(a) of the Bankruptcy Code. The exceptions to discharge set forth in §523(a)(2), (4) and (6) of the Bankruptcy Code are not self-executing. See Mohsen v. Wu (In re Mohsen), 2010 WL 6259979 at *6 (9th Cir. BAP Dec. 21, 2010). Rather, § 523(c)(1) provides, with exceptions not applicable here, that a creditor must request and receive a judgment that the debt owed is not dischargeable. To have certain types of debts deemed not discharged pursuant to Sections 523(a)(2),(4) and (6) an adversary lawsuit must be filed and a judgment received. Then the debt can be enforced again under state law.

9th Circuit BAP Agrees With Bankruptcy Court

Mr. Mendez lost the appeal given the Ninth Circuit Bankruptcy Appellate Panel could not find error in the bankruptcy courts overruling of Mr. Mendez’s objection to confirmation of Harwood’s Chapter 13 Plan. Based upon these facts anyway the petition and plan were found to be filed in good faith.

Ninth Circuit Bankruptcy Appellate Panel Affirms Decision That Tuition Credits Are Not Excepted From Discharge


On July 15, 2014, I wrote an article about tuition credits and a case of first impression since the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) in the Ninth Circuit Bankruptcy Court for the Northern District of California regarding whether tuition credits are excepted from discharge or not discharged. On March 27, 2015, the Ninth Circuit Bankruptcy Appellate Panel affirmed bankruptcy court’s ruling that tuition credits are not excepted from discharge, BAP No. NC-14-1336-PaJuTa, and not excepted from discharge pursuant to Section 523(a)(8)(A)(ii). Ms. Christoff received tuition credits from a for-profit education company named Institute of Imaginal Studies dba Meridian University prior to filing for bankruptcy protection. This is a blow to the for-profit educator sector and a little consolation prize for students with tuition credits. Other for-profit colleges have come under fire recently for their lending practices and the job prospects of their students. At least a student with a tuition credit can discharge that part of their debt when filing for bankruptcy protection.

Procedural History

The debtor, Tarra Nichole Christoff, filed for bankruptcy protection under Chapter 7 of the Bankruptcy Code on April 19, 2013, in the Northern District of California, Bankruptcy Case No. 13-10808-DM-7. As part of her petition Ms. Christoff listed a general unsecured debt of around $11,000 owed to Meridian. Meridian proceeded to file an adversary proceeding (lawsuit within the main bankruptcy case) to determine whether the tuition credits and resulting loan from Meridian to Ms. Christoff was excepted from discharge pursuant to Bankruptcy Code Section 523(a)(8)(A)(ii).

Section 523(a)(8)(A)(ii) of the Bankruptcy Code provides:
(a) A discharge under section 727, 1141, 1228 (a), 1228 (b), or 1328 (b) of this title does not discharge an individual debtor from any debt—
(8) unless excepting such debt from discharge under this paragraph would impose an undue hardship on the debtor and the debtor’s dependents, for—
(ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend;

After Meridian filed a motion for summary judgment in the adversary proceeding the Bankruptcy Court denied the motion for summary judgment and entered a judgment in favor of Ms. Christoff. The Honorable Dennis Montali starts the memorandum of decision: “In addressing the issue court must consider two powerful competing principles: the need to give the honest debtor a fresh start and the seemingly endless desire of Congress to except more and more student loans from discharge absent undue hardship.” Meridian’s bankruptcy lawyers argued that Ms. Christoff received a loan from Meridian and the loan proceeds went directly to Meridian and Ms. Christoff then received the education. Ms. Christoff’s bankruptcy attorneys argued she never received any funds from Meridian or anyone else. The Honorable Judge Dennis Montali in the adversary proceeding held that no funds were received even though the transaction between Meridian and the Ms. Christoff resulted in loans for repayment of tuition credits to Meridian. Therefore, the tuition creditors are not excepted from discharge. The decision in the adversary case was immediately appealed to the Ninth Circuit Bankruptcy Appellate Panel for review.

Ninth Circuit Bankruptcy Appellant Panel Affirmation of the Bankruptcy Court’s Ruling

Ms. Christoff, the debtor, was awarded $6,000 in financial aid to pay for some of her tuition. She signed a promissory note. She did not actually receive any funds from Meridian though. Instead, what she received was a tuition credit. The terms of the note required her to pay back the funds at $350 per month after she finishes her coursework or she withdraws from Meridian along with 9% interest to be compounded monthly. She received another $5,000 in tuition credit the following year after signing a promissory note with the same terms. She withdrew from Meridian after completing all her coursework and clinical hours but before she completed her dissertation.
In interpreting the funds received requirement in Section 528(a)(8)(A)(ii), the Ninth Circuit Bankruptcy Appellate Panel agreed with the bankruptcy court and held Meridian simply agreed to be paid the tuition later and it did not receive any funds from a third party financing source. The key here is the language in Section 528(a)(8)(A)(ii) that grants exception to discharge for “an obligation to repay funds received.” That means funds received by the plain language of the Bankruptcy Code. The long stand principle is that exceptions to discharge should be confined to those plainly expressed. Hawkins v. Franchise Tax Bd. of Cal., 769 F.3d 662, 666 (9th Cir. 2014) The plain language of this prong of the statute (Section 523(a)(8)) requires that a debtor receive actual funds in order to obtain a nondischargeable educational benefit.” Cazenovia Coll. v. Renshaw (In re Renshaw), 229 B.R. 552, 555 n.5 (2d Cir. BAP 1999), aff’d, 222 F.3d 82 (2d Cir. 2000)) Again, no funds were received so Section 528(a)(8)(A)(ii) did not except from discharge the tuition credits Ms. Christoff received.

Are Substituted Tax Returns Considered a “Filed” Tax Return So That Unpaid Income Tax Can Be Discharged in Bankruptcy?

By Ryan C. Wood

In order for your tax debt to be dischargeable in bankruptcy you need to meet all these criteria: 1) the taxes need to be due more than three years ago, 2) filed at least two years prior to filing bankruptcy, 3) the taxes need to be assessed more than 240 days (8 months) ago, and 4) no filing of fraudulent returns or willful attempts to evade or defeat a tax. If you meet those 4 requirements, your unpaid income taxes can be dischargeable in your bankruptcy case. Today we are going to focus on Internal Revenue Service policies and whether a substituted tax return filed by a taxing authority on behalf of a taxpayer is considered a “filed” tax return to satisfy number two listed above.

What is a substituted tax return? A substitute for return (“SFR”) is a tax return the Internal Revenue Service (“IRS”) files on your behalf if you fail to do so. The IRS gathers all the information submitted to them (W-2s, 1099s, etc.) and the taxing authority prepares your return on your behalf. Keep in mind that the SFR is most likely not going to include all the deductions, exemptions, and credits that you may be entitled to so the tax assessment may be higher than what you actually owe. The IRS will send you a Notice of Deficiency and provide you with a proposed assessment and give you 90 days to file a return or a petition in Tax Court. If you do not respond the IRS will proceed with the assessment and for all intents and purposes the SFR will be considered a valid return for tax assessment and interest and penalties will accrue. Now just because the IRS filed an SFR for you does not mean that you cannot file your own tax return. In fact it is encouraged that you still file your own return because as indicated previously, the IRS does not take into account all the deductions, credits, and exemptions that you may be entitled to. By filing your own return you can reduce your tax liability if not eliminate it altogether. You may even be due a refund. If you do not file your return within 3 years of the date the return is due you risk losing your refund and your right to claim tax credits. Make sure your bankruptcy attorney or you obtain an account transcript from the IRS to verify your tax history and verify that a SFR was filed on your behalf.

Now that you know what a SFR is the next step is to determine if the SFR acts as a filed tax return if the IRS prepares the SFR. The short answer is a resounding NO! Please see IRS Chief Counsel Notice CC-2010-016 and Internal Revenue Code §6020(b). The SFR does not count as a filed return and therefore if you owe taxes pursuant to the SFR it is not dischargeable in bankruptcy. If you prepare and file your own tax return after a SFR was prepared by the IRS, taxes are assessed and file it with the IRS and meet all the criteria of a dischargeable tax debt, then only the portion of the tax that was not previously assessed would be dischargeable. If you end up owing no taxes or a decrease in taxes owed, those taxes would not be dischargeable.

After the IRS prepares a SFR and assesses taxes owed from the SFR you can still prepare and file your own tax return. Once you file your own tax return and if your unpaid income tax meets all the criteria for the taxes to be dischargeable, only the portion that was not previously assessed from the SFR would be dischargeable. If it turns out that you do not owe as much as the IRS claims, whatever amount remaining owed to the IRS from the taxes assessed by the SFR is not dischargeable.

For example:

Let’s look at an example to help you picture this rule. Let’s say you want to file for Chapter 7 bankruptcy in November 2014 and you ask your bankruptcy lawyer if your taxes are dischargeable. You owe taxes for the 2008 tax year but you never filed a tax return for this year and the IRS filed an SFR on your behalf and assessed the taxes in 2010 and the SFR indicated you owed $15,000 for the 2008 tax year. Even though you meet all the other criteria to have your taxes discharged, the $15,000 is not dischargeable because you did not technically file a return since SFRs do not count as a valid return. Now let’s say you immediately go to a CPA to file the 2008 tax return and you were assessed an additional $5,000. That $5,000 would be dischargeable in bankruptcy once it meets the other discharge rules. If the CPA helps you file the tax return and you end up lowering your tax liability from the $15,000 the IRS assessed from the SFR to only $3,000, your tax liability will only be $3,000. This is good news since you only owe $3,000 rather than $15,000, but the bad news is that the entire $3,000 is not dischargeable no matter how long you wait to file for bankruptcy.

The harsh effect of the SFR should encourage you to file your taxes on time in the event you know you are going to owe income taxes. Not filing a return and the Internal Revenue Service filing a substituted return could make any otherwise dischargeable income tax not dischargeable. So no, substituted tax returns are not considered a “filed” tax return so that unpaid income taxes can be discharged when filing bankruptcy.

Are Expenses Related to My Minor Children’s Incarceration Dischargeable in Bankruptcy?

By Ryan C. Wood

If you have a minor child who is currently or was previously incarcerated you already know that you are responsible for the expenses related to their support while they are incarcerated. But did you also know that those expenses related to the incarceration are not dischargeable in bankruptcy?

This is exactly what the Ninth Circuit Bankruptcy Appellate Panel decided in Rivera v. Orange County Probation Department (In re: Rivera), 13-1476 (BAP, 9th Cir., June 4, 2014). In this case, Maria Rivera’s son was incarcerated in Orange County for close to 2 years from 2008 to 2010. In accordance with Cal. Welf. & Inst. Code §903, the parents of the minor are liable for the reasonable costs of support while the minor is incarcerated. The costs of support are only for the actual costs incurred by the county for food and food preparation, clothing, personal supplies, and medical expenses, not the total cost of the incarceration. Additionally, the costs of support can not exceed $30 per day and the county will be reimbursed for the costs of legal representation. Additionally, the liability is only imposed on people that have the ability to pay. Orange County indicated that the total cost of incarceration for Ms. Rivera’s son was $420 per day. Orange County only tried to collect $23.90 a day from Ms. Rivera. The county represented this was for the “food and food preparation, clothing personal supplies and medical expenses” while he was incarcerated. In addition to the $23.90 per day, the County wanted $2,199 from Ms. Rivera for her son’s legal representation while he was incarcerated. The County sent Ms. Rivera multiple bills as well as court orders that require her to meet with a financial officer to determine her ability to repay the expenses but Ms. Rivera did not respond to any of the communications. She paid approximately half of the amount due to Orange County in May 2010 ($9,508.60). The remaining balance was $9,905.40. Ms. Rivera’s bankruptcy attorneys helped her file for Chapter 7 bankruptcy protection on September 12, 2011. Orange County was listed in Schedule E as a priority unsecured creditor. The Chapter 7 trustee determined it was a no asset case and Ms. Rivera received a discharge of her debt in January 2012. After the case was closed Ms. Rivera continued to receive collection notices from the County and Ms. Rivera’s bankruptcy attorney reopened her case to file a motion for an order directing Orange County to show cause why they shouldn’t be held in contempt for a violation of the discharge order. The judge decided that the debt owed to Orange County was excepted from discharge under §523(a)(5) and therefore the County did not violate the discharge order. Ms. Rivera appealed to the Bankruptcy Appellate Panel (BAP).

The judges in the BAP compared the exception to discharge before and after the BAPCPA amendments to the Bankruptcy Code. BAPCPA is the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 or nicknamed by some bankruptcy lawyers, BARF, for “Bankruptcy Abuse Reform Fiasco.” Prior to BAPCPA, 523(a)(5) provided that debts owed to “a spouse, former spouse, or child of the debtor, for alimony to, maintenance for, or support of such a spouse or child” is not dischargeable in bankruptcy. Under this rule, Orange County would not be included in this exception since Orange County was not a “spouse, former spouse, or child” and therefore their debt would have been discharged along with the rest of Ms. Rivera’s debt. However, since BAPCPA was enacted, §523(a)(5) only states that the debts for a domestic support obligation are not dischargeable. §101(14A) defines “domestic support obligation” to mean debts “(A) owed to or recoverable by (i) a spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative; or (ii) a government unit; (B) in the nature of alimony, maintenance, or support (including assistance provided by a government unit) of such spouse, former spouse, or child of the debtor or such child’s parent…” The new amendments definitely include Orange County since they are a government unit that provided support to the child. The judges held that since the debt was accrued before the bankruptcy petition was filed and owed to a government unit, incurred for the support of the child, was determined by a court order before Ms. Rivera filed for bankruptcy and the debt was not assigned to a nongovernmental entity for collection, the debt was nondischargeable.

If you owe money for the expenses related to a government agency due to the support for the incarceration of your minor child, it is best that you seek the advice of an experienced bankruptcy lawyer in your jurisdiction for advice on how to proceed.