Discharging Income Tax Debt in a Chapter 7 Bankruptcy, What is Considered Willful Evasion?

When determining the dischargeability of income tax debt in a chapter 7 bankruptcy, there are five basic rules which need to be considered. In summary, income taxes in a chapter 7 bankruptcy are dischargeable if all of the below described rules/conditions are met.

The Three-Year Rule: The taxes are for a taxable year for which the due date was more than three years ago. The three year period is computed from the most recent date the tax return is due for the tax year (typically April 15 of the year following the taxable year or the extension date). 11 U.S.C. § 507(a)(8)(A)(i).

The Two-Year Rule: A tax return for the taxable year in question was filed more than two years preceding the filing date of the bankruptcy. 11 U.S.C. § 523(a)(1)(B).

The 240-Day Rule: The tax claim was assessed more than 240 days preceding the filing date of the bankruptcy. 11 U.S.C. § 507(a)(8)(A)(ii). A tax is deemed “assessed” when it can no longer be appealed administratively, i.e., when it is final.

The above three rules are easy to determine by interviewing your client. However, it is recommended to confirm this information by requesting and reviewing IRS tax transcripts. The next two rules can be more subjective and may require a more detailed analysis.

Non-Fraudulent Return: The tax return in question was not fraudulent. 11 U.S.C. § 523(a)(1)(C). An example of a fraudulent tax return would be one in which income is inaccurately or under reported.

No Willful Tax Evasion: This is the most common issue raised by the Government when opposing the dischargeability of IRS debt. Specifically, when opposing dischargeability of IRS debt, the Government often argues that the debtor “willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. § 523(a)(1)(C).

When the Government objects to the dischargeability of IRS taxes, it is the Government’s burden to prove the nondischargeability by a preponderance of the evidence. In re Mitchell, 633 F. 3d 1319 (11th Cir. 2011) citing Grogan v. Garner, 498 U.S. 279. The Eleventh Circuit has set forth a two-prong test for determining whether a debtor willfully evaded his taxes pursuant to 11 U.S.C. § 523(a)(1)(C). The test requires proof by the Government that the debtor engaged in (1) evasive conduct with (2) a mental state consistent with willfulness. Id. at 1327.

With regard to the conduct requirement, the Government must prove the debtor engaged in affirmative acts to avoid payment or collection of taxes, either through commission or culpable omission. Id. citing In re Jacobs, 490 F.3d 913 (11th Cir. 2007). The Eleventh Circuit has previously held that mere non-payment of taxes is insufficient to satisfy the conduct requirement; however, nonpayment in conjunction with a failure to file tax returns has been deemed to constitute evasive conduct. Id. citing In re Fretz, 244 F.3d 1323 (11th Cir. 2001). Examples of affirmative acts to evade paying taxes include concealment of assets and dealing in cash. In re Lewis, 151 B.R. 140 (Bankr. W.D. Tenn. 1992)

After the conduct requirement is satisfied, the Government must then prove the willfulness requirement. A debtor acts willfully when the debtor’s attempt to avoid tax liability is “ ‘done voluntarily, consciously or knowingly, and intentionally.’ ” Id. citing In re Jacobs, 490 F.3d at 921. The required mental state is shown when the Government proves that the debtor: (1) had a duty under the law, (2) knew he had that duty, and (3) voluntarily and intentionally violated the duty. Id. citing In re Jacobs, 490 F.3d at 921. Typically, the Government will have no difficulty in proving the first two elements of the willfulness test. The third element, or the mental state requirement, “prevents the application of the exception to debtors who make inadvertent mistakes reserving nondischargeability for those whose efforts to evade tax liability are knowing and deliberate.” Id. at 1327 citing Fretz at 1330. The determination of the mental state element is very fact specific and will, in large part, be based upon the debtor’s testimony.

Recently, the Government has taken a greater interest in defending against debtors who seek to discharge IRS debt. Accordingly, debtor’s counsel must identify and discuss all potential issues with their clients prior to filing bankruptcy, especially when the primary objective of the bankruptcy filing is to discharge IRS debt. While these rules may seem simple, they can be quite complex and require a thorough examination of the tax history and law in each case.