§ 107.3 — Tax Problems
Revised: June 7, 2004
Debtors sometimes file Chapter 13 to manage tax claims. It has been held that it is not bad faith for a Chapter 13 plan to have as its sole purpose the deferral of tax debt.1 There is no provision of Chapter 13 analogous to 11 U.S.C. § 1129(d): in a Chapter 11 case, “the court may not confirm a plan if the principal purpose of the plan is the avoidance of taxes.” However, tax protestors and aggressive prepetition tax planners have had difficulty proving good faith, especially when the Chapter 13 case is only the latest in a series of maneuvers aimed at managing taxes without paying taxes.2
Tax claims are usually priority claims that must be paid in full to accomplish confirmation of a Chapter 13 plan under § 1322(a)(2).3 But Chapter 13 also permits priority tax claims to be paid in deferred payments through the plan without interest.4 The reported cases acknowledge that a sincere effort by the debtor to pay even very large tax debts using the deferred payment mechanism is within the good-faith boundaries of Chapter 13 practice.5
One court rewarded a Chapter 13 debtor’s careful bankruptcy tax planning by denying confirmation for bad faith. In In re Norman,6 the debtor filed Chapter 13 on September 1, 1992, and then filed (delinquent) tax returns for 1986, 1987 and 1988. Because the taxes involved were more than three years old and because the debtor delayed filing the delinquent returns until after filing the Chapter 13 case, some of the delinquent taxes were converted from nondischargeable, priority claims into ordinary dischargeable unsecured claims. The debtor proposed a 36-month plan that paid priority tax claims in full and 21 percent of general unsecured claims. The bankruptcy court denied confirmation, finding a lack of good faith:
[T]he Debtor delayed the filing of tax returns for tax years 1986, 1987 and 1988 in order to render the taxes due for these years dischargeable as nonpriority unsecured claims. . . . [T]his Debtor did indeed manipulate the Code in order to escape the full liability for unpaid taxes by seeking refuge in the super discharge provision of Chapter 13 . . . while offering a pittance to his only meaningful creditor, the Government.7
This outcome must indeed seem perverse to the debtor and the debtor’s counsel, who staggered the filing of the case and the filing of delinquent returns to maximize the dischargeability of tax debt. Was the debtor in Norman obligated by the good-faith test to delay filing the Chapter 13 case until after filing the delinquent tax returns to maximize the nondischargeable, priority claim of the IRS? Other unsecured creditors probably applaud the debtor’s timing because it increases their recovery by decreasing priority claims. Would a Chapter 13 filing be in bad faith if a debtor waited a few days for a statute of limitations to pass to create the predicate for disallowance of a claim? The tax planning in Norman was certainly hardball but hardly a foul play.
1 In re Goeb, 675 F.2d 1386 (9th Cir. 1982). See also Lilley v. United States (In re Lilley), 181 B.R. 809, 810–13 (Bankr. E.D. Pa.) (The good-faith requirement in § 1325(a)(3) “does not include an inquiry into whether a particular debt was nondischargeable in a Chapter 7 case.” Debtor was 66 years old, in poor health and disabled. Debtor’s only income was a $900 monthly social security benefit, and he owed $178,000 for nonpriority personal income taxes for 1976 through 1984. Debtor had been in the medallion- and jewelry-minting business until his assets were seized by the United States Secret Service on the erroneous belief that the debtor was counterfeiting. The debtor apparently decided to “recoup his losses” by refusing to pay income taxes. “‘The phrase “good faith” as it appears in section 1325(a)(3) is entitled to its historical meaning’ in the predecessor Bankruptcy Act, i.e., as relating solely to ‘debtor misconduct [in the bankruptcy proceeding], such as fraudulent misrepresentations or serious nondisclosure of material facts.’ . . . This court therefore finds it inconsistent with Congressional intent to suggest that the fact that a debt is nondischargeable in a Chapter 7 case is in itself a ground for denying confirmation of a Chapter 13 plan. . . . We therefore reaffirm our formulation of the § 1325(a)(3) criteria set forth in In re Gathright, 67 B.R. 384 (Bankr. E.D. Pa. 1986), aff’d, 71 B.R. 343 (E.D. Pa. 1987). While it is not inevitable that courts will widen the ‘improper purpose’ and ‘unfair manipulation’ criterion to suck in all debts which would be nondischargeable in a Chapter 7 case, . . . the temptation to do so appears to us to be very great, and this leads to inconsistent and unpredictable results. . . . [T]he Debtor was not guilty of misconduct in the course of the instant bankruptcy proceeding. His only debt, to the IRS, . . . was admittedly stated accurately. No fraudulent misrepresentations of the Debtor to this court were alleged. That is all the Gathright test obliges the Debtor to do to satisfy the § 1325(a)(3) requirement.”), rev’d in part, aff’d in part, 185 B.R. 489, 494 (E.D. Pa. 1995) (Court affirms finding that plan was proposed in good faith but then dismisses case for cause under § 1307(c) because “we find that he attempted to defraud the Government by intentionally evading payment of his Federal income taxes and such action constitutes cause for dismissal of his Chapter 13 bankruptcy petition pursuant to 11 U.S.C. § 1307(c).”), rev’d and remanded, 91 F.3d 491, 494–96 (3d Cir. 1996) (District court erred in reversing bankruptcy court with respect to dismissal of Chapter 13 case for cause; however, bankruptcy court erred in holding that good faith is not a filing requirement in a Chapter 13 case. “[T]ax fraud is not ‘cause’ for dismissal of a Chapter 13 petition . . . . Section 1328(a) and 523(a)(1)(C), read together, demonstrate Congress’s intent that tax-related debts of the sort at issue here be dischargeable under Chapter 13 . . . . The bankruptcy court concluded as a matter of law that Chapter 13 has no [good-faith filing] requirement. . . . [T]he district court sidestepped the controversy . . . . We therefore join the Seventh, Ninth and Tenth Circuits in holding that the good faith of Chapter 13 filings must be assessed on a case-by-case basis in light of the totality of the circumstances. . . . Accordingly, we will remand this matter . . . to the bankruptcy court for a determination whether, in light of the totality of the circumstances, Mr. Lilley filed his Chapter 13 petition in good faith.”).
2 See, e.g., In re Love, 957 F.2d 1350 (7th Cir. 1992) (Court affirms dismissal of Chapter 13 petition on good-faith grounds where debtor was an admitted tax protester, debtor understated the amount of debt in the petition, bankruptcy was filed to thwart the collection of taxes, debtor was not forthcoming with information or in dealings with the IRS, debtor failed to list three insurance policies, debtor understated income and debtor’s plan separately classified the IRS for less than full payment.); Schaffner v. IRS, 95 B.R. 62 (E.D. Mich. 1988) (Court affirms denial of confirmation on bad-faith grounds when tax protestor seeks to use Chapter 13 to discharge tax debts after conviction for filing false returns and so forth.); In re Paulson, 170 B.R. 496, 498–500 (Bankr. D. Conn. 1994) (Court denies confirmation of tax protester’s plan filed solely to stop IRS collection activity. Applying totality-of-the-circumstances test, “where the debt to be discharged under Chapter 13 could not be discharged under Chapter 7, a court should closely scrutinize the debtor’s motivation and any other relevant factors in considering whether good faith exists. . . . All courts that have addressed the specific issue before the court have concluded that the use of Chapter 13 by so-called tax protesters in an attempt to discharge their federal tax liabilities amounts to an unfair manipulation of the Bankruptcy Code. . . . The debtor’s prepetition flouting of tax laws is the exclusive source of his present indebtedness. His plan proposes to satisfy none of the unpaid tax liabilities except for those mandated by the § 507 priority category. . . . [T]he debtor is unfairly manipulating the Bankruptcy Code.”); In re Crayton, 169 B.R. 243, 245 (Bankr. S.D. Ga. 1994) (Bad faith justifying denial of confirmation is shown by the fact that the debtor failed to file tax returns for six years prior to filing bankruptcy and failed to file the delinquent tax returns after being told to do so by the Chapter 13 trustee. “Debtor’s failure to file his returns before filing his Chapter 13 plan, coupled with his failure for six months after filing to bring himself into compliance with federal law, constitute ‘unmistakable manifestations of bad faith.’ Debtor has enjoyed protection from collection activities by his creditors, including the IRS, while his case is pending, yet shows no sense of any duty to file his federal tax returns. Such behavior is the epitome of a lack of good faith on the part of Debtor.”); In re Jahnke, 146 B.R. 830 (Bankr. E.D. Cal. 1992) (Court denies confirmation on good-faith grounds based in part on evidence that the debtor intentionally failed to pay taxes during a prior Chapter 7 case in order to include the taxes in a future Chapter 13 case.); In re Ramski, 102 B.R. 269, 269 (Bankr. S.D. Fla. 1989) (Court denies confirmation of plan when IRS is owed 99% of the total debt and “the obvious purpose of the plan is to deprive the government of all its statutory means of revenue collection by promising delayed payment of the tax liability without interest.”); In re Silva, 82 B.R. 845 (Bankr. S.D. Ohio 1987) (Court denies confirmation of 100% plan where the primary purpose is to repay tax obligations excepted from discharge in prior Chapter 7 case. This was debtor’s fifth bankruptcy case in 15 years, filed after discharge but before completion of administration of prior Chapter 7 case.); In re Hazel, 68 B.R. 287, 290 (Bankr. E.D. Mich. 1986), aff’d, 95 B.R. 481 (E.D. Mich. 1988) (It is bad faith for self-styled “tax protester” to seek confirmation of a 1% plan that would discharge tax claims “arising from the debtor’s unlawful refusal to pay those taxes.” “[T]o file a petition in bankruptcy in order to discharge a debt arising from illegal activity is clearly bad faith.” Court applies United States v. Estus (In re Estus), 695 F.2d 311 (8th Cir. 1982), but notes that the amount of a debtor’s payment “is no longer a significant consideration of good faith” after the 1984 amendments to the Bankruptcy Code.).
3 See § 292.1 [ Taxes ] § 136.2 Taxes before BAPCPA.
4 See §§ 100.1 [ Deferred Payments Are Permitted ] § 73.4 Deferred Payments Are Permitted, 100.2 [ Interest Not Required, with Exceptions ] § 73.5 Interest Not Required, with Exceptions and 299.1 [ Postpetition Interest on Priority Claims ] § 136.16 Postpetition Interest on Priority Claims before BAPCPA.
5 See, e.g., In re Smith, 196 B.R. 565, 572–73 (Bankr. M.D. Fla. 1996) (In a 60-month, 100% plan, not bad faith for an airplane pilot with an annual income of $168,420 to pay $500 per month for telephone bill, to include expenses for an adult dependent child, to build equity in a 401(k) retirement plan and to pay tax obligations in excess of $147,000. “The IRS argues that debtor’s high telephone bill, investment property, savings plan and support of his adult child are luxury expenses which illustrate debtor’s refusal to effectuate lifestyle changes commensurate with his financial difficulties. Inclusion of such luxury items in a debtor’s plan of reorganization, however, is not necessarily indicative of bad faith. . . . [S]uch items are to be considered in the totality of the circumstances. . . . The Court finds that debtor’s retention of his investment property is not a bad faith attempt to deprive his creditors of the value of their claims. The plan provides that all claims will be paid in full, and the court finds that neither the IRS or the other creditors are harmed by debtor’s retention of the investment property. . . . [D]ebtor’s contribution to his savings plan is not a bad faith attempt to avoid payment to his creditors. Although debtor’s savings allotment could be used to increase his monthly plan payment, it would not increase the amount any creditor would receive under the plan. . . . The IRS has offered no evidence to support its argument that the debtor’s telephone expenses are excessive. . . . [D]ebtor in this case is an airline pilot who travels for a profession. . . . [T]he IRS has failed to prove that the debtor filed his petition solely to avoid payment of his tax obligation. . . . Debtor’s plan fully discloses that he mistakenly made payments to two creditors outside the plan. The Court finds that the debtor did not attempt to conceal this information and that the other creditors have not been prejudiced by debtor’s inadvertence. . . . Although this Court agrees that support of an adult child is not a legal obligation, in this case, the debtor’s creditors are not in any way harmed by debtor’s claimed expenses related to his dependent child.”).
6 162 B.R. 581 (Bankr. M.D. Fla. 1993).
7 162 B.R. at 582–83.