As part of an ongoing trend, revenue-strapped Lawrenceville announced that it would seize income tax returns to satisfy delinquent accounts.
Under the Tax Return Intercept Program, participating local governments essentially place a lien on certain tax returns. Taxpayers in these situations should receive a notice letter that gives them thirty days to successfully challenge the lien or resolve the debt. If the City of Lawrenceville, or any other government unit, executes on the lien, the taxpayer has thirty days to file a dispute in Atlanta with the state.
Successful grounds for a dispute are basically limited to misidentification of the debtor or successful account resolution.
Tax Revenue in Georgia
For the most part, the Peachtree State has recovered nicely from the effects of the recent recession. People are working and tax revenue is up.
But, the news is not all good. Some are concerned that although the state is in the black at the moment, it may be unable to handle future growth. As a result, some advocates support drastic measures to create new revenue streams. Moreover, Georgia is particularly notorious for holding onto tax refund checks until the last minute and delaying them whenever possible in the name of “fraud investigations,” so the state gets an extra few dollars in interest revenue.
Discharging Taxes in Bankruptcy
Against that backdrop, although it is possible to discharge both state and federal taxes in Chapter 7 or Chapter 13 bankruptcy, very strict rules apply. Moreover, if the federal IRS or state Department of Revenue contests the discharge, the taxing authority need only prevail by a preponderance of the evidence, which means “more likely than not.”
The rules for discharge are very well-established:
- Income Tax: Payroll, property, excise, and anything other than income taxes are not dischargeable under any circumstances. The Bankruptcy Code does not really define “tax” or “income tax,” so to prevent discharge, the taxing authority only needs a reasonably compelling reason to classify the tax as something other than income tax, because of the low standard of proof.
- No Fraud: Courts have consistently ruled that fraud is not a matter of intent but rather a matter of mathematics. Instead of an evil or impure motive,theIRS/DOR must only show “badges of fraud,” such as:
- Failure to keep records,
- Large income understatements,
- Failure to cooperate, and
- Inconsistent behavior.
Bear in mind that the standard is more likely than not, so if Tom Taxpayer fails to return a couple of phone calls, the IRS/DOR could deem such behavior as failure to cooperate, and a bankruptcy judge might very well agree.
- No Willful Evasion: A willful failure to pay taxes is intent-based, because it basically involves an acknowledgement that the tax is due but a refusal to pay it. Therefore, taxpayers who file their returns on time and ignore collections notices while they wait for the clock to tick down may be ineligible for discharge.
- Three/Two/240 Rule: The income taxes must be at least three years old (g. 2012 taxes were due on April 15, 2013 and thus became dischargeable on April 15, 2016), the returns must have been on file for at least two years (substitute returns normally do not count), and the tax must not have been assessed in the last 240 days (i.e. the taxpayer has not received a letter in the last nine months). The time rules are extremely strict, and bankruptcy courts have been known to deny discharge based on an event that occurred one or days too early or too late.
Penalties and interest are generally dischargeable as well, if they are related to an income tax debt that’s discharged and they are at least three years old.
Effect of Discharge
Although a debt is legally forgiven, the direct effects sometimes remain. Assume David Debtor has an unpaid tuition bill from good ol’ State U. If David files bankruptcy, the school cannot attempt to collect the debt and the debt is probably dischargeable, but State U. may still have the right to withhold David’s transcript until the account is paid or otherwise resolved.
The same rule applies to taxing authorities. If the IRS/DOR obtained a lien against unpaid income tax, bankruptcy forgives the debt but does not release the lien. Similarly, the automatic stay does not stop all tax collection proceedings. For example, if David filed bankruptcy in Georgia and owed income taxes to the DOR, that agency could still:
- Offset his tax refund,
- Audit him,
- Assess unpaid taxes and demand payment,
- Issue a notice of delinquency, and
- Demand his tax returns.
The automatic stay has no effect whatsoever if the taxing authority does not receive the proper notice at the proper address.
What About Tax Refunds?
Procedures vary by jurisdiction, but most trustees send letters to all debtors in bankruptcy in the late spring of each year demanding their tax returns for the current year. If the debtor expects an income tax refund from the previous year, such a windfall is typically property of the bankruptcy estate.
Some debtors can amend their petitions and exempt the anticipated refund, or at least a portion of it, using the wild-card exemption, but that is not an option in all cases. Moreover, some of the traditional arguments for keeping cash – like mootness and floating check – are not as effective when dealing with sudden windfalls. Nevertheless, motions for turnover are a labor-intensive process that most trustees want to avoid if possible.
So, most trustees use a cutoff. If the anticipated refund is less than about $1,000, the trustee will normally take no action. Substantially larger refunds may draw adverse action, but the trustee is nearly always willing to accept a portion of the refund as opposed to the whole amount.