Three major areas of nondischargeable taxes frequently overlooked when initially interviewing clients regarding bankruptcy are the failure to file returns [11 USC § 523(a)(1)(B)(i)], fraudulent return and a willful attempt to evade or defeat taxes [11 USC § 523(a)(1)(C)].

In obtaining background information, nearly every attorney checks to see when taxes were assessed to determine applicability of the 240-day rule. However, just because a tax has been assessed for a particular taxable year does not necessarily mean that the taxpayer filed a return. The Internal Revenue Service could have prepared a "dummy" return for the taxpayer to facilitate processing of proposed assessments after the Service had determined the taxpayer's income from sources other than a taxpayer filed return [26 USC § 6020(b)]. Not infrequently tax, as well as bankruptcy, practitioners ask the question "if the IRS has filed a return on the taxpayers behalf more than 2 years ago, is the tax dischargeable"? Unfortunately for the taxpayer client, the answer is NO.

Every reported decision addressing the issue has held that a "forced filing" by the Internal Revenue Service does not constitute a filed return sufficient to permit discharge under 523(a)(1)(B). [In re Chastang, 116 BR 833 (Bkrtcy.M.D.Fla. 1990); In re D'Avanza, 101 BR 787 (Bkrtcy.M.D.Fla. 1989); In re Hofmann, 76 BR 764 (Bkrtcy.S.D.Fla. 1987) - fact assessment was more than 13 years previously for tax year more than 18 years ago held to be irrelevant; Matter of Crawford, 115 BR 381 (Bkrtcy.N.D.Ga. 1990); In re Pruitt, 107 BR 764 (Bkrtcy.D.Wyo. 1989)]. This holding has also been extended to state taxing authorities. [In re Haywood, 62 BR 482 (Bkrtcy.N.D.Ill. 1986)] Yet, it has been held that where a taxpayer signs a form "Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment," unaccompanied by schedules, constitutes the equivalent of filing a return by the taxpayer if the Service has already prepared a summary of the taxes due and owing and debtor confirms those assessments of tax liability were correct. [Matter of Carapella, 84 BR 779 (Bkrtcy.M.D.Fla. 1988); cf. 26 USC § 2060(a); In re Haywood, supra]

The second frequently overlooked area is the fraudulent return. Initially, the practitioner should review the taxpayer's assessment record to determine if a civil fraud penalty has been imposed; if so, the issue of nondischargeability under 523(a)(1)(C) will unquestionably become an issue.

However, absence of a civil fraud penalty does not necessarily render otherwise nondischargeable taxes dischargeable, irrespective of whether or not the assessment is the result of an audit. Interpreted in light of 11 USC § 102(5), 523(a)(1)(C) must be read in the disjunctive. Thus, even if the returns are not fraudulent in and of themselves, if the taxpayer's conduct constitutes a willful attempt to defeat or evade taxes, the third part of the trilogy is brought into play and the taxes nondischargeable. [In re Gilder, 122 BR 593 (Bkrtcy.M.D.Fla. 1990); In re Fernandez, 112 BR 888 (Bkrtcy.N.D.Ohio 1990)]

There are few decisions of the bankruptcy courts construing the willful evasion element of 523(a)(1)(C). In addition, the distinction between willful evasion and fraud in the context of the Internal Revenue Code becomes somewhat blurred. This stems in part from the difference between the civil penalty for tax fraud [IRC § 6653(b)] (there being no specific civil penalty for tax evasion) and the distinctly different and separate treatment given to criminal tax evasion [IRC § 7201 - $100,000 fine and 5 years imprisonment] and tax fraud [IRC § 7207 - $10,000 fine and 1 year imprisonment].

The Tax Court has historically treated the civil tax fraud penalty of IRC § 6653(b) as including a specific intent to evade a tax believed to be owing [Habersham-Bey v. Commissioner, 78 T.C. 304 (1982)]. At least one bankruptcy court has held that the precedents construing IRC § 6653(b) provide persuasive guidance for construing the "willful evasion" element of 523(a)(1)(C) [In re Gilder, 122 BR 593 (Bkrtcy.M.D.Fla. 1990); see also In re Carapella, 105 BR 86 (Bkrtcy.M.D.Fla. 1990); In re Kirk, 98 BR 51 (Bkrtcy.M.D.Fla. 1989)].

One interesting argument that has arisen in this arena is whether a willful attempt to evade payment falls within the nondischargeability ambit of the "willful evasion" element of 523(a)(1)(C). Surprisingly, there is a split of authority on this issue.

In In re Gathwright [102 BR 211 (Bkrtcy.D.Ore. 1989)], the bankruptcy court, comparing 523(a)(1)(C) with IRC § 7201, held that, while 7201 specifically proscribed willful attempts to evade payment, 523(a)(1)(C) did not. Thus, the Gathwright court reasoned, in the absence of any indication that Congress intended different meanings for the phrases in the different codes, evidence of a willful attempt to evade or defeat payment was irrelevant to a determination of nondischargeability under 523(a)(1)(C).

In In re Jones [116 BR 810 (D.Kan. 1990)], the district court rejected Gathwright holding that a willful attempt to evade payment rendered a tax nondischargeable under 523(a)(1)(C). In rejecting the Gathwright approach, Jones cited several bases. (1) The language "in any manner" was sufficiently broad to include attempts to evade payment. (2) Misgivings about using a criminal statute to interpret a civil statute, even though exceptions to discharge are to be strictly construed in favor of the debtor. (3) Would render the language superfluous because, without including an attempt to defeat collection, it was hard for the court to conceive how a debtor could willfully attempt to evade or defeat a tax without also filing a fraudulent return. (4) Common meaning of the term "evade" with respect to taxes includes "failure to pay." (5) the legislative history of the 1966 amendment to § 17(a)(1) of the Bankruptcy Act which rendered for the first time some tax obligations dischargeable, clearly indicated an intent to provide relief for the financially unfortunate but not to create a tax evasion device.

With respect to this issue, the author must concur with the Jones rationale. What the Gathwright court fails to address is how a "willful attempt to evade payment" does not also constitute a "willful attempt to evade or defeat a tax" It seems to the author to be illogical to assume that Congress, intentionally or unintentionally, intended to discharge tax liability where the debtor has reported the tax as due but "willfully attempted to evade taxes" by taking deliberate and affirmative action to avoid collection. This is true whether through uncooperative or obstructive conduct intended to thwart or mislead the Revenue Officer or an out-and-out concealment of assets [U.S. v. Mollet, 290 F2d 210 (CA2. 1961)].

The following (neither all-inclusive nor exhaustive) is a synopsis of those frequently encountered activities that the courts have found supported the imposition of a civil fraud penalty or a finding of guilt in criminal tax evasion cases. The existence of any of these factors should serve as a "red-flag" alerting the practitioner to the very real probability that the Service may challenge discharge of otherwise dischargeable tax liabilities.

The most common is, of course, omission of income [Conforte v. Commissioner, 74 TC 1160 (1960) rev'd on other issues & appeal dism'd 692 F2d 587 (CA9 1982) stay den. 459 US 1309]. This includes a failure to report personal expenses paid by a corporation [U.S. v. Proner, 405 F.2d 943 (CA2 1969) rev'd on other grounds 395 US 823 (1969)], or a consistent pattern of substantial understatements of income [Lollis v. Commissioner, 595 F2d 1189 (CA9 1979)]. Claiming false deductions [Price v. Commissioner, 88 TC 860 (1987)] or false exemptions [Daniels v. Commissioner, TC Memo 1981-58] may also result in a denial of discharge. Filing a W-4 claiming either excessive exemptions or to be "exempt" [a gambit long popular with Alaskan's] is also indicative of fraud [Habersahm-Bey v. Commissioner, supra].

Yet another area ripe for a nondischargeability finding involves books and records: failure to maintain records [Lollis v. Commissioner, supra]; maintaining a double set of books and records and/or the destruction of records [Spies v. U.S., 317 US 492, 63 SCt 364 (1943)]; or ignoring books and records in preparing one's return [U.S. v Cramer, 447 F2d 210 (CA2 1971) cert. den. 404 US 1024].

Another problem fact situation involves the taxpayer who fails to file returns for several years then files them all at once [frequently because someone from the Service, perhaps a Special Agent from CID, was making inquiries]. The usual excuse is that, because the taxpayer had missed a few years, the taxpayer continues to fail to file for fear of prosecution for past failures to file. This excuse is usually rejected and the pattern of failure to file treated as an indicium of fraud [Lord v. Commissioner, 525 F2d 741 (CA9 1975)].

In defending a nondischargeability action brought by the Service, always bear in mind that the burden is on the Service to establish by a preponderance of the evidence that the elements making the tax debt nondischargeable exist, in particular "willfulness." "Willfulness" does not exist simply because the taxpayer/debtor was negligent, ignorant, careless or even stupid. Moreover, good faith reliance on professional advice or an honest difference of opinion as to the proper application of the tax code is a valid defense [Estate of Spruill, 88 TC 1197 (1987)].

Where there is a substantial tax liability, reliance on the "3-year/2-year/240-day" rule can lead to an unpleasant shock when the Service trundles out 523(a)(1)(B)(i) [the debtor did not file a return] or 523(a)(1)(C) [the debtor filed a fraudulent return or willfully attempted to evade or defeat the tax]. When the client learns that a tax liability the client was told would be discharged is not, in fact, discharged, the ensuing scene in the attorney's office can be best described as something less than pleasant. Although clients detest anyone, even their own attorneys, delving into such areas, it is best to ask the tough questions early or risk being caught flat-footed and embarrassed later. You can bet your bottom dollar that the Service probably knows the answers so you had best be prepared to tackle the issues yourself. Finally, if you are not conversant with tax law, associate or consult with a tax specialist --it may just save not only your client from a massive case of heartburn, but your malpractice carrier as well!

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