Non-Dischargeable Debts

A disadvantage to bankruptcy may be that it will not discharge the debts which are causing a client the most amount of problems. If a significant portion of a client’s debt involves a non-dischargeable debt such as recent income taxes, employment taxes, student loans or support, it may not be a good idea to file bankruptcy at all in that a majority of the debt will survive the bankruptcy proceeding. Before every case is filed, a thorough analysis of these types of debts should occur.

A. PUBLIC POLICY

The Bankruptcy Code recognizes that, for public policy reasons, certain debts should be excepted from discharge. A good, but not exclusive, list is contained in 11 USC § 523(a). Some of the more common non-dischargeable debts are listed below.

B. TYPES OF POTENTIALLY NONDISCHARGABLE DEBTS

1. Taxes

• Income taxes:

  i).Generally. Income taxes, both federal and state, are non-dischargeable unless each of the following elements exist:

  • 3 Years – The tax year in question is more than three years before the filing of the Bankruptcy Petition [11 U.S.C. §507(a)(7)(A)].
  • Note that more than three years must have elapsed from the date that the return was first due (usually April 15 of the following year) plus any time an extension to file was in effect. [See In re Wood,886 F 2d. 1367 (11th Cir. 1989)].
  • Note that the debtor may not dismiss a Chapter 7 Bankruptcy that was filed prematurely. Consequently, the debtor will lose the opportunity to discharge taxes unless the time provisions are calculated correctly. [In re Leach, 130 B.R. 855 (BAP 9th Cir.1992)].
  • 2 Years – The tax return must have been filed more than two years preceding the filing of the Bankruptcy [11 U.S.C. §523(a)(1)(B)]. A debtor is unable to discharge taxes if the debtor failed to file a return.
  • 240 Days – The tax in question was assessed more than 240 days prior to the bankruptcy filing. [11 U.S.C. §507(a)(7)(A)]
  • This usually applies in audit situations.
  • Any time plus 30 days in which an offer in compromise is in effect is deducted from the 240-day period.
  • Time period extended for State tax – In re King 961 F.2d 1423;
  • 1992 essentially extended this period by 60 days for taxes due the Franchise Tax Board. California law holds that the tax assessment is not “final” unit 60 days after the assessment; thus, the 240-day period does not begin to run until that time.
  • A tax may be non-dischargeable if the taxes are still assessable at the time the Bankruptcy Petition is filed (even though the return was filed two years before.) Also, an assessment by the Internal Revenue Service causes a debtor under state law to be required to file an amendment with the state. The amendment may be considered a return which would preclude the discharge of the state taxes for two years after the filing of the amendment. The state taxes could not be discharged unless the amendment was filed.
  • No Fraud – There must be no fraud, or allegation of fraud. A discharge is not allowed for a tax “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or to defeat such tax.” 11 U.S.C. §523(a)(1)(C)].
  • Note that a Chapter 13 Bankruptcy might be considered in an effort to discharge taxes where there is a fraud situation. A Chapter 13 Bankruptcy might also be successful where the tax return was filed within the last two years. The “super-discharge” provisions contained in 11 U.S.C. §1328(c) provide that a Chapter 13 discharge even eliminates taxes which fall within these non-dischargable criteria!
  • Unsecured – The tax must be unsecured. To the extent that the government possesses a valid lien upon property owned by bankrupts prior to filing of their Bankruptcy Petition, the Internal Revenue Service could seek to collect the underlying unpaid tax liabilities, notwithstanding their discharge in the bankruptcy.
  • In re Verran, 623 F. 2d 477 (1980); In re Isom, 95 B.R. 148 (9th Cir.1988), 901 F. 2d 744 (9th Cir. 1990). The underlying tax is discharged but the lien is not to the extent it has attached to any property of the debtor. The tax is considered in rem. Only the property owned by the debtor on the date of filing is subject to the lien. The lien is not valid against after-acquired property. See In re Braund, 289 F. Supp. 604 (9th Cir. C.D.C. 1968). But the tax lien is superior to a claim of homestead and the lien cannot be cut off under 11 U.S.C. §522(f).

  ii). Penalties: Penalties relating to income taxes are “compensation for actual pecuniary loss” and are dealt with in 11 U.S.C. §507(a)(7)(G). In essence, if the penalty is related to a tax which will discharge, the penalty will discharge. If the underlying or related tax will discharge, so will the penalty.

  iii). Interest: There is no provision in the Code specifically relating to the dischargeability of interest. However, the courts have generally held that it is dischargeable to the same extent as the tax to which it relates.

  See In re H.G.D. & J. Mining Co., 74 B.R. 122 (S.D. M.D. Penn 1986); In re Healis, 49 B.R. 939 (Bankr. S.D.N.Y. 1985); In re Elmer Eugene Palmer, 88 B.R. 101 (N.D. Tex. 1988).

• Employment taxes:
  989. Trust Fund Taxes. Trust fund taxes are never dischargeable. “Trust fund” taxes include “income taxes which an employer is required to withhold from the pay of his or her employees, the employees’ shares of social security and railroad retirement taxes, and also federal unemployment insurance. This category also covers the liability of a responsible corporate officer under the Internal Revenue Code for income taxes or for the employees’ share of employment taxes which, under the tax law, the employer was required to withhold from the wages of employees. This category also includes excise taxes which a seller of goods and services is required to collect from a buyer and pay over to a taxing authority.” Senate Report No. 95-989.
  990. Employer’s taxes. “Employment tax” is the employer’s contribution required to be paid in addition to the amount withheld from the employee’s paycheck. An employment tax on wages, salary, or commission earned before the petition was filed is non-dischargeable provided the date the last return was due, including extensions, is within three years before the filing date.
• Excise taxes:

  “Excise taxes” include sales taxes (in some states), estate and gift taxes, gasoline taxes, and other federal, state, or local taxes defined by statute as excise taxes. To be non-dischargeable, the transaction giving rise to the tax must have occurred more than three years before the filing of the petition. If a return needs to be filed, three years must have elapsed since the return was due, including any extensions. [ 11 USC § 507(8)(E)]

• Sales taxes:

  The Bankruptcy Code does not specifically address the dischargeability of sales taxes. Rather, it discusses income taxes, trust fund taxes, employers taxes, excise and property taxes. The question then becomes into which category sales tax belongs. In Washington, Texas, Alabama, Oklahoma and Tennessee, their state law imposes a tax on the customer or buyer, to be collected by the retailer and forwarded to the taxing entity. Accordingly, these taxes have been held to be non-dischargeable trust fund taxes (11 U.S.C §507(a)(8)(c)). However, in states such as California and Hawaii, excise taxes are imposed on the retailer for the privilege of doing business. Thus, sales tax in these states appears to more of an excise tax and are dischargeable under 11 U.S.C.507(a)(8)(E) if the conditions of that section are met (more than three years has elapsed from the filing of the return, or if no return is necessary, three years from the date of transaction giving rise to the tax). In at least one California state court case, the California sales tax was held to as an excise tax. In Livingston Rock and Gravel Co. v. De Salvo 136 Cal App 2d. 156, 288 P. 2d 317 (1955) the state court found that the sales tax under California law is an excise and privilege tax levied on the retailer for the privilege of selling tangible property. No Bankruptcy Court has specifically ruled on this issue. However, the Bankruptcy Appellate Panel, In re George, 95 B.R. 718 (9th Cir. BAP 1989), indicated in a footnote that the sales tax may very well be an excise tax. The court did not specifically rule on this issue as it did not seem to be relevant to the specific issue before the court. Further, the Bankruptcy Appellate Panel in In re Raiman 172 B.R. 933 (9th Cir. BAP 1994) held that the California sales tax was akin to a personal income tax. Accordingly, in order to render a sales tax non-dischargeable, it may very well be that all of the requirements to discharge a personal income tax under 11 U.S.C. §508(8)(a) need to met as well (more than three years old and assessed more than 240 days previous to the bankruptcy).

• Property taxes: Property taxes assessed and payable within one year before the petition is filed are non-dischargeable. [11 U.S.C. §507(7)(B)].

2. Alimony and Support Obligations [11 U.S.C. §523(a)(5)]. This does not include obligations to divide community property unless the obligation is designated for or deemed in the nature of support.

3. Fraud [11 U.S.C. §523(a)(2)]
   • Presumptive Fraud – 11 USC § 523(a)(2)(C) provides that if a debtor has consumer debts owing to a single creditor and aggregating more than $1,075. for “luxury goods or services” incurred by an individual debtor on or within 60 days from the date that he bankruptcy is filed, or cash advances totaling more than $ 1,075. that are extensions of consumer credit under an open end credit plan within 60 days before the filing of the bankruptcy, are presumed to be non-dischargeable. “Luxury goods and services” do not include goods or services reasonably acquired for the support or maintenance of the debtor.
   • Fraud – Other types of fraud, as described in 11 U.S.C. §523, can cause a debt to be held non-dischargeable. This includes not only debts obtained by “false pretenses, a false representation, or actual fraud.” The Code also specifically excepts from discharge debts incurred through the use of a false financial statement. The burden of proof on a creditor has changed from “clear and convincing” (the common law burden of proof for fraud) to “a preponderance of the evidence.” [See Grogan v. Garner, 498 U.S.C. 279 (1991)].
   • Credit Card Fraud – The use of credit cards at a time when the debtor knows, or should have known, that he or she could not repay the debt can cause the court to deem the debt to have been fraudulently incurred. In In re Eashai, 87 F.3d 1082 (9th Cir.1996) the Court referred to the “totality of the circumstances” theory to determine credit card fraud. This includes a review of various factors and/or badges of fraud as indicators to determine if such fraudulent intent existed. Those factors are as follows: 1.) the length of time between the charges made and the filing of the bankruptcy; 2.) whether or not an attorney has been consulted concerning the filing of bankruptcy before the charges were made; 3.) the number of charges made; 4.) the amount of the charges; 5.) the financial condition of the debtor at the time the charges were made; 6.) whether the charges were above the credit limit of the account; 7.) whether the debtor made multiple charges on the same day; 8.) whether or not the debtor was employed; 9.) the debtor’s prospects for employment; 10.) the financial sophistication of the debtor; 11.) whether there was a sudden change in the debtor’s buying habits; and 12.) whether the purchases were made for luxuries or necessities.

     PRACTICE TIP: If a client has recent credit card use, review their monthly statements. If there appears to be a problem, advise the client to hold off filing for a while or consider a Chapter 13 filing. Allowing more time to elapse between the time a debt was incurred and the filing of a petition can substantially reduce the chances of a creditor’s claim of fraud under 11 USC § 523(a). This is especially true if payments on account are made in the interim. In the alternative, a successful Chapter 13 plan will eliminate these types of debts as the debtor receives the “super-discharge” contained in11 USC Section 1328.

4. Violation of Fiduciary Duty [11 U.S.C. §523(a)(4)] Debts arising from fraud while acting in a fiduciary duty can be held non-dischargeable. This includes embezzlement or larceny.

5. Intentional Acts/Willful Torts [11 U.S.C. §523(a)(6)] damages arising from intentional or willful acts can be held non-dischargeable.

6. Fines, Penalties, and Forfeitures [11 U.S.C. §523(a)(7)] Fines, penalties, and forfeitures payable to a governmental unit are non-dischargeable.

7. Student Loans [11 U.S.C. §523(a)(8)]
   • In October 1998, then President Clinton signed the Higher Education Amendments Act of 1998. It provides that all student loans, regardless of age, are forever non-dischargeable. This replaces the seven-year requirement which had been in effect for many years.
   • Student loans can discharge if they will impose an undue hardship on the debtor or the debtor’s dependents. In 1999, the Ninth Circuit adopted a more formal test to determine whether a student loan could be discharged due to undue hardship. In re Pena, 207 B.R. 919, (9th Cir. BAP (1997) held that a debtor must show: (1)

     that they cannot maintain, based on current income and expenses, a minimal standard of living for them and their dependents if forced to pay the loans, (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment of the student loan, and (3) that they have made a good faith effort to repay the loans.

8. Drunk-Driving Awards [11 U.S.C. §523(a)(9)] Debts arising from death or personal injury caused by the debtor’s operation of a motor vehicle while intoxicated can be held non-dischargeable.

9. A debt that was or could have been listed in a prior bankruptcy proceeding where the debtor waived or was denied a discharge. [11 U.S.C.§523(a)(10)].

10. A payment of an order of restitution issued under title 18, United States Code. [11U.S.C.§523(a)(13)].

11. A debt that was incurred to pay a non-dischargeable tax. [11 U.S.C.§523(a)(14)].

12. Debts incurred in connection with a divorce or separation. Debts incurred in connection with a divorce or separation can be held non-dischargeable [11U.S.C.§523(a)(15)]. However, there are two defenses to the court declaring that this debt is non-dischargeable: (1)The debtor does not have the ability to pay such debt from income or property of the debtor, or (2) discharging the debt would result in a benefit to the debtor that outweighs the detrimental consequences to the spouse or child. [11U.S.C.§523(a)(15)(A)(B)]

C. PROCEDURE

The debts generally listed in 11 U.S.C.§523 will not discharge in a bankruptcy. However, it is critical to note that debts listed under 11 U.S.C.§523(a) (2) Fraud, (4) breach of fiduciary duty, (6) embezzlement and (15) community property obligations, will discharge unless a complaint for non-dischargability is filed before the date set by the Court (usually approximately

60 days after the first meeting of creditors.) If a complaint is not filed, these debts will automatically be discharged in the bankruptcy proceeding.

PRACTICE TIP: In the initial client interview, ask every client about the most common non- dischargeable debts: taxes, student loans, and fraud issues. mark in your notes that these issues were discussed. This is done for several reasons. First, these issues will many times greatly affect your analysis of the situation and your resulting advice. Second, your notes can protect you from claims from unhappy clients that these issues were never discussed.

PRACTICE TIP: Every client should be asked to review a list of non-dischargeable debts as well as reasons why a discharge can be denied. It is almost impossible to go over each of these issues individually with a client. However, if they are asked to review a simply worded list and required to disclose and discuss any potential problem issues with you, they are then put on notice and are aware that this type of issue could arise. Many attorneys even ask that a client sign a letter indicating that they have read this list and had their questions answered. Many times, this causes issues regarding these types of problems to arise before the bankruptcy filing. Further, it protects an attorney from a claim by a client that they were not informed of these potentially problem debts.