Today’s lesson is about how to maximize the discharge of tax liabilities through bankruptcy. It's a lesson on timing. Last year I blogged two cases showing how a bankruptcy tolls both the collection and assessment limitation periods in the Tax Code. See Lesson From The Tax Court: For Whom The Bankruptcy Tolls, TaxProf Blog (July 19, 2021). Today’s lesson is the flip side: we learn how taxpayers who want to discharge old tax liabilities through bankruptcy need to be careful about how the two-year lookback exception to discharge may be tolled by provisions in the Tax Code.
I offer today’s lesson in honor of Bob Pope, who died on April 29th. Bob was one of those remarkable attorneys who could navigate the complex interplay of bankruptcy and tax law. He was one of the founders of the Tax Collections, Bankruptcy and Workouts Committee in the ABA Section of Taxation, along with Paul Asofsky, Fran Sheehy, Ken Weil, and Mark Wallace. He will be missed.
Bob would appreciate today’s lesson. In Robert J. Norberg and Debra L. Norberg v. Commissioner, T. C. Memo 2022-30 (Apr. 5, 2022) (Judge Lauber), the taxpayers filed their 2016 return in February 2019 without paying the tax they reported due. When the IRS started collection, the Norbergs asked for a CDP hearing. When they got to Tax Court in September 2020 they filed a bankruptcy petition, hoping to wipe out the liability. They failed because they mis-timed their bankruptcy petition. An irony is that these taxpayers could have likely gotten their desired discharge if they had ignored the siren song of CDP. Bob could have taught them that. And, if you click below the fold, you too can learn this lesson on how to maximize the discharge of tax liabilities in bankruptcy.
Law: The Basic Rules for Discharging Tax Liabilities in Bankruptcy
Debtors desire discharge of their delinquent tax liabilities. In general, the Bankruptcy Code (BC) is very generous with giving honest but unfortunate debtors significant relief by discharging them from personal liability for a wide array of pre-bankruptcy debts including tax debts. But there are limits. Those are called exceptions to discharge. For more details on the tension behind generosity towards debtors and fairness towards creditors, I recommend reading Grogan v. Garner, 498 U.S. 279 (1991).
The scope of discharge varies, depending on which bankruptcy chapter the debtor has invoked. All debtors, however, are subject to the same set of exceptions to discharge found in BC §523. Specifically as to taxes, BC §523(a)(1) prohibits discharge of three kinds of taxes.
First, BC §523(a)(1)(A) does not permit discharge of taxes “described in BC §507(a)(8).” Those are called “priority taxes” because BC §507 is titled “Priorities” and §507(a)(8) gives the general rules for which tax claims against the debtor get priority over the claims of other creditors. The general rule is that taxes with priority status are also non-dischargeable. Id. One of the main types of taxes that get priority status (and thus gets exempted from discharge) are those taxes for which a return was filed within the three years before the date of the bankruptcy petition.
Second, BC §523(a)(1)(C) does not permit discharge of those taxes that result from a fraudulent return or willful evasion of tax.
Finally, as relevant to today’s lesson, BC §523(a)(1)(B) does not permit discharge of those taxes that were supposed to be reported on a return but the return was either unfiled as of the bankruptcy petition date or was filed within the two year period looking back from the bankruptcy petition date. That’s the two-year lookback rule and today we see how that works.
Law: Tolling The 2-Year Lookback Period
Courts have long recognized that the purpose of the two-year lookback rule in BC §523(a)(1)(B) is very similar to the purpose of the three-year lookback rule for priority status in BC §507(a)(8): to give the IRS time to collect the tax debt. See e.g. In re Greenstein, 95 B.R. 583, 585 (Bankr. N.D. Ill. 1989) (“The effect of the two year limitation period is to allow the taxing authorities a reasonable time to collect the tax or create a lien on assets of the debtor.”)
There has always been a concern that taxpayers would use bankruptcy to try and stave off collection until a tax aged out. The House Judiciary Committee’s report the on the seminal Bankruptcy Reform Act of 1978, Pub.L. 95–598, 92 Stat. 2549, explains that the discharge provisions should give the government adequate time to collect outside of bankruptcy. See H. Rep. No. 95–595, 95th Cong., 2d Sess. at 190 (sorry, I could not find a free link; I used USCAAN). Most of the discussion in that report concerns the §507 rules for giving tax claims priority status, but remember that those rules also affect discharge. In addition, the report also noted how the two-year lookback rule in §523(a)(1)(B) was likewise intended to provide taxing authorities with a reasonable time in which “to pursue delinquent debtors and obtain secured status.” Id.
The leading case on equitable tolling in bankruptcy rests firmly on this idea that the government deserves some minimal time to collect taxes outside of bankruptcy. In Young v. United States, 535 U.S. 43 (2002) the question was whether a prior bankruptcy tolled the three-year priority period in §507(a)(8). The debtors argued that the three-year lookback period was a substantive definition of a priority tax claim. The Supreme Court disagreed. First, it said the lookback period was like a statute of limitations and could be equitably tolled. Second, it said that the lookback period could be tolled “regardless of petitioners' intentions when filing back-to-back Chapter 13 and Chapter 7 petitions—whether the Chapter 13 petition was filed in good faith or solely to run down the lookback period.” Id. at 50. That is, while equitable tolling is often linked to the behavior of the party against whom it is asserted, there may be other reasons for tolling. In bankruptcy, tolling was not limited to punishment for bad behavior by the debtor. No. Tolling was appropriate in Young because “the IRS was disabled from protecting its claim during the pendency of the Chapter 13 petition.” Id. at 50.
Congress reaffirmed this reason for tolling—the need for adequate time to collect outside of bankruptcy—in 2005 when it modified §507(a)(8) to explicitly permit tolling the three-year lookback rule for priority purposes where the government was prohibited from collecting the debt during that time by non-bankruptcy law. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), P.L. 109-8, 119 Stat. 23, added this flush language to the end of the §507(a)(8) priority provision:
“An otherwise applicable time period specified in this paragraph shall be suspended for any period during which a governmental unit is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days....”
Notice this was a modification to the priority provisions in §507(a)(8) and thus only indirectly affected the discharge provisions in §523. However, while Congress made no similar statutory modification to the discharge provisions over in §523, some courts have applied the same rationale to equitably toll the two-year lookback period in §523(a)(1)(B) (without the 90 additional days). See e.g. In Re Putnam, 503 B.R. 656 (Bankr. E.D.N.C. 2014) (permitting the two-year lookback period to be equitably tolled during the periods where the IRS was barred from collecting because of prior bankruptcy automatic stays).
Given the similarity between the purpose of the §507 three-year lookback period and the purpose of the §523—to give the government a minimum time to act on its tax claim outside of bankruptcy—it makes sense to arrive at a similar result: just as a debtor should not be rewarded with a bankruptcy discharge when they use multiple bankruptcy filings to bar collection during the three-year lookback period (even assuming good faith), so should a debtor not be rewarded with a bankruptcy discharge when, by exercising their rights under the Tax Code, they bar collection during the two-year lookback period.
At least I sure would not want to so advise my clients, especially when there is a better way that significantly decreases any potential equitable tolling argument by the government.
Let’s see what we learn from this case.
Mr. and Mrs. Norberg filed their 2016 return on February 11, 2019 but did not fully pay the reported liability. They owed about $9,000 including some $4,000 in penalties for failure to file and failure to pay under §6651. The IRS collection machine went into action and in September 30, 2019 sent them a levy CDP notice. They timely requested and received a CDP hearing asking for CNC status. (That was their first mistake.) They provided all the requested financial information. It was not enough to get them into CNC. The Settlement Officer (SO) decided that the Norbergs could actually pay $62 per month and offered a Partial Pay Installment Agreement. Under the basic rules of PPIAs they would pay the $62 per month and the IRS would reassess their ability to pay every two years. See IRM 126.96.36.199.1. The Norbergs refused the PPIA. That was their second mistake.
Rather than taking the PPIA the Norbergs decided to spend their money differently. After receiving their Ticket to the Tax Court in the form of a September 30, 2020 Notice of Determination, they filed a petition (they paid the filing fee). Apparently they had the money to do that. Then, in October 2020, they filed a Chapter 7 bankruptcy. That was their third, and biggest mistake.
The bankruptcy filing automatically stayed the the Tax Court case pending resolution of the bankruptcy petition. BC §362(a)(8). Once the Norbergs received their bankruptcy discharge, the Tax Court resumed consideration of their CDP case in November 2021.
Some readers may not know that a bankruptcy discharge order does not specify what particular debts are discharged. Nope. The order is just a really short statement to the effect that “Congratulations! You are now free of all the debts that have been discharged!” Debtors and creditors are left to their own devices to figure out which debts are covered and which are not. Later disagreements must resolved in court, often in the bankruptcy court that granted the discharge.
In this case, the IRS agreed that the penalties for failure to file and failure to pay were discharged (because they were not taxes for bankruptcy discharge purposes). But the IRS disagreed that the actual 2016 tax liability had been discharged. Fortunately, the parties were already in Tax Court. So that's why we get the lesson from the Tax Court.
The Basic Lesson: The 2-Year Lookback Period Prevents Discharge
Back in Tax Court the Norbergs claimed that their 2016 tax liabilities had been discharged. They focused on the priority provisions in §507. They argued the 2016 liabilities were not priority claims under §507 because their return had been due in April 2017 and they had filed bankruptcy more than three years later. True enough. But they confused priority with discharge. As you learned above, the discharge rules in BC §523 go further than piggybacking on priority tax claims. The rules also prevent the discharge of liabilities reported on a return filed within the two year lookback period. Here, that period ran from October 2020 two years back to October 2018. And the Norbergs had filed their return within that two years, in February 2019.
Well, that takes care of that! They lose on a short and sweet and direct application of the two-year lookback rule.
Variation 1: What if the Norbergs Had Waited To File Bankruptcy?
My first reaction when I read this case was likely the same as many readers: If only the Norbergs had waited until February 12, 2020 to file their bankruptcy! Doing that would certainly have given them a better chance at discharge. Their 2016 return would then not have been filed within the two year lookback period. Why didn't they just wait those 3+ months? They would now win on a short and sweet and direct application of the two-year lookback rule.
Equitable tolling, however, would likely still make them losers. While the text of BC §523(a)(1)(B) admits of no exceptions, remember that courts routinely apply equitable tolling to both this and similar lookback periods in the Bankruptcy Code, and do so for similar reasons: to ensure that the government receives the minimal time period to collect tax liabilities given by Congress. BC §523(a)(1)(B) says that minimum period is two years. When the Norbergs filed their CDP request with the IRS, that triggered a stay of collection of their 2016 liability. §6330(e). That stay continued “for the period during which such hearing, and appeals therein, are pending.” Id. And the Tax Court could enforce the stay by court order if need be. Id. Accordingly, it would be reasonable then for a court to toll the two-year lookback period to account for the time the IRS is prevented from using its primary collection tool, the levy, to enforce the tax laws.
But still, filing the bankruptcy petition before the two-year period had expired was a big mistake.
Variation 2: What if the Norbergs had foregone the CDP Hearing?
My second reaction after reading the case was to wonder why the heck did the Norbergs ask for a CDP hearing and not an Equivalent Hearing? When taxpayers miss catching the CDP butterfly, the IRS will still give them an opportunity to work out collection alternatives with Appeals in an Equivalent Hearing. IRM 188.8.131.52 (08-26-2020). And that can take almost as long. While the IRS is not statutorily prohibited from collecting, it suspends collection as a matter of course. Id. Thus, per the reasoning in In Re Young, supra, courts are highly unlikely to equitably toll the bankruptcy lookback periods. 535 U.S. at 53 (“tolling is inappropriate when a claimant has voluntarily chosen not to protect his rights within the limitations period.”).
Here, for example, if the Norbergs had obtained an Equivalent Hearing, they would not have been able to petition Tax Court. Assuming the Equivalent Hearing took the same amount of time, they would have to tough it out from the Determination Letter (September 30, 2020) until February 12, 2021 when they could safely file their petition.
That would have been the cleanest strategy, It is why I think that going for the CDP hearing was a mistake.
Variation 3: What If the Norbergs Had Taken the PPIA of $62?
My final reaction was to wonder why the Norbergs did not just take the PPIA to end the CDP hearing, and then file bankruptcy after accounting for the time the CDP hearing likely tolled the two-year lookback period. If they were paying the Tax Court filing fee and (presumably) paying the fees for bankruptcy, it sure seems they could get the money to pay $62 a month for the time necessary to run out the BC §523(a)(1)(B) two-year clock, even as tolled by the CDP hearing. The IRS will not collect during the pendency of an installment agreement, but unlike the CDP provisions, it’s the IRS’s voluntary act to enter into a PPIA and so the reasoning from Young makes any equitable tolling far less likely.
As usual, I welcome substantive comments on any aspect of today's Lesson. That is why Paul and I keep the comments open. It may interest readers to know that I regularly receive some bizarre and irrelevant comments from folks who use fake names and emails from which to launch their invective. I don’t publish them. They make me sad. Life is just too short for such nonsense, as Bob's passing reminds us.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law. He invites readers to return each week to TaxProf Blog for another Lesson From The Tax Court.