tax return with hundred dollar billsSome time ago I wrote about discharging income taxes in bankruptcy.  I subsequently wrote about discharging income taxes in bankruptcy for a tax year in which the debtor filed a return after the taxing authority ― for simplicity I will generically label the authority as the IRS, though the discussion applies to other taxing authorities ― filed a substitute for return and assessed the tax.

A fellow bankruptcy attorney of the highest caliber, who is also a good friend, read the substitution for return post ― Yippee!  I always love hearing that people are reading the blog ― and drew my attention to a brand new decision of the Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) in the appeal of one of the cases I discussed in substitute for return post.  He suggested that I write a follow up post.  Following the rule always to take requests from the audience (please try the veal piccata, and be sure to tip the wait staff), I offer the following update.

To set the stage for this post I will begin with a précis of the aforementioned (does anyone other than an attorney use the word “aforementioned”?) two previous posts.  If you want more detail, read those two posts.

I.  The Three-Part Tax Dischargeability Test

For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:

1.  (The three-year rule) The tax return for the tax year in question must have been due (including extensions) – but not necessarily actually filed – at least three years before the filing of the bankruptcy papers,

2.  (The two-year rule) The debtor must have actually filed a legitimate, nonfraudulent tax return for that tax year at least two years before the filing of the bankruptcy papers, and

3.  (The 240-day rule) The taxing authority cannot have assessed the tax during the 240 days prior to filing the bankruptcy papers.

The second requirement, the so-called two-year rule, has been the subject of extensive litigation throughout the country, with a wide range of inconsistent outcomes.  It is the afflatus for this post.
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IRS From 1040Some time ago I wrote about discharging income taxes in bankruptcy.  I stated that there is a three-part test for determining their dischargeability, and started with the following executive summary:

For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:

  1. (The three-year rule) The tax return for the tax year in question must have been due (including extensions) – but not necessarily actually filed – at least three years before the filing of the bankruptcy papers,
  2. (The two-year rule) The debtor must have actually filed a legitimate, nonfraudulent tax return for that tax year at least two years before the filing of the bankruptcy papers, and
  3. (The 240-day rule) The taxing authority cannot have assessed the tax during the 240 days prior to filing the bankruptcy papers.

The second requirement, the so-called two-year rule, has been the subject of extensive litigation throughout the country, with a wide range of inconsistent outcomes.  Therefore, I suspect that the Supremes will eventually be asked to consider the matter.

My focus today is on what happens if the taxing authority files something called a substitute for return on behalf of the debtor/taxpayer.  For linguistic simplicity, I will refer to the taxing authority as the IRS, though the discussion applies, mutatis mutandis, if the taxing authority is a state taxing authority such as California’s Franchise Tax Board.
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Chapter 13 bankruptcy has an important limitation.  If the debtor’s debts are too large, Chapter 13 is unavailable:

Only an individual with regular income that owes, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts of less than $383,175 and noncontingent, liquidated, secured debts of less than $1,149,525, or an individual with regular income and such individual’s spouse, except a stockbroker or a commodity broker, that owe, on the date of the filing of the petition, noncontingent, liquidated, unsecured debts that aggregate less than $383,175  and noncontingent, liquidated, secured debts of less than $1,149,525 may be a debtor under chapter 13 of this title.

11 U.S.C. § 109(e).

By the way, the numbers at the Cornell Law School site to which this links haven’t been updated for some time.  I corrected them in the quote above.  The modified quote is correct as of September 2014.

If either debt ceiling — either the secured, or unsecured — is exceeded, the debtor is ineligible for Chapter 13 protection, and must consider Chapter 11 bankruptcy.  This leads to the following question that was posed by a fellow bankruptcy attorney:

Question:

Suppose a debtor has a mortgage — for simplicity let’s say a first mortgage — that is undersecured, i.e., the value of the house is less than the current balance on the mortgage.  Does the unsecured portion of the mortgage count toward the $383,175 unsecured debt ceiling?

My answer was:  It depends on whether or not the house is the debtor’s principal residence.  But it’s a bit more complicated than you might imagine.  Let’s start with the simpler “nonprincipal residence” scenario.
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