Rulings that state taxes are nondischargeable in a bankruptcy proceeding have broad ramifications.

In a series of decisions beginning with Schlossberg v. Maryland, 119 F3d 1140 (4th Cir. 1997), and most recently Massachusetts u. Gosselin, DC Mass, 7/31/00, courts have concluded that state taxes are not dischargeable in a bankruptcy proceeding.

Each of these decisions is predicated on an interpretation of Seminole Tribe of Florida v. Florida, 517 US 44 (1996), in which the Supreme Court held that the Eleventh Amendment to the Constitution precluded states from being the subject of lawsuits in a Federal court, unless the state's laws waived immunity.

In Seminole Tribe, the Supreme Court established two requirements for a state to be subject to an adjudication in Federal court: "first, whether Congress has `unequivocally expressed' its intent to abrogate the immunity ... and second, whether Congress has acted pursuant to a valid exercise of power."

Statutory Tests for Dischargeability

The Bankruptcy Code provides that income taxes are dischargeable if three tests are met:

1. Under 11 USC Section 507 (a) (8) (A)(i), a return (whether or not filed) must have a filing date (including extensions) three years before the filing of a bankruptcy petition.

2. Under 11 USC Section 507 (a) (8) (A) (ii) , the tax to be discharged must not have been assessed within 240 days before the bankruptcy petition's filing date. Note: when an offer-in-compromise is made within the 240-day period, the statute tolls from the time the offer is pending, plus an additional 30 days.

3. Under 11 USC Section 523 (a)(1)(B) (in conjunction with 11 USC Section 523(a)(8)), the tax to be discharged must relate to a return filed after the date on which it was last due, under applicable law or under any extension, and two years before the date of the filing of the petition. Note: there is a growing body of law on nondischargeability of taxes for sequential nonfilers.

These provisions were intended to address both state and Federal tax delinquencies (the dischargeability of Federal taxes is unaffected by the courts' holdings).

Section 106 of the Bankruptcy Code is entitled "Waiver of Sovereign Immunity." However, while Congress intended Section 106 to provide for the discharge of state taxes, the courts have ruled (with one exception) that Congress did not have the authority to enact legislation that affected state taxes.

Ramifications

Historically, due to either local practice or the primacy of Federal law, the IRS has often been considered as a creditor of utmost importance. While the Service's legal standing on collection of past due taxes has not changed, the effect of these recent decisions will assuredly affect taxpayers' and their advisers' actions.

The greatest impact will occur when financial circumstances require choosing between a payment of dischargeable Federal income taxes and nondischargeable taxes (including trustee taxes and state income taxes). When a business will continue operating, a taxpayer may make choices that will leave Federal income taxes unpaid.

Further, for taxpayers considering installment payment agreements with the IRS and a state taxing authority, they should consider entering into an agreement with the state before finalizing an agreement with the Service.

Possible Strategies for Resolving Outstanding State Taxes

Many states have adopted programs similar to the IRS's offer-in-compromise program, which provides the opportunity to address state tax delinquencies. As established government policies, these programs provide a basis for financially troubled taxpayers to request the assistance of the bankruptcy court in resolving a state tax issue. Section 525(a) of the bankruptcy code makes it unlawful to "revoke, suspend or refuse to renew a license, permit, charter, franchise or other similar grant, to condition such a grant, to discriminate with respect to such a grant against, to deny employment to, or terminate the employment of an individual solely on the basis that such individual has filed bankruptcy."

If a taxpayer has filed for bankruptcy (particularly under Chapter 11 or 13), it can bring a court action to request that the state government consider the taxpayer's settlement offer.

This request would appear to qualify for an exemption from the immunity from suit provided to the states by Seminole Tribe. In Ex parte Young, 209 US 123 (1908), the Supreme Court ruled that "an individual may obtain injunctive relief in order to remedy a state officer's ongoing violation of federal law."

Accordingly, for taxpayers with. nondischargeable state taxes who qualify for the state equivalent of the Service's offer-in-compromise, it would appear that bankruptcy counsel can request that a court order the state to treat the bankrupt taxpayer in a manner consistent with its established policies.

Support for the position that a state government can be ordered to consider a bankrupt taxpayer for an offer-in-compromise is provided by two cases adjudicated in the Bankruptcy Court in West Virginia. In both these cases, the court held that the IRS's policy of refusing to consider offers from debtors in bankruptcy proceedings violated Bankruptcy Code provisions prohibiting discrimination against persons who have filed bankruptcy; see Mills and Chapman (6/23/99).

While this litigation procedure can be avoided if states fairly comply with their settlement procedures, financially troubled taxpayers may wish to avail themselves of the opportunity for judicial consideration of a state's actions in dealing with their financial issues.

Additionally, Section 362 of the Bankruptcy Code provides for an automatic stay on "any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate."

While the courts disagree about the extent that assets (including a debtor's wages) can be protected during a bankruptcy proceeding, if they are protected, a state cannot attempt to collect on them during the proceeding.

In states in which the statute of limitations on the collection of past due taxes is not tolled by the filing of a bankruptcy petition or the pendency of a bankruptcy will impede collection of tax for a substantial time, a state may be motivated to join in the taxpayer's reorganization plan.

Conclusion

Court decisions that hold that state taxes are not dischargeable in a bankruptcy proceeding affect taxpayers and their advisers in their consideration of the most rational method of addressing tax delinquencies. These decisions may require a reconsideration of longstanding thought on addressing tax delinquencies.

FROM TIMOTHY BURKE, CPA, J.D., BURKE AND ASSOCIATES, BRAINTREE, MA

Editor's note: Mr. Ely is former chair of the AICPA Tax Practice and Procedures Committee. Ms. Jacobs and Messrs. Dougherty, Marchbein and Burke are committee members.

Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC