Determining When State Income Taxes Are Dischargeable Under Chapter 13

Let's say you file a Chapter 13 bankruptcy petition in a given year. You state in your petition that you owe state income taxes for the previous year and give an estimate of that amount. The bankruptcy court confirms your plan. You then file your state income tax return, showing you owe even more than you stated in the plan, and you don't pay the taxes. You successfully complete the plan over the next few years. The bankruptcy court issues a discharge order, declaring you free of all debts under the plan. Everything seems fine: you're ready to put your troubled financial past behind you and move on with your new life. But then you get a bill in the mail for the unpaid income taxes from the year before you filed your petition. Do you have to pay them?

The Ninth Circuit recently faced this question in Joye v. Franchise Tax Board, and it said "no.- In that case, California residents Shelli and Teresa Joye filed a Chapter 13 petition in March 2001. The Joyes listed an estimated debt of $10,000 in state income taxes for the year 2000. They had not yet filed their state income tax return, and they got an extension to file it late. The Franchise Tax Board of California (FTB) did not file a proof of claim for the taxes. The bankruptcy court approved the Joyes' plan. Five months later, the Joyes filed their state income tax return, which showed they actually owed more than $28,000. Over the next few years, the Joyes made payments on the plan and successfully completed it in February 2004. The next month, the bankruptcy court issued the discharge order.

But then the FTB sent the Joyes a bill for the year 2000 unpaid taxes. The Joyes went back to the bankruptcy court, arguing that the FTB was in violation of the discharge order. The court agreed: it found the taxes had been properly discharged under the plan. The FTB appealed to the district court. That court also found the taxes had been discharged, but ultimately ruled in favor of the FTB. It found that prohibiting the FTB from collecting the debt would be fundamentally unfair because the state relies on the taxpayer to determine the taxes due and the Joyes did not file their return until after the period to file a proof of claim had elapsed.

It was the Joyes' turn to appeal now, and they brought their case to the Ninth Circuit. The Joyes got the answer they wanted: the court ruled they did not have to pay the $28,000. The key to this decision was the court's finding that the taxes did not qualify as a "post-petition- claim protected from discharge. The Bankruptcy Code allows a governmental entity to file a post-petition claim "for taxes that become payable to a governmental unit while the case is pending.- So, if the taxes became "payable- during the pendency of the case, the Joyes were on the hook. But they did not, according to the Ninth Circuit.

The court reasoned that Chapter 13 of the Bankruptcy Code is generally concerned with satisfying or discharging "claims- against a debtor. The Code defines "claim- broadly to include any right to payment, whether or not the right has actually matured or become enforceable by the time the petition is filed. Thus, the term "payable- in the context of such claims is broad enough to "refer[] to a time before the creditor's right to payment matures into a legally enforceable prerogative.- In other words, it is enough that the claim "is capable of being paid- before the petition is filed. If it is, the claim is considered a debt that was incurred before the petition was filed and is thus included among the debts subject to discharge at the end of the plan.

The taxes the Joyes owed from the year 2000 were technically "payable- -“ that is, "capable of being paid- -“ any time after the last calendar day of that year. Regardless of when they filed the income tax return or when the taxes were actually due, the Joyes could have determined and paid the taxes as early as January 1, 2001. Because this was before the Joyes filed their petition, the debt was a pre-petition debt subject to discharge at the end of the plan.

The Ninth Circuit rejected the FTB's argument that the taxes were "payable- on the date they were actually due. In doing so, the court noted there was a split in the federal circuits here. The Tenth Circuit has applied a similar interpretation of "payable- in resolving this issue, but the Fifth Circuit has held such taxes are "payable- when they "must be paid- -“ i.e., when they are actually due. In the Joyes' case, that was months after they filed their petition.

The Ninth Circuit quickly dismissed the FTB's alternative argument that it was denied adequate notice since the Joyes' tax liability was undetermined until they filed their return. The court found the FTB received adequate notice through the bankruptcy court's official notice of the petition, which informed the FTB of the deadline by which to file a claim for unpaid taxes.

So now the Joyes can rest easy in the knowledge that they can scrap the $28,000 tax bill from the state of California. This is also good news for other debtors living in the Western and mid-Western states (the states within the geographical areas subject to the jurisdiction of the Ninth and Tenth Circuits) who enter a Chapter 13 case with state income tax liability from the previous year. But this issue will surely resurface again. As more circuits weigh in on the question of when such tax claims become "payable,- the Supreme Court may have to step in to resolve it once and for all.

From: The Law Offices of John T. Orcutt, with convenient office locations in Raleigh Durham, Fayetteville, and Wilson. Call (toll free) +1-833-627-0115, to set up a free, confidential debt consultation. Visit www.billsbills.com for more information.