Discharging Tax Penalties in Chapter 7 Cases Can Be Complicated

Discharging the penalties on taxes does not perfectly correlate to the discharge of the taxes.  The Bankruptcy Code has a different section dealing with discharging penalties on taxes, and the operation of that section can be more complex than discharging taxes:  Sections 507(a)(8)(A)(i) for discharging taxes versus 523(a)(7) for discharging penalties on taxes.

A case in the Northern District of California Bankruptcy Court has underscored how complex the analysis for discharging tax penalties can get.  In US v. Wilson, Case No. 15-cv-01448-VC  (January 21, 2016) assets were available in the bankruptcy estate to pay the taxes in question, but not for the failure-to-file and failure-to-pay penalties.  After the bankruptcy, the IRS seized assets to pay both penalties.  The taxpayer initiated an adversarial action in the bankruptcy case.  In that action, the IRS then conceded that the failure-to-pay penalty was discharged.   The parties disagreed whether the failure-to-file penalty was discharged.

Section 523(a)(7)(B) provides that, “A discharge under . . . this title does not discharge an individual debtor from any debt . . . to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty . . . imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition.”

The issue was whether the taxpayer filing of an extension to file the tax return applied to the computation of the three-year rule for the discharge of the failure-to-file penalty.

The court held that filing of an extension affected the three-year rule for the purposes of the failure-to-file penalty.  The IRS previously conceded that the extension is not used in computing the three-year rule for the failure-to-pay penalty.

The reason for the ruling is found in the statute for the failure-to-file penalty, 26 U.S.C. § 6651(a)(1):

“In case of failure to file any [required tax] return . . . on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate.”

This is to be distinguished from the failure-to-pay penalty which accrues from the original due date for the return, regardless whether an extension has been filed.

Thus in this case the taxpayer filed his return within three year-rule and, therefore, neither the tax nor the failure-to-file penalty were discharged.  But the due date for the return was beyond the three-year rule.  This is why the IRS conceded that the failure-to-pay penalty was discharged.