Non-Dischargeable Tax Debt Not Special Class of Unsecured Creditors

In numerous previous posts, we have noted that the purpose of the Bankruptcy Code is to help the “honest but unfortunate debtor.” Like gerrymandering, certain “creative” debtors have attempted to classify their non-dischargeable debt as a separate, special class of unsecured creditors. In a recent case out of the Eighth Circuit, In re Copeland, the court summarily dismissed the debtors’ argument that they had not unfairly discriminated against their other unsecured creditors.

The Copelands filed for Chapter 13 bankruptcy protection in 2011, and proposed a plan to pay non-dischargeable state and federal tax debts before other unsecured creditors. If put in effect, the plan would, in essence, completely pay the Copelands’ tax creditors, leaving all other unsecured creditors with little or no payments from the estate. The bankruptcy court rejected their 2011 plan, and the Copelands amended the plan to place the tax creditors in the same class as its other unsecured creditors. After they submitted their amended plan, they objected to their own plan, raising the argument once more that the separate classification was not discriminatory. Because the bankruptcy court had already ruled on the issue and found the plan discriminatory, the court accepted the amended plan.

It is important to note that the debtors’ tax claims became non-dischargeable because they failed to file pre-petition tax returns. The court noted that had the debtors filed such returns, much of their tax debt would be dischargeable under §§ 523(a)(1)(B) and 1328 (a)(2). Unlike child support, which is by its very nature non-dischargeable, the tax debt becomes non-dischargeable only after the debtor fails to file timely prepetition returns.

Without much analysis, the court applied the Eighth Circuit’s four prong test to determine whether the plan was unfair. Ultimately, the opinion hinged on the Copelands’ bad faith classification of their unsecured claims. The court also rejected their argument that post-petition tax preparation fees should be treated as pre-confirmation legal fees or trustee administration fees, because “like the non-dischargability of the underlying debt, this [was] a self-created problem.”

The ultimate takeaway from the Copeland case is that bad faith will not be tolerated in bankruptcy proceedings. Although no punitive action was taken against the Copelands for their bad faith, discriminatory plan, the inability to discharge their tax debt was a significant loss for the debtors. For debtors that may be contemplating bankruptcy, the filing of any past-due tax returns before filing for bankruptcy protection is essential. For unsecured creditors, Copeland is another arrow in their non-discriminatory classification quiver.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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