The 8th Circuit Bankruptcy Appellate Panel has ruled that a Chapter 13 debtor may not create a special class of unsecured creditors for nonpriority, nondischargeable tax debts at the expense of other unsecured creditors.  In the case of Shawn & Lauren Copeland v. Richard V. Fink, the debtors sought to create a separate class of unsecured creditors for claims of income tax debts that were not considered a priority debt (i.e., the debt became due more than 3 years prior to the filing of the bankruptcy case) but were nevertheless non dischargeable since the tax returns were filed within 2 years of the bankruptcy case.

This situation only occurs when a debtor fails to file their income taxes when due.  Income tax debts are considered “priority” when they become due within 3 years of the bankruptcy filing.  The consequences of being a priority tax debt is that the debt must be paid in full through a chapter 13 plan before anything is paid to general unsecured creditors.  Income tax debts may be discharged in Chapter 7 or Chapter 13 if the debtor files the return and more than 3 years have expired since the return was due or 2 years after a late return is filed, whichever date is later.   But what if the return was due more than 3 years before the bankruptcy was filed and the tax return was filed within two years of the bankruptcy filing?  That is the circumstance of the Copeland case.  The debt is not discharged, but it is also not a priority tax debt.  The debt survives bankruptcy.

Section 1322(b)(1)  of the Bankruptcy Code allows a Chapter 13 plan to “designate a class or classes of unsecured claims, as provided in section 1122 of [the Bankruptcy Code], but [it] may not discriminate unfairly against any class so designated.  A classic example of a separate class of unsecured creditors is where a debtor must make a restitution payment arising out of a criminal sentence.  Since the debtor would wind up in jail if the restitution is not paid, the bankruptcy code permits the debtor to pay those unsecured debts in full before paying other general unsecured claims. 

To determine when a debtor may create a separate class of unsecured debts, the 8th Circuit applies a four-part test:

  1. Does the discrimination have a reasonable basis?
  2. Can the debtor can carry out a plan without the discrimination?
  3. Is the discrimination is proposed in good faith?
  4. Is the degree of discrimination directly related to the basis or rationale for the discrimination?

Unlike the necessity of paying a criminal restitution a child support debt, the court indicated that the failure to file tax returns in a timely manner did not meet the requirements of this test.

Standing alone, the non-dischargeability of a debt is not a proper basis for discrimination against other unsecured non-priority claims. . .

By asking for special treatment of their tax claims, the Debtors ask their other
unsecured non-priority creditors to pay for the Debtors’ failure to file timely tax

The key practice point with this case is that bankruptcy attorneys should be very careful to determine the precise date that income taxes are assessed prior to filing the Chapter 13 case if the attorney knows the returns were filed late.  This can be accomplished by obtaining an Account Transcript by submitting Form 4506 to the IRS prior to filing the case.