The United States Bankruptcy code allows individuals to manage and reduce debts in certain circumstances. Depending on the type of bankruptcy, certain debts can be reduced or re-structured to allow the individual to pay certain debts while retaining certain assets. Bankruptcy is an important tool for the insolvent debtor. It is also a legitimate and legal means of evading payment of certain assessed taxes if done properly. It can, however, be construed by federal prosecutors at U.S. Attorneys office (under the DOJ) as a means of committing tax fraud.
Once a bankruptcy filing is made, an automatic stay is entered, halting collection activities from the time of the filing. The stay applies to all creditors and requires them to cease all collection activities as soon as the stay is entered. The stay applies equally to the IRS. While the IRS may still demand returns, audit or assess taxes, they cannot violate the automatic stay to collect any taxes owed. If used legitimately, this can be a potentially powerful tool for any taxpayer seeking to avoid or delay the collection of assessment.
Bankruptcy filings made fraudulently for the purpose of delaying and avoiding payment of income taxes are illegal. In addition to bankruptcy fraud, a taxpayer can also be prosecuted for tax fraud for filing a false bankruptcy filing in order to evade taxes. But of course, not everyone can file for bankruptcy simply because they want to avoid taxes and debts. The government is quick to prosecute individuals it alleges whom, in order to evade taxes, have created false debts in their filings and even included fake payments of these fake debts as part of their bankruptcy plan as a means of evading income taxes.
The government has alleged that overly ambitious defendants have evaded taxes entirely by manufacturing fake debts so large that their “payment” would entirely absorb the taxpayer’s income, leaving no income to tax. Combined with the automatic stay, the IRS and DOJ have alleged that these would-be taxpayers managed to both avoid previously assessed taxes as well as reducing subsequent tax assessments by reducing or eliminating taxable income.
The government typically ropes in one alleged co-conspirator in order to successfully prosecute these bankruptcy fraud and tax evasion cases. The alleged co-conspirator is often a tax attorney who both assists with the fraudulent bankruptcy filing and the creation of the fraudulent debts. Federal prosecutors have also alleged that such tax attorneys assisted the tax evader in making sure the stay lasts as long as possible. This scheme is designed primarily to avoid the payment of taxes, not the assessment.
The tax evader may acknowledge that he owes taxes to the federal government, but through the abuse of bankruptcy proceedings, the prosecution’s theory is that he illegally avoided and defeated payment of those taxes. Those caught in this type of scheme face stiff penalties and steep sentencing exposure if convicted. Individuals under investigation would be wise to hire a criminal tax defense attorney prior to speaking to any government official. In fact if currently facing a civil tax audit often times hiring an accountant or tax lawyer is not enough. In cases where the audit is likely to uncover questionable tax practices a criminal attorney who is well versed in criminal tax matters should get involved early on to work behind the scenes with the client.
The same caveat applies to those filing for bankruptcy where there is a high likelihood that fraud might be alleged. Prior to attending any 541 hearing, in addition to retaining bankruptcy counsel, such debtors would be wise to hire criminal counsel who is equipped to defend both bankruptcy fraud charges as well as allegations of tax fraud. Such an attorney is not going to assist the debtor in any fraudulent filing or reporting, but can audit the matter internally to help decide whether going forward would expose the debtor to criminal charges.