When is a Tax Liability Discharged? Implications of Maryland v. Ciotti on Post-Discharge Extensions of Credit
In March 2011, the Fourth Circuit issued a decision that has potentially substantial impact on the banking community at large, especially as it relates to decisions on whether to extend credit to a debtor after he or she receives a discharge in bankruptcy. In Maryland v. Ciotti (In re Ciotti), 2011 U.S. App. LEXIS 4492 (4th Cir. Mar. 8, 2011), Chief Judge Traxler issued a decision that, while fact-specific, could lead to continuing tax liabilities after discharge for a number of debtors. The decision serves as an important reminder to the banking community that not all debts are discharged, and it also reveals that tax liabilities that a potential borrower asserts have been discharged should be viewed skeptically when assessing a potential borrower’s financial statements.
Denise Ciotti filed Maryland state income tax returns for each year between 1992 and 1996. In 1998, the IRS issued a Letter of Determination making adjustments to each of Ciotti’s federal returns for those years that significantly increased her federal adjusted income. Maryland taxable income is based on the federal adjusted income, and Maryland law required Ciotti to report the amount of changes to her federal adjusted income to Maryland tax authorities. Ciotti did not report the changes; however, the IRS forwarded its determination to the Maryland Comptroller, and the Comptroller made adjustments based on the determination resulting in an assessment of more than $500,000.00 in taxes, penalties and interest.
Ciotti filed for protection under Chapter 7 of the Bankruptcy Code (11 U.S.C. 101, et. seq.) and received a discharge of her debts. After the Maryland authorities continued to attempt to collect the past-due taxes, Ciotti reopened her bankruptcy in February 2009 and sought a ruling from the Court that her tax liabilities had been discharged. The Fourth Circuit held that the Maryland state taxes imposed for the years 1992 through 1996 were excepted from discharge under 11 U.S.C. § 523(a)(1)(B). This section provides that a discharge under Chapter 7 does not discharge a tax liability with respect to which a return or equivalent report or notice was not filed or given. The Fourth Circuit observed that § 523(a) reflected the Congressional attempt to balance the tension between general creditors, the debtor and the tax collector. Because Maryland law—specifically Md. Code Ann., Tax-Gen. § 13-409(b)—required Ciotti to report the changes to her adjusted income to the Maryland tax authorities, the Court found that Ciotti contributed to the staleness of the Maryland tax claims by her own wrongdoing. As a result, the Court held that Ciotti’s tax liabilities between 1992 and 1996 were excepted from discharge. The Court issued this ruling despite the fact that Maryland was given notice of the determination by the IRS and assessed additional taxes based on that determination.
As an initial matter, Ciotti is a reminder to the banking community that some liabilities (and in this case a substantial liability) are not discharged through a bankruptcy. Any bank making a determination on whether to extend post-discharge credit to a borrower should review the borrower’s bankruptcy schedules closely, especially Schedule D (secured claims), Schedule E (unsecured priority claims), Schedule F (unsecured nonpriority claims), Schedule I (income), Schedule J (expenses), and the Statement of Financial Affairs, and match those schedules with the debtor’s financials. More specifically, Ciotti is a reminder to the banking community that it should be extremely cautious to accept a borrower’s representation that a tax liability that appears on the schedules was discharged through the bankruptcy. Ciotti reminds us that whether a debt was discharged (and a tax liability especially) often hinges on specific factual nuances that cannot be captured in a financial review unless a potential lender asks the right questions. In Ciotti, for example, the determination of whether a $500,000.00 debt was discharged came down to one simple and specific question: whether Ciotti herself filed the required notice or not. Ultimately, when a bank is faced with questions over whether to extend post-discharge credit to a borrower, the application and accompanying financials should be reviewed by either an in-house bankruptcy specialist or an external creditors’ rights practitioner.