Around this time of year, taxpayers (and CPAs) may be scrambling to file federal income tax returns or, at the very least, extensions. For many, seeing the current year’s tax return in the rear-view mirror provides a serious feeling of relief. However, taxpayers should pause before quickly hitting the “file” button. The information and representations provided on a federal tax return can later be used as evidence against the taxpayer. Here, a taxpayer sought bankruptcy relief related to a loan incurred for education. However, the bankruptcy court ultimately used the taxpayer’s representations and treatment of the loan (specifically, the interest) on her tax returns as an admission against her.

Bankruptcy and Exceptions, Generally

An individual debtor may voluntarily file for bankruptcy by filing a petition with the bankruptcy court, hoping to discharge many of his or her debts currently owed.[1] As an initial consequence of filing for bankruptcy, the “automatic stay” begins to operate. This “legal shield” provides, among other things, certain defense mechanisms for the debtor, including: preventing any act to create, perfect, or enforce any lien against property of the estate; and stopping the commencement or continuation of a judicial action against the debtor.[2]

However, filing for bankruptcy does not provide an “automatic discharge” of all debts in a debtor’s estate. In fact, Section 523(a) of the Bankruptcy Code outlines 19 specific exceptions to discharge—some of which are provided below:

(a) A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—

. . .

(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny;

(5) for a domestic support obligation;

(6) for willful and malicious injury by the debtor to another entity or to the property of another entity;

(7) 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—

(A) relating to a tax of a kind not specified in paragraph (1) of this subsection; or

(B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition;

(8) unless excepting such debt from discharge under this paragraph would impose an undue hardship on the debtor and the debtor’s dependents, for—

(A)

(i) an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or

(ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend; or

(B) any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual . . . .[3]

In the following case, the debtor attempted to argue that a certain loan (incurred for educational purposes), should be discharged in bankruptcy court. The debtor filed for bankruptcy, scheduling the student loan as owed to a trust. The trust (via assignment), in turn, sued to have the debt determined to be nondischargeable under Section 523(a)(8) of the Bankruptcy Court.

In re Mallett[4]

The debtor took out both federal and private loans to attend college. After graduation, the debtor consolidated her student loans into one federal consolidated loan and one private consolidated loan. After making loan payments for two years, the debtor entered into a written loan agreement with her then-husband’s grandmother (“Mrs. Mallett”). According to the loan agreement, Mrs. Mallett loaned the debtor $70,996.19 (with repayment terms of 25 years at 4 percent interest) to be used to pay off the debtor’s student loans. The debtor paid off the loans and made payments to Mrs. Mallett for several years, claiming the interest she paid on the loan as a deduction on her tax returns. The debtor later filed for divorce and stopped making loan payments. Thereafter, Mrs. Mallett passed away, and her son sued the debtor and obtained a money judgment of $61,407. Three months later, the debtor filed for bankruptcy, listing the money judgment, and the son sued for a determination on the dischargeability of the debt.[5] The bankruptcy court found the debt to be nondischargeable, stating, in part, as follows:

Section 221(a) of the Internal Revenue Code provides a tax deduction for certain “qualified education loans.” Section 221(d)(1), in turn, defines what constitutes a “qualified education loan.” Thus, if a loan meets the definition of “qualified education loan” under Internal Revenue Code § 221(d)(1) for tax purposes, then it is nondischargeable under Bankruptcy Code § 523(a)(8)(B).

A loan meets the definition of Internal Revenue Code § 221(d)(1) if it was “incurred by the taxpayer solely to pay qualified higher education expenses.” “Higher education expenses” are defined as the “cost of attendance” (itself a defined term) at an “eligible institution” (another defined term). The Court must decide whether the debt owed to Mrs. Mallet is a “qualified education loan” under Internal Revenue Code § 221(d).

The loan by Mrs. Mallet itself, of course, was not used to directly pay “higher education expenses.” Rather, the loan from Mrs. Mallet was used to refinance the Debtor’s private student loans. Under Internal Revenue Code § 221(d)(1), a loan used to refinance a loan is a “qualified education loan” if the original loan being refinanced was a “qualified education loan.” So, the loan from Mrs. Mallet, which was used to refinance the Debtor’s private student loans, is nondischargeable under § 523(a)(8)(B) if the Debtor’s original private student loans are “qualified education loans.”[6]

Conclusion

The bankruptcy court ultimately made an interesting statement regarding the debtor’s tax returns as an evidentiary admission: “the Debtor’s representation on her tax returns—under the penalty of perjury—that the interest on her loan from Mrs. Mallett was tax deductible is the equivalent of her sitting on the stand and testifying under oath that the loan from Mrs. Mallett met all the requirements of a ‘qualified education loan’ under Internal Revenue Code § 221(d)(1).”[7] Because the debtor offered no explanation of the admission, debtor’s tax returns were ultimately used as evidence.

This case is just one example of why a taxpayer should be certain of his or her representations on a tax return. Not only are tax return representations made under penalty of perjury to the federal government, but such representations may also be used against the taxpayer as admissions—such as in bankruptcy court.

[1] See 11 U.S.C. § 301.

[2] See generally 11 U.S.C. § 362(a).

[3] See 11 U.S.C. § 523(a)(4)-(8) (emphasis added).

[4] In re Mallett, 625 B.R. 553 (Bankr. M.D. Fla. 2021).

[5] Id. at 555.

[6] Id. at 556 (internal citations omitted).

[7] Id. at 558 (emphasis added).

Have a question? Contact Zachary Montgomery, Freeman Law, Texas.