Tax practitioners may be encouraged by a recent bankruptcy ruling in the Southern District of New York on June 22, 2020 (In re Starling, 125 AFTR 2d 2020-2587, Bankr. S.D.N.Y. 2020). Practitioners generally support the idea that late-filed tax returns, even those filed after an IRS Substitute of Return (“SFR”), should start the two-year clock running concerning the filing of tax returns for dischargeability purposes in bankruptcy proceedings. Under 11 U.S.C. § 523, Exceptions to Discharge, three rigid rules govern the dischargeability of income taxes. One, more than three years must have passed since the tax year generating the liability was due, including extensions. Two, 240 days or more must have passed since the date of an IRS assessment. And three, at issue in Starling, the tax return must have been filed more than two years before the filing of the bankruptcy petition; and because SFRs are not considered “filed” tax returns (filed in good faith and under penalties of perjury), SFRs never start the two-year clock for dischargeability purposes.
The question as to whether a tax return filed after an SFR can start the two-year clock is debatable and has produced a split among Federal Circuit Courts. By far, the majority view is that a later-filed tax return, after an SFR, is not a “filed” tax return for dischargeability purposes; and as such, if a taxpayer files his or her tax return after an SFR, that tax year – the subject of the SFR – can never be discharged in bankruptcy. That view, according to most practitioners, is a draconian application and an impractical and too conservative interpretation of the prevailing four-part Beard Test.
The U.S. Tax Court in Beard defined what is meant by a “tax return”. Beard v. Commissioner, 82 T.C.766 (1984), aff’d 793 F.2d 139 (6th Cir 1986). Widely accepted as the preeminent case on the topic, Beard makes clear that in order for a document to qualify as a valid “tax return” it must:
1. It must purport to be a return;
2. It must be signed under penalty of perjury;
3. It must contain sufficient information to allow the tax to be calculated; and
4. It must represent an honest and reasonable attempt to satisfy the requirements of the tax law.
Clinging to the fourth requirement, the IRS has successfully argued that a late-filed tax return, after an SFR, is not an honest and reasonable attempt to comply with the tax laws – largely because the U.S. tax system is built on voluntary compliance – that is, unprompted obedience. Most Federal Courts follow the IRS’s interpretation, while three Federal Circuits, 1st, 5th and 10th, hold a firmer “one-day-late” rule, whereby a taxpayer filing a tax return late – even one day late – prevents that taxpayer from ever obtaining a discharge as to it. Fortunately, the IRS rejects the one-day-rule itself (as does the 11th Circuit). What seems to get missed is that an SFR is not signed under penalties of perjury at all, like a later-filed tax return is.
But there is ray of sunshine rising out of the Southern District of New York. In Starling, the bankruptcy court ruled that a late-filed tax return – after an SFR was filed – may be dischargeable. The court adopted the Colson theory (from the 8th Circuit: AR, MO, IA, NE, MN, SD, ND), where under forthright intentions a taxpayer’s late-filed tax return, despite the SFR, may be eligible for discharge (so long as filed two years prior to the bankruptcy petition and the other two criteria are met). The IRS is sure to appeal but it is nonetheless a case to keep an eye on. The hope is for affirmation by the 2nd Circuit and the gaining of some momentum – hopefully down the Eastern seaboard to the 4th Circuit.
It is doubtful that Congress ever contemplated the deep entanglement of SFRs and later-filed tax returns; instead, it is more likely they intended to promote a larger goal – rewarding and encouraging tax compliance and penalizing non-compliance, irrespective of SFRs. The 2nd Circuit joining the 8th Circuit would link together 10 states, then holding a more holistic view – slowly inching towards what most practitioners feel is a fairer result. Missing a tax filing deadline should not be an economic death sentence and prevent a debtor-taxpayer from a later fresh start. There are few things in life that are unforgivable – filing a tax return late should not be one of them.