Reprint of Article written for the North Carolina Tax Bar, see: NC Tax Bar Assessments at http://tax.ncbar.org.
A. “Tax Return” Ain’t What It Used To Be.
Under Title 11 of the Bankruptcy Code, a debtor may discharge certain personal income tax liabilities. Instead of the traditional offer in compromise (“OIC”), the bankruptcy option often becomes a non-filer’s best recourse for resolving old personal tax debts. However, that tax debtor must first satisfy, in part, 11 U.S.C. §523(a)(1)(B), which excepts from discharge tax returns that are filed within two years of the bankruptcy petition filing date. As a result, it becomes critical that a debtor actually file tax “returns” more than two years from his or her filing date. Seems easy enough, right? Not so fast says the IRS.
The definition of a “tax return” is noticeably absent from the Bankruptcy Code and is nowhere to be found in the Internal Revenue Code. Instead, some courts formulate a four-part test in determining whether a document is treated as a tax return for bankruptcy dischargeability purposes. The non-filer, who later files his or her tax returns in response to a substitute for return (“SRF”), almost always satisfies the first three prongs of the test:
(1) was there sufficient data on the form to calculate a tax liability?;
(2) did the document purport to be a tax return?;
(3) did the taxpayer execute the document under penalties of perjury?
See In re Hatton, 216 B.R. 278 at 282 (9th Cir. BAP 1997) (citing Beard v. Commissioner, 82 T.C. 766, 777 (1984).
It is the fourth prong that stymies almost every delinquent late-filer: did the taxpayer make an honest and reasonable attempt to satisfy his or her requirements under the tax laws? Id. The prevailing view sets against taxpayers. That is, an income tax form filed late, after the IRS has filed an SFR and made its assessment, does not constitute a tax return for the purposes of 11 U.S.C. §523(a)(1)(B)(i) (returns for bankruptcy dischargeability purposes).
B. The Fourth Circuit Agrees with the IRS (sort of…).
In the Middle District of North Carolina, the IRS Insolvency Division uniformly tells practitioners that “tax returns” filed subsequent to SFRs are never dischargeable in bankruptcy. Local IRS counsel will also tell practitioners that it is a bright-line position supported by In re Maroney, 352 F.3d 902 (4th Cir. 2003). However, Maroney may be read with more caution than angst. In Maroney, the taxpayer failed to file personal income tax returns for 1990 and 1992. In 1994, the IRS prepared SFR’s for each tax year. The taxpayer then, in 1998, filed his personal 1040s, and the IRS accepted them and even abated some portion of the unpaid assessments. More than two years later, in 2000, the taxpayer filed a Chapter 7 bankruptcy and declared tax years 1990 and 1992 as non-priority claims, subject to full discharge. The IRS objected, claiming that no tax return had been filed within the meaning of 11 U.S.C. §523, and as a result, tax years 1990 and 1992 were nondischargeable.
Maroney agreed with the IRS, with a small and important caveat. Again, the crux of the inquiry was whether the taxpayer satisfied prong four of the Hatton test (that is, did the taxpayer make an honest and reasonable attempt to satisfy his or her requirements under the tax laws?). The court answered “NO” because the taxpayer offered no substantive evidence to demonstrate that “his eventual filings were anything other than self-serving attempts to reduce his tax liabilities.” The IRS convinced the court that simply filing late tax returns, subsequent to an SFR, did not serve any basic purposes of the tax system: “to self-report to the IRS… returns [that] may be readily processed and verified”, and as a result could not be considered “an honest and reasonable attempt to comply with the tax code.” The court appeared to empathize with the IRS, calling the preparation of an SFR burdensome and onerous. That characterization may have been a bit of good lawyering by IRS counsel, as most practitioners know the simplicity upon which SFRs are calculated. Nevertheless, the court held that unjustifiably late tax returns, filed after an SFR, do not constitute tax returns for the purposes of discharge under 11 U.S.C. §523.
Maroney, however, did not adopt the broader IRS position that any late-filed tax return, post-SFR-assessment, never qualifies as a return for dischargeability purposes. The court contemplated circumstances where a late-filed return, post SFR, may satisfy the honest and reasonable and good faith prong of Hatton (e.g., where a later filed tax return actually increases the taxpayer’s liabilities). For practitioners, the challenge becomes ensuring that non-filers satisfy this honest and reasonable prong with any delinquent, post-SFR, tax-filing they make. See generally, In re Maroney, 352 F.3d 902 (4th Cir. BAP 2003).
Most recently in Perry v. United States, 500 B.R. 796 (Bankr. M.D. Ala. 2013), the court succinctly discussed the Maroney reasoning and the IRS’ opposing reasoning. The IRS views an SFR as creating a debt (i.e., a non-dischargeable debt) for which there is no tax return. That debt is priority debt and non-dischargeable because it relates to an SFR assessment and does not relate to a tax return. The court, however, recognized favorably Maroney and In re Payne, 431 F.3d 1055 (7th Cir. 2005), whereby a later-filed tax return, post-SFR assessment, may demonstrate good faith and may permit some portion of the tax to be subject to discharge (Maroney: where taxpayer subsequent filing increased his or her liabilities; Payne: where taxpayer tried to file timely but was unable to do so because of Postal Service error). Nevertheless, the taxpayer who enters the Bankruptcy Court with no credible explanation for his or her tardiness is unlikely to garner any sympathy or support for dischargeability purposes.
C. Courts Split, but IRS Chief Counsel Firm.
Other courts are split on this issue. Cases tending to generally agree that returns filed after SFR assessment are tax returns, include: Colsen v. U.S., 446 F.3d 836 (8th Cir. 2006); In re Nunez, 83 A.F.T.R. 2d 99-591, 232 B.R. 778 (9th Cir. BAP 1999); and In re McGrath, 80 A.F.T.R. 2d 97-8241, 217 B.R. 389 (Bktcy Ct. NYBankr. N.D.N.Y. 1997). Cases tending to agree with the IRS that there is no return if one is filed after SFR assessment include: U.S. v. Payne, 431 F.3d 1055 (7th Cir. 2005); Hetzler v. U.S., 88 A.F.T.R. 2d 2001-6624, 262 B.R. 47 (Bankr. D.N.J. 2001); Pierchoski v. U.S., 84 A.F.T.R. 2d 99-5599, 243 B.R. 639 (Bankr. W.D. PA 1999); Sgarlat v. U.S., 88 A.F.T.R. 2d 2001-6403, 271 B.R. 688 (Bankr. M.D. Fla. 2001); and McCoy v. Mississippi State Tax Comm., 666 F.3d 924 (5th Cir. 2012).
Despite the split, IRS Chief Counsel takes a firm view that a “Form 1040 filed after the taxpayer failed to pursue his remedies in the Tax Court and after the Service makes an assessment should have no legal effect because filing such a document after the Service has made its own determination of liability is inconsistent with the basic principle of self-assessment in our tax system that taxpayers are required to report their income information on a return and make their own determination of liability on which an assessment can be made under IRC section 6201(a).” IRS Chief Counsel further takes the position that after assessment is final, any reconsideration or adjustment by the IRS is a matter of administrative grace, but is not a requirement of law. Therefore, that a delinquent taxpayer submits income information later on a Form 1040, after assessment, carries no greater legal effect than if the information were simply submitted by letter or telephone. In each case, says Chief Counsel, the Service has discretionary authority whether to accept or reject the information supplied, but since the SFR assessment has already been made, there is no legal requirement that the information be placed on a Form 1040 and signed under penalties of perjury – the time for doing so was before the SFR was made.
Nevertheless, most recently, IRS Chief Counsel, in Notice 2010-016, recognized that in cases where subsequent tax returns are filed in response to an SFR, a split may occur in what exactly is dischargeable and what is not, “Regardless of whether a Form 1040 filed after [an SFR] is a “return” for tax purposes, the portion of a tax that was assessed before the Form 1040 was filed is nondischargeable under section 523(a)(1)(B)(i)”. However, if a later Form 1040 filing results in increased tax, then it may qualify for discharge purposes: “For bankruptcy discharge purposes, a debt for an income tax recorded by an [SFR] should be considered independently of any part of the tax for the same tax year where [the taxpayer later files a Form 1040 that reports an additional amount of tax]”. That portion of the tax that was not previously assessed by an SFR would be a dischargeable debt. See generally, Chief Counsel Notice 2010-016.
Therefore, that the information submitted on a late-filed Form 1040 is recorded in return form, signed under penalties of perjury, and starts the statute of limitations clock does not make it a reasonable attempt to comply with the taxpayer’s filing obligations (e.g., even closing agreements signed by the taxpayer under the Internal Revenue Manual do not constitute tax returns in the IRS’ view). While the author here respectfully disagrees with that proposition, it is the prevailing view at this time.
D. What are Non-filers to do?
First and foremost, a practitioner filing late returns post-SFR-assessment, should be prepared to argue reasonable cause for abatement. If the taxpayer is granted some abatement, of say late-filing penalties, some ground-work is laid that the taxpayer acted in a good-faith attempt to comply with the tax laws. At a minimum, the IRS then makes an affirmative acknowledgment that some cause prevented the taxpayer from complying with the tax laws in the first place. Second, a common theme in the above taxpayer losses cases here is a lack of substantive evidence excusing the taxpayer’s tardiness. Include substantive evidence in your post-SFR-assessment filing demonstrating that the late-filing was something more than a self-serving attempt to reduce tax liabilities (e.g., show unreported income, expenses, missing 1099s to employees, et al); then, as a result, the late-return will serve a tax purpose beyond what was contained in the SFR. Finally, the bigger lesson learned is that if you, the practitioner, see SFRs on IRS account transcripts and contemplate bankruptcy in your client’s near future, take extra care when filing delinquent tax returns to protect the dischargeable nature of the income tax later under the loosened Maroney reasoning.
E. Pseudo IRS Settlement Inside a Bankruptcy?
A notable case, unpublished, recently came from the Fourth Circuit Court of Appeals, out the United States Bankruptcy Court, Eastern District. In that case, Reeves v. Callaway, Trustee, and Internal Revenue Service, No. 12-2127 (decided Nov. 20, 2013), the court, by agreement between the bankruptcy trustee and the IRS, permitted the sale of a joint-debtor’s principal residence in a joint Chapter 7 bankruptcy despite the home’s value ($325,000) not exceeding the first lien (Wells Fargo, $195,500) and the federal tax lien ($382,300); therefore, there was no equity in principal residence beyond the debtor’s exemptions. In large part, the sale commenced because of the IRS’ willingness to carve out 30% of the net proceeds of the sale (otherwise subject to its lien) to pay unsecured creditors: “Notably, the fact that the IRS agreed to allocate part of its tax lien as a carve-out for unsecured creditors [had] no adverse consequences for Debtors because… the Debtors will receive full credit with respect to the IRS lien for any amount paid to unsecured creditors from the sale proceeds as part of the carve-out” [emphasis added].
While at first blush it may be alarming that otherwise exempt property was subject to a trustee sale, it is indicative that the IRS is willing to deal (and settle) given the right circumstances inside a bankruptcy. Such a result should be read with caution, but with an eye towards opportunity. Caution in the sense that property once thought to be (iron-clad) exempt may not be; however, opportunistic for tax practitioners who utilize tax bankruptcies, outside the OIC process, to obtain better results for clients with tax troubles.
Finally, while it may be unsettled here in North Carolina, some bankruptcy courts permit the consideration of offers in compromises inside bankruptcies. The Bankruptcy Court of the Southern District of West Virginia found the IRS policy of refusing to consider an offer in compromise submitted by a taxpayer in bankruptcy to be a violation of the anti-discrimination provision of the Bankruptcy Code. Mills v. United States (In re Mills), 240 B.R. 689 (Bankr. S.D. W. Va. 1999). The court did not state the IRS could be compelled to accept an offer in compromise. However, the court held that the refusal to even consider an offer solely because the debtor was in bankruptcy (here, a Chapter 13 case) unlawfully discriminated against such debtor. Id. at 695-698.
Given the right circumstances, tax practitioners may have another planning tool in their toolkits. Tax settlement inside bankruptcy (whether it be a Chapter 7 or 13) is now a serious consideration for any tax controversy case.
Jason A Morton, Morton Law PLLC