In In re Martin 2015 WL 9252590 (BAP 9th Cir, 12/17/2015), the Bankruptcy Appellate Panel of
the Ninth Circuit ruled that Debtors who file income tax returns late - - even after the IRS assesses taxes for the years in question - - can still discharge such income tax liabilities in bankruptcy. The decision directly contradicts holdings from the First, Fifth and Tenth Circuit Courts of Appeal, which have held that late-filed tax returns do not count as returns for the purpose of determining whether such obligations are discharged in bankruptcy. See In re Fahey 779 F3d 1 (1st Cir. 2015), In re McCoy 666 F3d 924 (5th Cir. 2012), and In re Mallo 774 F.3d 1313 (10th Cir. 2014).
The BAP ruled that the 2005 amendments to the Bankruptcy Code did not alter previous Ninth Circuit law on the issue. As a result bankruptcy courts in the Ninth Circuit must now analyze whether debtors who filed tax returns after an IRS assessment engaged in “an honest and reasonable attempt to comply with the requirements of the tax law.” This requires consideration of the length of the delay in filing returns, the reasons for the delay, and the number of years that had elapsed.
In Martin the debtors did not file their tax returns for years 2004, 2005 and 2006 when due.
As a result the IRS conducted an audit examination in June 2008 to fix the amount of liability for the three years in question. In August 2008 the IRS issued a notice of deficiency for each of 2004, 2005 and 2006.
In December 2008 the Martins hired an accountant who signed and completed the Martins' tax returns for the 3 years but - - for unknown reasons - - did not file the returns until June 2009. In March of 2009 the IRS assessed the Martins for years 2004-2006. The Bankruptcy Appellate Panel went out of its way to note that the Internal Revenue Service twice sent notices to the Debtors of the unpaid taxes, and demands for payments, in March and April 2009, and then gave the Martins notice of their intent to levy.
The IRS accepted the untimely returns (filed in June 2009) and adjusted the Martins’ tax liability based on the information in the returns. The liability for 2004 was adjusted downward by approximately $1,000, the 2005 liability was adjusted upwards by approximately $5,000 and the 2006 liability was adjusted downward by approximately $5,000.
The Martins filed a Chapter 7 bankruptcy case in 2011 and filed an adversary proceeding to de-termine that their 2004, 2005 and 2006 tax debts were in fact dischargeable. The IRS responded that such debts were not dischargeable because the tax returns which were filed did not “satisfy requirements of applicable non-bankruptcy law” insofar as they were late. The IRS argued that a tax return filed after the IRS has already made an assessment is the functional equivalent of no tax return at all.
The bankruptcy court in Martin ruled that the legal test established in Beard v. Commissioner, a 1986 Sixth Circuit decision, still applied to determine whether the debtor had filed a return. That test re- quired the consideration of four factors:
1. The return must purport to be a tax return;
2. It must be executed under penalty of perjury;
3. It must contain sufficient data to allow calculation of the tax; and
4. It must represent an honest and reasonable attempt to satisfy the requirements of the tax law.
On appeal the IRS argued that returns filed after the IRS has made an assessment should not count as returns. In fact this is the position of the First, Fifth and Tenth Circuit Courts of Appeal, as noted above.
The Bankruptcy Appellate Panel noted that many cases take a literal approach and rule that any tax return filed late (before or after an IRS assessment) should not count as a return for
non-dischargeability purposes. The IRS itself expressly rejected that literal construction as
being overly harsh, and instead only sought a ruling that returns filed after an IRS assessment
should not count. The BAP noted that it was interpreting the following language, which was added to the Bankruptcy Code in 2005:
"For purposes of this subsection, the term ‘return’ means a return that satisfies requirements of applicable non-bankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to Section 6020(a) of the Internal Revenue Code of 1986… .”
The BAP disagreed with the “plain meaning” approach adopted by the First and Fifth Circuit Courts of Appeal. The BAP reasoned that the second sentence quoted above specifically states that returns within the definition of the first sentence includes returns “prepared pursuant to Section 6020(a) of the Internal Revenue Code.” But 26 USC §6020(a) provides:
“If any person shall fail to make a return required by this title or by regulations prescribed
thereunder, but shall consent to disclose all information necessary for the preparation
thereof, then, and in that case, the Secretary may prepare such return, which, being signed
by such person, may be received by the Secretary as the return of such person.”
So, if a taxpayer does not file a return, but discloses information to the IRS when it prepares a return for the taxpayer, that could still count as a return for non-dischargeability purposes. The BAP was so disturbed by this logical inconsistency that it stated:
"thus, under the literal construction of the hanging paragraph, a debtor taxpayer who is 1 month or 1 day or even 1 hour late in filing his or her return will have his associated tax debt excepted from discharge, whereas a debtor taxpayer who never bothers to file his or her own return can discharge his or her associated tax debt if the IRS fortuitously prepares a return on that person's behalf."
The BAP also discussed the inconsistency created by Section 523(a)(1)(B)(ii) of the Bankruptcy
Code. That paragraph excepts from discharge tax debts associated with untimely tax returns that were filed more than 2 years prior to the debtor's bankruptcy filing. The fact that this Code section remains in the Bankruptcy Code after 2005 also undermines the literalist interpretation of the hanging paragraph in Section 523.
Finally, the BAP noted that "Congress could have conditioned discharge of tax debt on whether a return was filed prior to an assessment. As correctly noted by the [bankruptcy] court, Congress used assessment as a trigger for other time periods in the Code, for example, the priority qualifications found in Section 507."
For these reasons the BAP determined that the amendments to the Code in 2005 did not change the pre-2005 law in the Ninth Circuit. The BAP did, however, reject the bankruptcy court's method of determining whether the tax returns filed were “honest and reasonable attempts to satisfy the tax law.” The BAP concluded that the bankruptcy court was in error by focusing only on the form and substance of the filed returns. This ignored the length of the delay, the reason for the delay, and the number of years that had elapsed. This
type of analysis was inconsistent with the 9th Circuit's earlier holding in Hatton II.
In Hatton II the taxpayer took no steps to cure his delinquency and did not begin to cooperate with the IRS until the IRS threatened to levy on his wages. According to the Ninth Circuit those facts established that the taxpayer had not engaged in "an honest and reasonable attempt to comply with the requirements of the tax law".
The BAP ruled in Martin that "because the bankruptcy court did not apply the correct legal standard for assessing the honesty and reasonableness of the Martins' efforts to comply with the applicable tax laws, we must vacate and remand so that the bankruptcy court can apply the proper legal standard to the relevant facts of the case, which are not limited to the form and content of the Martins' filings, but also include the number of missing returns, the length in the delay, the reasons for the delay, and any other circumstances reasonably pertaining to the honesty and reasonableness of the Martins' efforts."