Income tax liabilities can be discharged in bankruptcy. In order to do so several tests need to be met, and tax years are analyzed individually. Frequently tax debts for older years may be discharged in bankruptcy, while debts for more recent years - - of for years where a tax return was never filed - - may not.
One of the legal tests for determining whether liability for a particular tax year may be discharged has been a matter of significant controversy lately. Specifically, in order to discharge tax liability for a given year in bankruptcy, a tax return for that year must actually have been filed at least two years before a bankruptcy case was filed.
When a person does not file an income tax return by the deadline to do so, the Internal Revenue Service will typically communicate with the taxpayer in an attempt to obtain information so that the IRS can prepare Substitute For Return (“SFR”). The SFR process allows the IRS to assess tax liability against a taxpayer even in the absence of a filed tax return. The Internal Revenue Service has been consistent in taking the position that once an SFR is filed the tax liability established by that SFR can never be discharged in bankruptcy.
Specifically, the IRS’ legal position is that a tax return filed by a debtor after SFR liability has been assessed does not constitute a tax return, at least not with respect to liabilities already assessed in the SFR. However, the IRS has conceded that with respect to liability over and above the amount in the SFR, a late filed tax return can constitute a ‘return,’ thus allowing for the discharge in bankruptcy of such excess liability.
The United States Courts of Appeal have had the opportunity to rule on this issue. Three of those Circuits have taken a position more extreme than that argued by the Internal Revenue Service itself. Those Circuits have ruled that a late filed return —- even one day late —- cannot constitute a return for bankruptcy discharge purposes at all, even if it pre-dates the date that the Internal Revenue Service makes its own assessment pursuant to an SFR. See In re McCoy 666 F.3d 924 (5th Cir. 2012).
In December 2015 the Bankruptcy Appellate Panel for the Ninth Circuit ruled that the McCoy test does not apply in the Ninth Circuit. In re Martin 2015 WL 9252590 (BAP 9th Cir, 12/17/2015). Specifically, it ruled that a late filed return - - even one filed after an IRS assessment - - could still constitute a "return" if it represented an honest and reasonable attempt to satisfy the requirements of the tax law. The Bankruptcy Appellate Panel in Martin also ruled that it was a mistake only to look at the late filed tax return itself; rather, courts should look at the length of the delay and the reason for the delay. The Martin case cited to an earlier Ninth Circuit Case - - In re Hatton. In Hatton, the Ninth Circuit ruled that a taxpayer want not “honest and reasonable” where the taxpayer had taken no steps to cure his delinquency and did not begin to cooperate with the Internal Revenue Service until there was a threat to levy on his wages. Those facts established that the tax payer had not engaged in an honest and reasonable attempt to comply with the requirements of the tax law. Again, in Martin the Bankruptcy Appellate Panel indicated that the court should also look at the number of missing returns, the length of the delay, and the reason for the delay, and any other circumstances relating to the reasonableness and honesty of the taxpayer's efforts to file returns.
But Martin is merely an opinion of the Bankruptcy Appellate Panel—- a court that is one level below the full Ninth Circuit Court of Appeals; thus it does not necessarily reflect the law in the Ninth Circuit on this critical issue. It is against this backdrop that the Ninth Circuit’s decision in In re Smith (Appeal No. 14-15857) is significant. In the case Mr. Smith did not file a 2001 tax return on time. In fact he filed it seven (7) years after it was due and three (3) years after the IRS assessed a deficiency pursuant to a substitute for return. In reciting the facts of the case the Ninth Circuit Court of Appeals noted that in March of 2006 the IRS mailed Smith a notice of deficiency which Mr. Smith did not challenge within the allotted 90 days. Smith reported higher income on his actual tax return, but did not file the return for a period of 3 years. Both the debtor and the IRS agreed that the increase in taxes due as a result of the debtor's late file tax return would be dischargeable. Rather, the dispute centered around the dischargeability of the $70,662 assessment made pursuant to the Internal Revenue Service's own Substitute For Return.
The Ninth Circuit in Smith resorted to In Re Hatton 220 F.3d 1057, 1059 (9th Cir. 2000) for the definition of a tax return. To constitute a tax return the document filed must:
1. Purport to be a tax return;
2. Be executed under penalty of perjury;
3. Contain sufficient data to allow calculation of the tax; and
4. Represent an honest and reasonable attempt to satisfy the requirements of the tax law.
In analyzing the issue of whether a late filed return could constitute an “honest and reasonable attempt to satisfy the requirements of the tax law” the Ninth Circuit noted that in the Hatton case the IRS had sent numerous notices to the debtor which were never responded to. The Ninth Circuit then noted that in the case at bar Smith did not make any tax filing until 7 years after his return was due and 3 years after the IRS "went to the trouble of calculating a deficiency and issuing an assessment." The Ninth Circuit noted that under these circumstances the debtor's conduct was not a reasonable attempt to comply with the tax code.
The Ninth Circuit noted that many other circuits have ruled that late tax filings, made after an assessment pursuant to a Substitute For Return by the I.R.S., do not constitute returns at all because they are not honest and reasonable attempts to comply. The Ninth Circuit stated "we need not decide the close question of whether any post-assessment filing could be ‘honest and reasonable’ because these are not close facts; the IRS communicated with Smith for years before assessing a deficiency, and Smith waited several more years before responding to the IRS or reporting his 2001 financial information."
The Smith case failed to resolve the most pressing tax discharge issue of our time —- whether a tax return filed after an IRS assessment can ever constitute an honest and reasonable attempt to comply with the tax law. Still, it sets a high bar for determining whether a filing constitutes an “honest and reasonable attempt to satisfy” the tax law. Being irresponsible in failing to file returns but subsequently “coming clean” will not suffice. In order to have any realistic chance at discharging taxes based on late filed returns it appears that a Debtor will have to show one of the following: a) that the return was not very late and was filed long before collection activity occurred, b) that the Debtor fully cooperated with the IRS in preparing the Substitute For Return, or c) that the Debtor’s lateness was excused by illness, disability or incarceration.