I wrote this post in October but ended up placing it in the October-November Journal of Tax Practice and Procedure, an excellent print publication on procedural issues. For those of you who do not read that publication, I am republishing it here since the issue presented in the post continues to exist and will continue for some time. Footnotes and more details can be found in the print version.
The article was triggered by a decision published in October out of the Middle District of Alabama. In Perry v. United States, the court determines that a taxpayer has not filed a return for purposes of excepting a liability from discharge in bankruptcy. The court examined all three theories now floating around on this issue and decided that Mr. Perry met none of the three theories that might have allowed him to discharge this tax debt.
Bankruptcy Code (BC) section 523(a)(1)(B)(i) provides that an individual debtor who fails to file a tax return cannot discharge the taxes owed for a period in which the individual did not file a tax return. That may have seemed simple enough in 1978 when the Bankruptcy Code was adopted but it has become increasingly complicated over the past 35 years. An amendment to the Bankruptcy Code in 2005 seeking to “fix” the problem has only increased the complexity.
The facts in the Perry case resemble the facts in most of the cases of this type. Mr. Perry did not file tax returns for 1997, 1999, 2001, and 2003. The opinion does not say if he had some type of tax filing phobia in odd years. As it often does, the IRS “assisted” Mr. Perry by preparing substitute returns. It sent him notices of deficiency setting forth the taxes it determined were due for those years. Mr. Perry did not petition the Tax Court. The IRS assessed the taxes. Collection of the taxes began and notices of federal tax liens were filed causing even more notices to go to Mr. Perry.
After ignoring the issue for many years for reasons that are not explained, Mr. Perry filed Forms 1040 with the IRS for each of the years between October 19, 2007 and January 3, 2008. The IRS treated these forms as requests for abatement because they reported substantially less tax liabilities than determined by the IRS through the substitute for return procedures. The IRS did abate his taxes to the lower amounts reflected on the Forms 1040. This fact pattern holds true in most substitute for return cases and in almost all of the exception to discharge cases involving what is a return.
Even though the IRS abated the taxes based on the Forms 1040, he still owed taxes for each of the years. After filing these Forms 1040, Mr. Perry waited two years before filing his chapter 7 bankruptcy petition. He sought a determination from the bankruptcy court that the Forms 1040 he filed satisfied the definition of return in BC 523(a)(1)(B). The decision of the court no doubt came as a disappointment.
The first one of these type cases appeared in 1999. In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999). In that case Mr. Hindenlang, who had a factual situation similar to Mr. Perry, filed Forms 1040 and waited two years before filing bankruptcy. This technique and the requirement to wait two years results from BC 523(a)(1)(B)(ii) which excepts from discharge returns filed late within two years of the date of the bankruptcy petition. So, bankruptcy lawyers developed the technique of filing Form 1040 for their clients who had not previously filed returns and waiting two years before filing a bankruptcy petition in order to avoid the problem of (B)(ii). For some reason, Mr. Hindenlang filed Forms 1040 that precisely matched the income and tax numbers on the substitute for returns that the IRS had previously prepared and assessed making it clear that the only reason he filed the Forms 1040 was his desire to obtain a discharge of the taxes for those years. He exhibited no desire to provide additional information about his tax situation even though the substitute returns have a very high probability of not properly reporting a taxpayer’s income. The Sixth Circuit agreed with the Government’s argument that the Forms 1040 submitted by Mr. Hindenlang did not meet the Beard test for what is a return because they did not “represent an honest and reasonable attempt to satisfy the requirements of the tax law.” In fact, for tax law purposes the Forms 1040 submitted by Mr. Hindenlang really served no purpose.
Having won the Hindenlang argument, the IRS then adopted a position that Forms 1040 filed after an assessment based upon a substitute for return in which the taxpayer did not cooperate in completing would not be treated as returns for purposes of determining discharge. It had success in three circuit level decisions and failure in one. See
Prior to 2005 the discussion focused on the four part Beard test established by the Tax Court for purposes of determining which documents satisfied the requirements of a return: (1) purpose to be a return; (2) be executed by the debtor 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 2005 Congress pass the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) which contained a hanging paragraph in section 523(a) that defines a “return” as follows:
For purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.
IRC 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.”
While the provision in the hanging paragraph holds out some hope for taxpayers who go through the IRC 6020(a) return procedure, this process generates very few returns. See generally In re Wogoman, 475 B.R. 239, 249 (Bankr. 10th Cir. 2012)(noting that the IRS has “commented that it prepares a return for the taxpayer’s signature under 6020(a) in only a minute number of cases”).
IRC 6020(b) describes situations in which the taxpayer submits no return, provides no information or fraudulent information, refuses to sign a return after the IRS prepares it requiring the IRS to send a notice of deficiency based on the best information it can collect independently. Usually, these returns are based upon the wage and income transcripts reported to the IRS by third parties but occasionally they result from independent fact gathering. Because the taxpayer has not consented, the IRS does not make elections for the taxpayer such as joint return filing status or itemized deductions, etc., that might reduce the tax liability. Usually, these returns overstate the liability because the IRS does not (cannot) make elections that might reduce the taxes; however, these returns might understate the liability because the IRS is unaware of income sources not reported to it by third parties.
All of the decisions discussed above interpreting the “what is a return” issue for purposes of discharge, did so looking at the law prior to the adoption of the hanging paragraph at the end of BC 523. Judge Easterbrook, in the dissent in 7th Circuit’s decision in Payne,
stated that, after the 2005 legislation, the interpretation of the law might change because an untimely return cannot lead to a discharge because of the reference to “applicable filing requirements” in the unnumbered paragraph in section 523(a).
In looking at the new legislation, the 5th Circuit, in In re McCoy, 666 F.3d 924 (5th Cir.), cert. denied, 113 S. Ct. 192 (2012), adopted the approach first suggested by Judge Easterbrook and first adopted in Creekmore v. IRS (In re Creekmore), 401 B.R. 748 (Bankr. N.D. Miss. 2008)(the bankruptcy court agreed with Judge Easterbrook’s dissent and concluded that any late-filed return can never qualify as a return for dischargeability purposes, unless it was prepared pursuant to I.R.C. § 6020(a). The bankruptcy court in Creekmore acknowledged that its reading of the unnumbered paragraph was harsh, but stated that debtors could avoid the problem by taking advantage of the “safe-harbor” of section 6020(a) by having the Service prepare their returns.) See also Pendergast v. Mass. Dept. of Revenue (In re Pendergast), __B.R.__, 2013 WL 2897050, (Bank. D. Mass. June 11, 2013). At this point the 5th Circuit is the only circuit court that has interpreted the hanging paragraph at the end of BC 523(a). It concluded that the first sentence of that paragraph provides “a clear definition of ‘return’ for both state and federal taxes” 666 F.3d at 930. In the view of the 5th Circuit the language in the statute requiring that the return must satisfy the requirements of applicable nonbankruptcy law includes the laws regarding timely filing of returns. A late filed return, even one filed one day late, cannot satisfy the requirements necessary for a return. Therefore, a late return is never a return for purposes of BC 523(a)(1)(B) unless it meets the narrow requirements of IRC 6020(a). This per se rule has been criticized by other courts, in part, because it seems to read the two year rule contained in BC 523(a)(1)(B)(ii) out of the Code. See Mallo v. United States, 2013 WL 4873057 (D. Colo. 2013) and Wogoman v. IRS, 475 B.R. 239 (Bankr. 10th Cir. 2012).
The IRS does not agree with the McCoy decision and has issued a notice explaining its view. Office of Chief Counsel Notice 2010-16, CC-2010-016 (September 2, 2010.) See also Brown v. Mass. Dept. of Revenue (In re Brown), 489 B.R. 1 (Bankr. D. Mass.2013); Martin v. United States (In re Martin), 482 B.R. 635 (Bankr. D. Colo. 2012); Rhodes v. United States (In re Rhodes), No. 11-4074 (Bankr. N.D. Ga. May 6, 2013). The Chief Counsel Notice takes the position:
“Read as a whole, section 523(a) does not provide that every tax for which a return was filed late is nondischargeable. If the parenthetical “(including applicable filing requirements)” in the unnumbered paragraph created the rule that no late-filed return could qualify as a return, the provision in the same paragraph that returns made pursuant to section 6020(b) are not returns for discharge purposes would be entirely superfluous because a section 6020(b) return is always prepared after the due date. It is a cardinal principle of statutory construction that a statute should be construed so that no clause, sentence or word is rendered superfluous. Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998) (refusing to read one provision of the Bankruptcy Code to render another superfluous).”
In addition to finding that the interpretation in McCoy cannot be reconciled with the balance of the hanging paragraph, the Notice goes on to point out that it cannot be justified with the basic provision creating the exception from discharge:
“Section 523(a)(1)(B)(ii) provides that an individual’s bankruptcy discharge does not discharge a debt for which a return was filed after the last date, including any extension, the return was due, and after two years before the date of the filing of the petition in bankruptcy. The Creekmore reading would limit the application of section 523(a)(1)(B)(ii) to cases in which the Service prepares a return for the taxpayer’s signature under section 6020(a) of the Internal Revenue Code. By presuming that Congress intended to limit section 523(a)(1)(B)(ii)’s long-standing discharge exception for debts with respect to which a late return was filed more than two years before bankruptcy to the minute number of cases in which the Service prepares a return for the taxpayer’s signature under section 6020(a), the Creekmore reading also contradicts a special rule
for interpreting the Bankruptcy Code. As the Supreme Court stated in Dewsnup v. Timm, 502 U.S. 410, 419 (1992), “This Court has been reluctant to accept arguments that would interpret the Code, however vague the particular language under consideration might be, to effect a major change in pre-Code practice that is not the subject of at least some discussion in the legislative history.” Finally, the supposed “safe harbor” of section 6020(a) is illusory. Taxpayers have no right to demand that the Service prepare a return for them under that provision. We, therefore, conclude that section 523(a) in its totality does not create the rule that every late-filed return is not a return for dischargeability purposes.”
The Notice concludes with a return to the basic position of the IRS under Hindenlang. Under that position a taxpayer can file a return late and obtain a discharge by waiting two years after the filing of the late return (and waiting whatever time period is necessary to also meet BC 523(a)(1)(A)). The IRS does not view the hanging paragraph as creating a problem for individuals who file late prior to the completion by the IRS of an IRC 6020(b) return and the assessment of that return. For those individuals who allow, or cause, the IRS to go through the IRC 6020(b) procedures, the Notice falls back to the basic position of the IRS in the Hindenlang cases:
“If the taxpayer later files a Form 1040 that reports an additional amount of tax, only
the portion of the tax that was not previously assessed would be a dischargeable debt based upon that subsection. The portion of a tax that was assessed before a Form 1040 was filed would be a debt for which no return was “filed” within the meaning of section 523(a)(1)(B)(i), because at the time of assessment the debtor had not met the filing requirements for that portion of the tax and the assessed portion was not calculated based upon the tax reported on the Form 1040. The assessed portion of the tax was a debt for a tax that was legally enforceable by lien or levy before any return was filed. In the case of a debtor who files a Form 1040 after assessment reporting no more tax than was previously assessed, no portion of the tax would be a dischargeable debt.”
This background sets the scene for the court’s decision in Perry which tests the facts in that case against the McCoy line of cases, the Hindenlang line of cases and against its interpretation of the IRS position which did not match either of those positions.
Applying Perry’s facts to the legal position on discharge espoused in McCoy takes little effort. Perry did not file the returns for the four years at issue by the due date of those returns. Therefore, under the rationale in McCoy, the exception to discharge under BC 523(a)(1)(B)(ii) applies and he still owes the taxes for these years after the granting of the chapter 7 discharge.
The application of Hindenlang reaches the same result. The IRS prepared 6020(b) returns and assessed the liability for these periods. Perry filed Forms 1040 after the assessment of the liabilities. The IRS treated the Forms 1040 as request for abatement and reduced his outstanding liability to the amount shown on the returns. The exception to discharge applies to the amount of tax remaining and he still owes the taxes for these years after the granting of the chapter 7 discharge.
The difference between McCoy and Hindenlang did not exist in the Perry case. Taxpayers who file their own tax returns after the due date of the return but before the IRS prepares a return under 6020(b) benefit from the Hindenlang view of “what is a return.” Since Mr. Perry did not file his Forms 1040 until after the IRS had already prepared 6020(b) returns, he was out of luck under either theory. The result for Perry provides no surprises and is consistent with almost all cases decided since the Hindenlang decision in 1999.
The slight twist in Perry comes from the Court’s description of the position of the IRS which departs from the Hindenlang analysis. The Court says that the “Internal Revenue Service relies on Smythe v. United States (In re Smythe), Bk. No. 11-04077, Adv. No. 11-04077, 2012 WL 843435 (Bankr. W.D. Wash. Mar. 12, 2012).” The IRS argued that the “tax debts [were] nondischargeable because the debts [were] base[d] on the I.R.S. assessments and not on the Debtor’ Forms 1040, so that the assessments [were] tax debts for which no returns were filed or given under 523(a)(1)(B)(i).”
The court finds that Perry fails under this argument as well. It stated that:
“When the I.R.S. made tax assessments against the Debtors, the Debtors’ tax obligations because enforceable and the I.R.S. could pursue its claims; therefore, the assessments created “debts[s]” as defined in the Bankruptcy Code. Although the Debtors subsequently filed Forms 1040, the tax debts had already been established by the I.R.S. assessments. The tax debts, therefore, are debts “for which no return was filed,” and are nondischargeable under 523(a)(1)(B)(i).”
This twist first emerged in Wogoman. Ken Weil, who represented Mr. Smythe, put a footnote in his brief addressing this argument but not expecting it to tax center stage. He stated that:
“The Smythes apologize for not pointing out that the Wogoman argument was a red herring. Wogoman v. United States (In re Wogoman), 2011 W.L. 3652281 (Bankr. D. Colo. 2011). Wogoman confuses what is a debt for Bankruptcy Code purposes with what is a debt (the assessment) for Tax Code collection purposes. It is well-established that, under the Bankruptcy Code, the debt arises at the end of the year and not at assessment. Midland Cent. Appraisal Dist. V. Midland Indus. Serv. Corp. (In re Midland Indus. Serv. Corp.), 35 F.3d 164 (5th Cir. 1994) (right to payment arose January 1; petition filed January 18; payment due after January 18; held, tax is prepetition), cert. denied, 514 U.S. 1016 (1995); W.Va. Dep’t of Tax Rev. v. IRS (In re Columbia Gas Transmission Corp.), 37 F.3d 982 (3rd Cir. 1994) (a tax liability is generally incurred on the date it accrues and not on the assessment date or the pay date), cert. denied, 514 U.S. 1082 (1995); and see, In re Stack Steel & Supply co. 28 B.R. 151 (Bankr. W.D. Wash. 1983) (bankruptcy filing between assessment date and payable date created prepetition obligation), rev’d on other grounds, United States v. Ledlin (In re Mark Anthony Constr. Inc.), 886 F.2d 1101 (9th Cir. 1989). This position is further buttressed by 11 USC § 507(a)(8)(A)(iii), which provides priority treatment of not assessed but still assessable taxes.”
The Smythe argument provides the IRS a cleaner path to victory than the straight Hindenlang argument because it avoids the problem it encountered in Colson of having a bankruptcy court apply the Beard test to determine that the Forms 1040 filed after the 6020(b) assessment represent a genuine attempt to file a return. Stay tuned. The “what is a return” question keeps getting more and more interesting.