Procedure Grab Bag: CCAs – Suspended/Extended SOLs and Fraud Penalty

My last post was devoted to a CCA, which inspired me to pull a handful of other CCAs to highlight from the last few months.  The first CCA discusses the suspension of the SOL when a petition is filed with the Tax Court before a deficiency notice is issued (apparently, the IRM is wrong on this point in at least one spot).  The second touches on whether failing to disclose prior years gifts on a current gift tax return extends the statute of limitations for assessment on a gift tax return that was timely filed (this is pretty interesting because you cannot calculate the tax due without that information).  And, finally, a CCA on the imposition of the fraud penalty in various filing situations involving amended returns.

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CCA 201644020 – Suspension of SOL with Tax Court petition when no deficiency notice

We routinely call the statutory notice of deficiency the ticket to the Tax Court.  In general, when a taxpayer punches that ticket and heads for black robe review, the statute of limitations on assessment and collections is tolled during the pendency of the Tax Court case.  See Section 6503(a).  What happens when the petition is filed too soon, and the Court lacks jurisdiction?  Well, the IRM states that the SOL is not suspended.  IRM 8.20.7.21.2(4) states, “If the petition filed by the taxpayer is dismissed for lack of jurisdiction because the Service did not issue a SND, the ASED is not suspended and the case must be returned to the originating function…”  But, Chief Counsel disagrees. Section 6503(a) states:

The running of the period of limitations provided in section 6501 or 6502…shall (after the mailing of a notice under section 6212(a)) be suspended for the period during which the Secretary is prohibited from making the assessment or from collecting by the levy or a proceeding in court (and in any event, if a proceeding in respect of the deficiency is placed on the docket of the Tax Court, until the decision of the Tax Court becomes final), and for 60 days thereafter. (emph. added).

Chief Counsel believes the second parenthetical above extends the limitations period even when the Tax Court lacks jurisdiction because no notice of deficiency was issued.   The CCA further states, “Any indication in the IRM that the suspension does not apply if the Service did not mail a SND is incorrect.”  Time for an amendment to the IRM.  I think this is the correct result, but the Service likely had some reason for its position in the IRM, and might be worth reviewing if you are in a situation with the SOL might have run.

CCA 201643020

The issue in CCA 201643020 was whether the three year assessment period was extended due to improper disclosure…of prior gifts properly reported on prior returns.  In general, taxpayers making gifts must file a federal gift tax return, Form 709, by April 15th the year following the gift.  The Service, under Section 6501(a) has three years to assess tax after a proper return is filed.  If no return is filed, or there is not proper notification, the service may assess at any time under Section 6501(c)(9).

In the CCA, the Service sought guidance on whether a the statute of limitations was extended where in Year 31 a gift was made and reported on a timely filed gift tax return.  In previous years 1, years 6 through 9, and 15 prior gifts were reported on returns.  On the year 31 return, however, those prior gifts were not reported.  That information was necessary to calculate the correct amount of tax due.

Section 6501(c)(9) specifically states:

If any gift of property the value of which … is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b)), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

Chief Counsel concluded that this requires a two step analysis.  Step one is if the gift was reported on the return.  If not, step two requires a determination if the item was adequately disclosed.  Counsel indicated it is arguable that the regulations were silent on the omission of prior gifts, but that the statutory language was clear.  Here, the gift was disclosed on the return, and the statutory requirements were met.  The period was not extended.  I was surprised there was not some type of Beard discussion regarding providing sufficient information to properly calculate the tax due.

CCA 201640016

Earlier this year, the Service also released CCA 201640016, which is Chief Counsel Advice covering the treatment of fraud penalties in various circumstances surrounding taxpayers filing returns and amended returns with invalid original issue discount claims.  The conclusions are not surprising, but it is a good summary of how the fraud penalties can apply.

The taxpayer participated in an “Original Issue Discount (OID) scheme” for multiple tax years.  The position take for the tax years was frivolous.  For tax year 1, the Service processed the return and issued a refund.  For tax year 2, the Service did not process the return or issue a refund. For tax year 3, the return was processed but the refund frozen.  The taxpayer would not cooperate with the Service’s criminal investigation, and was indicted and found guilty of various criminal charges.  Spouse of taxpayer at some point filed amended returns seeking even greater refunds based on the OID scheme, but those were also frozen (the dates are not included, but the story in my mind is that spouse brazenly did this after the conviction).

The issues in the CCA were:

  1. Are the original returns valid returns?
  2. If valid, is the underpayment subject to the Section 6663 fraud penalty?
  3. Did the amended returns result in underpayments such that the penalty could apply, even though the Service did not pay the refunds claimed?

The conclusions were:

  1. It is likely a court would consider the returns valid, even with the frivolous position, but, as an alternative position, any notice issued by the Service should also treat the returns as invalid and determine the fraudulent failure to file penalty under Section 6651(f).
  2. To the extent the return is valid, the return for which a refund was issued will give rise to an underpayment potentially subject to the fraud penalty under Section 6663. The non-processed returns or the ones with frozen refunds will not give rise to underpayments and Section 6663 iis inapplicable.  CC recommended the assertion of the Section 6676 penalty for erroneous claims for refund or credit.
  3. The amended returns did not result in underpayments, so the Section 6663 fraud penalty is inapplicable, but, again, the Service could impose the Section 6676 penalty.

So, the takeaway, if a taxpayer fails to file a valid return, or there is no “underpayment” on a fraudulent return, the Service cannot use Section 6663.  See Mohamed v. Comm’r, TC Memo. 2013-255 (where no valid return filed, no fraud penalty can be imposed).  In the CCA, Counsel believed the return was valid, but acknowledged potential issues with that position.  Under the Beard test, a return is valid if:

 four requirements are met: (1) it must contain sufficient data to calculate tax liability; (2) it must purport to be a return; (3) it must be an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) it must be executed by the taxpayer under penalties of perjury. See Beard v. Comm’r,  82 T.C. 766 (1984). A return that is incorrect, or even fraudulent, may still be a valid return if “on its face [it] plausibly purports to be in compliance.” Badaracco v. Comm’r, 464 U.S. 386 (1984).

The only prong the CCA said was at issue was the third prong, that the return “must be an honest and reasonable attempt to satisfy the requirements of the tax law.”  As the taxpayer had been convicted of Filing False Claims with a Government Agency/Filing A False Income Tax Return, Aiding and Abetting, and Willful Attempt to Evade or Defeat the Payment of Tax, it is understandable why you would question if the returns were “an honest and reasonable attempt to satisfy the requirements of the tax law.”  Further, the Service had imposed the frivolous filing penalty under Section 6702, which only applies when the return information “on its face indicates that the self-assessment is substantially incorrect.”

The CCA notes, however, it is rare for courts to hold returns as invalid solely based on the third prong of Beard, but clearly there would be a valid argument for the taxpayers in this situation.  The CCA acknowledges that by stating “[t]o guard against the possibility that the returns are not valid, the Service should include the Section 6651(f) fraudulent failure to file penalty as an alternative position,” so the taxpayer could pick his poison.

As to the underpayment, Counsel highlighted that overstatements of withholding credits can give rise to an underpayment under the fraud penalty.  The definition was shown as a formula of Underpayment = W-(X+Y-Z).  W is the amount of tax due, X is the amount shown as due on the return, Y is amounts not shown but previously assessed, and Z is the amount of rebates made.  Where the refund was provided, the penalty could clearly apply.  In “frozen refund” situations, the Service has adopted the practice of treating that amount as a sum collected without assessment, which can cancel out the X and Y variables so no underpayment for the fraud penalty will exist.

But, as shown above, even if the fraud penalty may not apply, the Section 6651 penalty will likely apply if the return is invalid, or the frivolous position penalty under Section 6702 may apply.

New Developments in the Cases Involving Discharge of Late Filed Returns

We have reported on numerous occasions regarding the issue of whether a taxpayer who files a return late may discharge the taxes owed on the late-filed returns in bankruptcy.  See prior posts here, here, here, and here.  The recent case of Biggers v. Internal Revenue Service decided by the District Court in the Middle District of Tennessee on September 9, 2016, demonstrates yet again the difficult administrative position that IRS put itself in by embarking on this argument almost 20 years ago.  In Biggers, the District Court reversed the bankruptcy court and determined that the application of the Beard test requires a subjective determination of the taxpayer’s intent in filing the late return.  The case has other interesting facets which I will discuss below.

Additionally, some new developments in the 3rd and 9th Circuits on this issue deserve mention for those following this line of cases.  In the 3rd Circuit, an attempted appeal to the Circuit Court bypassing the district court or Bankruptcy Appellate Panel has been turned back.  In the 9th Circuit, a case on which we reported previously has requested cert.

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I will start with the Biggers case.  Mr. and Mrs. Biggers did not timely file tax returns for the years 2001 through 2004 for reasons that the court does not explain.  The IRS prepared substitute returns for Mr. Biggers for each of these years, sent him notices of deficiency on which he defaulted, and then assessed the taxes.  After the IRS had assessed taxes through this process for all of the years, Mr. and Mrs. Biggers filed joint Forms 1040 for each of these years on February 15, 2007.  On three of those returns, the reported liability decreased from the amount previously assessed; however, on the return for 2002, the joint return reported an increased liability of about $15,000.  The Biggers then waited slightly more than two years and filed a joint chapter 7 petition in December of 2009 after which they received a discharge three months later.

The IRS conceded that the discharge relieved Mrs. Biggers of liability for the four years.  It also conceded that the discharge relieved Mr. Biggers of the $15,000 increase in tax reported on the Form 1040 for 2002 but not for the amount assessed through the substitute for return process.  For the other three years the IRS abated the taxes down to the amount shown on the late filed Forms 1040 but argued that the bankruptcy petition did not relieve Mr. Biggers of the liability because it had prepared the substitute returns first and made assessments before he filed the Forms 1040.  The bankruptcy court agreed with the IRS citing to the seminal case in this area, United States v. Hindenlang, 164 F.3d 1029 (6th Cir. 1999) as controlling circuit precedent.  On appeal, the district court took a different tack.

Before I get to what the district court decided, I need to pause to point out what the district court said that the IRS argued.  The principal argument of the IRS focused on the prior assessment through the substitute for return process.  The argument of the IRS did not exactly mirror the holding in Hindenlang, the controlling circuit authority.  Hindenlang adopted a subjective test based on the Tax Court’s Beard case and found that Mr. Hindenlang, whose return filed subsequent to the preparation of the substitute return, matched the substitute return exactly.  That, said the 6th Circuit, was not a good faith attempt to file a return, and good faith is one of the Beard elements.  The IRS primary argument morphed the Hindenlang argument into an essentially per se rule that once the IRS has assessed based on a substitute for return any Form 1040 filed thereafter can never meet the Beard test and lead to discharge.  This is standard stuff in these cases; however, the district court reports that the IRS went further.  Alternatively, it argued that if the court did not want to adopt its primary argument, the court should adopt the position of the three circuits holding that for bankruptcy cases filed after the 2005 amendments the language in the handing paragraph of B.C. 523(a) means that a late return can never satisfy the discharge requirements because it does not meet the additional statutory requirements in the hanging paragraph.

The district court noted that this argument by the IRS represented a change in its position from other cases.  It does.  This argument goes directly against the Chief Counsel Notice giving guidance on this issue.  It is unclear if the alternative argument the IRS appears to have made in Biggers represents an unannounced shift in the IRS position, a disagreement between Chief Counsel’s office and the Tax Division on this issue or merely a rogue argument by the Tax Division attorney arguing this case.  Unless making this argument represents a mistake by the trial attorney in the heat of battle, the ground seems to have shifted in these cases from a situation in which only certain states argue for the per se rule that filing a return one day late forever  prevents it from receiving a discharge to one where the IRS will also make this argument.  If it will make this argument, it will change the way it administratively processes these cases upon discharge.  This change comes as quite a surprise.

The district court did not adopt the per se rule argued by the IRS as its lead argument or its alternate argument of the one day late rule.  It concluded “that ‘applicable bankruptcy law’ as used in section 523(a)(*) includes pre-BAPCA [the 2005 legislative amendments to the bankruptcy code] case law, which encompasses the Beard test, as well as any other non-bankruptcy law as to requirements for a return.”  So, the district court finds that in deciding whether a document filed as a tax return satisfies the test for being a tax return requires a look at Beard and other case law deciding what constitutes a return.  The court cited a Tax Court case, Swanson v. Commissioner, 121 T.C. 111 (2003) which carefully examined the debtor’s intent before deciding that the taxpayer in that case did not have an intent to file a return.  Imagine IRS bankruptcy examiners doing that in every case.  Impossible.  The IRS cannot administer the subjective test which explains why it has morphed to its own form of per se rule when it has made an assessment pursuant to a substitute for return.

The district court also went back to a long standing anomaly in the IRS argument concerning how it treats taxpayers in bankruptcy cases versus offer in compromise cases.  In bankruptcy cases, it says that Forms 1040 filed after the IRS has made an assessment based on a substitute for return exist only as claims for abatement; however, in offer cases, it requires taxpayers to file Form 1040 even where it has already made an assessment based on a substitute for return.  The district court found the IRS treatment of taxpayers in the offer context suggestive of the continued possibility that Forms 1040 filed in this context could meet the Beard test or otherwise meet the statutory requirement necessary for consideration as returns.  As a result, the district court remanded the case to the bankruptcy court for it to look into the subjective intent of Mr. Biggers in filing the late Forms 1040 in order to determine if they might, in fact, be returns.  If the district court’s analysis of the applicable test holds up, the IRS must carefully investigate the taxpayer’s intent in each of these late file return cases and have courts second-guess its conclusions in hearings involving the violation of the discharge injunction.  Because the IRS cannot handle such a test, I suspect it will seek to appeal this decision.

Meanwhile, a petition for cert has been filed in the Smith case out of the 9th Circuit which we blogged here.  The petition, partially written by Professor John Pottow at University of Michigan, does an excellent job of explaining the state of the law and the various splinters into which it has broken over this issue.  The Supreme Court has denied cert on this issue before, but I do not think that it has previously received a request of this quality.  Whether the Smith case provides the best vehicle for cert is something about which parties will disagree.  Those in the 9th Circuit which averted the per se rule in Smith may prefer to live with Smith rather than face the possibility of the McCoy per se rule, but Mr. Smith can choose to seek cert if he wishes.  Will the IRS, which declined to seek cert before when it had the chance after the creation of the first circuit split based on the decision of the 8th Circuit not to follow Hindenlang, join in this request or will it continue to find that the current state of the law provides it the best avenue for administering the discharge of late-filed returns?  The brief cites to the importance to individual debtors to have consistency in the law across the country.  Will the IRS also find administrative importance in the need for consistency?  Does the alternative argument it made in Biggers signal a new litigating strategy that will play out in its response to the cert request?

Another, meanwhile, concerns the Third Circuit.  We posted previously on a case headed to that circuit; however, it appears that the Third Circuit has turned down the direct appeals, meaning that it will be longer before that circuit joins the parade of circuits weighing in on this issue.

Ninth Circuit Rules in Smith Case but Passes on Addressing the One Day Late Discharge Issue

A copy of the 9th Circuit’s opinion issued today in the Smith case can be found here:  Smith v. United States.  We will have commentary about the opinion in coming days.  Like the recent opinion from the 11th Circuit, the 9th Circuit goes back to pre-2005 law to decide the case and passes on the opportunity to address the one day late rule.  Because the IRS does not argue the one day late rule and because the debtor will never argue for that rule, it requires affirmative action by the Court as the 10th Circuit took in Mallo to raise the issue.

Bankruptcy Discharge Regarding Late Filed Return Moves Forward in Third Circuit

I have previously written on several occasions, here, here, here, here, and here, about the interpretation of the bankruptcy code concerning the discharge of taxes related to tax years for which the taxpayer files a late return.  Three Circuits have ruled that when a taxpayer files a late return, even a moment late though that is rarely the case, the taxes related to that return can never be discharged because of the language added to Section 523(a) of the Bankruptcy Code in 2005.  Though the IRS does not yet agree with the determination of the Circuit courts, its representative has stated that it may have to reconsider that position if more Circuits adopt the strict reading of Section 523(a).  At present, taxpayers living outside the 1st, 5th or 10th Circuits can generally discharge their federal taxes even if they have filed a late return as long as they did not cause the IRS to prepare a substitute for return (SFR) with respect to the period.  If the IRS had to go to the trouble of preparing an SFR, it will take the position that any tax liability for the period is excepted from discharge.

Enter the next case in this saga.  On June 29, 2016, the District Court for the District of New Jersey, which is within the 3rd Circuit, entered an order certifying the issue to the 3rd Circuit from the bankruptcy court.

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Mr. Davis filed a Chapter 7 petition on July 24, 2012.  He listed the IRS as a creditor for just over $100,000.  Before he filed his Chapter 7 petition, the IRS prepared SFRs for him for 2005 and 2006 since he had not had time to prepare his own tax returns.  After the IRS prepared the SFRs, sent the notice of deficiency, waited for the 90-day period to file a petition in Tax Court to run and assessed the liabilities for these two years, Mr. Davis freed up some time and filed Forms 1040 for each of the years on January 28, 2010.  The Forms 1040 he filed reduced the liability by small amounts in each year.  He waited more than two years after filing the Forms 1040 before filing his Chapter 7 bankruptcy petition.  The IRS treated the 2005 and 2006 liabilities as excepted from discharge for the reasons discussed in the prior blog posts and not because of a strict reading of Section 523(a) of the Bankruptcy Code.

Probably because the Chapter 7 case did not get Mr. Davis where he wanted to be with respect to his federal tax obligations, he filed a Chapter 13 petition on August 11, 2014.  Seems like he could have saved a lot of time and trouble by filing his returns on time or even working with the IRS when it undoubtedly began a long chain of correspondence with him about the unfiled returns, but that’s not what happened.  The IRS filed a proof of claim for over $60,000 of which a small portion was secured, a small portion was priority (for a later year) and the largest portion was general unsecured.  Mr. Davis disputed the debt from 2005 and 2006 arguing that it was discharged in his prior bankruptcy.  The bankruptcy court granted his motion.  The bankruptcy court relied on an earlier decision in the bankruptcy courts of New Jersey, In re Maitland, 531 B.R. 516 (Bankr. N.J. 2015) which had rejected the decisions of the three Circuit courts.  The Davis court also rejected the IRS argument that the Forms 1040 filed after an SFR did not cause the exception to discharge to apply.  Finding Maitland persuasive, the bankruptcy court held that “there is no timeliness requirement when determining if a filing constitutes a return for purposes of discharge” and ruled that the late filed Forms 1040 filed more than two years before the first bankruptcy petition met the requirements of Section 512(a)(2)(ii) for purposes of meeting the requirements of returns to be discharged.  The IRS filed a notice of appeal to the district court and Mr. Davis moved for certification for direct appeal to the Third Circuit.

Normally, a decision of a bankruptcy court gets appealed to the local district court; however, 28 U.S.C. 158(d)(2) provides that a litigant may appeal the decision of a bankruptcy court directly to a Circuit court if the district court certifies (1) that the matter “involves a question of law as to which there is no controlling decision of the court of appeals for the circuit or of the Supreme Court of the United States or involves a matter of public importance; (2) the judgment order, or decree involves a question of law requiring resolution of conflicting decisions, or (3) an immediate appeal from the judgment, order, or decree may materially advance the progress of the case or proceeding in which the appeal is taken”

The IRS opposed the certification which surprises me from the perspective that getting this issue resolved will reduce its exposure for a large drawer full of potentially discharged cases on which it is violating the discharge injunction.  It is certainly not clear that a resolution would result in a holding that the IRS is violating the discharge injunction on a wholesale basis but since that is, at least, a possibility, I would think that the IRS would want to resolve this issue as quickly as possible and seek certification in as many cases as possible.  The IRS opposition to certification points to exactly the problem with the position it has taken since Hindenlang.  It argues here that the issue is not a purely legal issue and that’s the rub because the IRS bankruptcy specialists sure want to treat it as if it is a purely legal issue to which they can apply mechanical tests.  The IRS seems to argue to the district court that the discharge issue here is “heavily dependent on the particular facts of the case.”  Why it would want to make such an argument is mind boggling.  Does it think that its bankruptcy specialists are making case by case decisions?  Does it want them to do so?  The IRS should be desperately seeking a legal decision.  It has tens of thousands of these cases to review and cannot possibly make a heavily dependent factual determination.  I did not go and read the IRS brief but only the characterization of its position.  The district court says that the IRS characterized the bankruptcy court’s decision as fact dependent.  Maybe that is the distinction between my concerns and its arguments but it should want the court to treat it as a legal decision rejecting its argument.

Because this case is between the IRS and the debtor, the issue of the one moment late rulings of the three circuit courts will not necessarily be argued to the 3rd Circuit.  The 3rd Circuit, however, will not be blind when it starts researching this issue and when it reads the last paragraph of the district court order.  In the Mallo case the 10th Circuit got to the one moment late issue even though only the IRS was before it.  The Third Circuit will quickly discover that there is a very simple way to dispose of this case that does not turn on intent or the bankruptcy court’s view of the timeliness requirement vis a vis SFRs.  So, this may be the next case to address the issue regarding the late filing of a tax return and the discharge of the liabilities for the year(s) when the returns are filed late.

The 11th Circuit Bypasses the Chance to Rule of the Late Return Issue

In Justice v. United States, the 11th Circuit had the chance to become the fourth Circuit Court to rule on the impact of the unnumbered paragraph, aka (*) paragraph, at the end of B.C. 523(a).  It passed on the opportunity and went back to the roots of this issue before siding with the majority of Circuit Courts that addressed this issue based on the pre-2005 law.  Mr. Justice loses because the majority of Circuit Courts deciding the issue prior to 2005 held that debtors filing a Form 1040 in circumstances similar to his were not filing a tax return under the Beard test.  I think everyone loses because the opinion just defers to another day the resolution of the (*) paragraph problem.  I have written about this issue on numerous occasions and the last post has links to the earlier ones.

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The Justice case provides a nice review of the law as it existed when Congress tried to fix the problem in 2005. Because the Court essentially ignores, or leaves for another day, the 2005 legislation, those following this issue simply have another opinion that follows the way the case law was developing prior to the legislative change. By deciding the case based on pre-2005 law, the 11th Circuit did a disservice to those concerned about this issue including debtors and the various taxing authorities trying to decide how to deal with this discharge provision. Both sides need a speedy resolution to a problem that has persisted for 18 years since the Sixth Circuit decided Hindenlang.

Resolution of the issue is important for debtors because so many individuals fail to timely file their returns. These individuals need to know if their failure to timely file the return means that they are forever barred from using bankruptcy to discharge the taxes or have some hope for relief that seems to exist in B.C. 523(a)(1)(B)(ii). The taxing authorities need to know because every day they must make a decision on whether to discharge a debtor in these circumstances. The longer the uncertainty lingers, the more debtors that have what may ultimately turn out to be a wrongful discharge determination and the more trouble the taxing authorities will have unwinding the situation. The IRS continues to resist applying the harsh discharge rule as interpreted by three Circuit Courts but it has no obligation to continue to do so in the face of continuing uncertainty and given the certainty that the harsh rule provides.

The problem with the pre-2005 state of the law and the problem that the Justice opinion prolongs is the difficulty of administering a law concerning discharge based on a case by case factual determination of whether the late for 1040 represents a meaningful attempt to file a return under the Beard test, there by resulting in a discharge, or does not represent a good faith attempt to file, thereby resulting in an exception to discharge. The IRS has offered a post-2005 alternative which provides certainty, viz., if the debtor does not file the return until after the IRS makes an assessment based on an SFR then the debt is always excepted from discharge because it is not a return and if the debtor files the late return before an assessment based on an SFR then the two year rule applies. The IRS offered up this outcome to the 11th Circuit but it was not buying what the IRS was selling. So, it sticks the parties with the factual determination test.

To its credit the 11th Circuit seems to choose the “best” of the factual determination cases – Moroney out of the 4th Circuit but Moroney is still a factual determination case at its heart although one in which the debtor will almost always lose making it easy for the IRS to administer and for debtors to predict the outcome. The application of the Moroney rules will almost always create the same result the IRS seeks in its post-2005 argument for a legal test but it does not quite get all the way to the legal test.

Last week I was working on a case in the clinic that demonstrates the problems with the application of the harsh (*) rule and cries out for a simple solution. The individual owes for three years and has a total liability over $60,000. For each of the three years he was running a small business and requested an extension of time to file his return. He clearly filed two of the three returns on time but he may have filed the third year late by a week or two. The year is old and I am trying to get a definitive answer on when the return was filed because it is so critical. The individual has a very low income now but has recently married someone with a good income. Because of her income, I do not think he can obtain an offer in compromise without a very high payment. He is someone who has always filed. With the possible exception of the one year where I am trying to find out if the return was timely filed or filed shortly after the extended due date, he has always filed timely. The IRS did not impose a late filing penalty on him and would have abated the penalty based on its first time abate rules if it had imposed the late filing penalty. Yet, if it turns out he did not timely file, he cannot discharge this debt in bankruptcy because he lives in the First Circuit. Because he got married to someone with a good and stable income, he also cannot obtain an offer unless his new spouse is willing to pay off his long outstanding and substantial tax debt. Understandably, she is not excited about paying off his old tax debts and the situation is putting a strain on their relationship. So, he may end up waiting out the statute of limitations on collection and putting pressure on his marriage.

This is a wasteful policy dilemma. Section 523(a)(1)(B)(ii) set up a system to allow late filers to still obtain a discharge if they waited extra time. In the case of my client, who, if he filed late, did so immediately after the due date, would not even have to wait extra time because of the timing of his filing. Yet, he appears to be prevented from obtaining a discharge for this year. By demurring on the correct interpretation of (*) the 11th Circuit sentences those seeking to know the answer to a longer wait. No matter which way it ruled, having the opinion of the 11th Circuit on (*) would have helped to move the issue to resolution faster.

Les’ post discussing how  filing within 10 days of an e-file rejection will still result in a timely return.  This work around will not present itself often but is worth remembering for those situation where your client has tried and failed to timely file their return electronically.

9th Circuit Bankruptcy Appellate Panel Decision on Unfiled Returns Takes Issue Back to the Future

I have written several times, here, here, here, here and here, on the case law that has developed after the 2005 amendments to section 523 of the bankruptcy code addressing the ability to discharge taxes when the taxpayer files the return late.  In 2015 two circuit courts, Mallo in the 10th and Fahey in the 1st, followed In re McCoy in the 5th and held that when an individual taxpayer files a return late, even one day late, the tax liabilities related to that return can never qualify for discharge.  These courts reach this result based on a literal interpretation of the unnumbered paragraph added to the end of 523(a)(hereinafter 523(a)(*)) in 2005.

A 9th Circuit bankruptcy panel, in the case of Martin v. United States examines and rejects the emerging case law applying a literal interpretation to 523(a)(*).  The court not only works its way through the literal interpretation argument but addresses and rejects the IRS’ current position resulting in an opinion that essentially finds the law unchanged by the 2005 legislation.

Before discussing the opinion, it is worth pausing for a moment to discuss bankruptcy appellate panels so that the opinion can have some context as it relates to the three circuit level opinions that currently exist. Bankruptcy courts reside beneath federal district courts in the pecking order for precedent.  Without getting into the constitutional issues created by the 1978 Bankruptcy Code and the resolution of those issues, it is safe to say that bankruptcy judges are not Article III judges and that their opinions, when appealed, go to the district court before going to the circuit court and then to the Supreme Court.  In 1978 Congress gave circuits the option of creating bankruptcy appellate panels as a place to appeal the decision of a bankruptcy judge.  In 1994 Congress said all circuits would have such panels.  The bankruptcy appellate panels consist of three bankruptcy judges.  The decision of the bankruptcy appellate panel goes to the appropriate circuit court.  There is more that could be said about these panels but for purposes of this discussion, I simply want to place them on the map of federal courts for those not familiar with bankruptcy procedure.  So, the opinion that this post will discuss will now go to the 9th Circuit if appealed and does not itself create a conflict among the circuits.

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The opinion has an interesting format because it leads off talking about misguided nature of the opinions holding that a return filed one day late must forever be denied a discharge. After the clear statement in the opening paragraphs, the court circles back to the facts before working its way through the legal arguments.  Because I very much agree with the views of the BAP regarding the literal reading of the 2005 amendment, the opening paragraphs made for enjoyable reading.

The facts of the case essentially mirror those of all cases of this genre. The taxpayers did not file returns for several years.  The IRS sent them notices about that fact.  They did not act in response to the notices.  The IRS eventually sent the Martins notices of deficiency for the years at issue.  The notices of deficiency inspired them to go to a preparer and get the returns prepared; however, they defaulted on the notices allowing the IRS to assess the liabilities.  The Martins then filed the missing returns and the IRS abated its assessments to reflect the liabilities reported on the late filed returns.  The Martins waited two years after filing the late returns and filed a chapter 7 bankruptcy.  They sought a determination that the liabilities on the late returns were discharged.  The IRS objected.

In deciding the case the BAP looked at three possible bases for reaching the correct conclusion. First, it examined the interpretation of discharge developed by the three circuits making the literal interpretation of 523(a)(*).  Second, it examined 9th Circuit law that had developed prior to 2005 on the issue of unfiled returns and finally, it addressed the argument advanced by the IRS regarding the effect of an assessment prior to the filing of the late return – an argument developed post 2005.

As mentioned above the BAP rejected the literal reading of 523(a)(*). I t found that such a reading did violence to the statutory scheme of discharge developed in 1978 with the passage of the bankruptcy code.  In addition, it found that the literal interpretation did not make sense even within the new paragraph added in 2005 and that the literal interpretation of that paragraph could not be resolved with the language of 523(a)(1)(B).  The opinion provides a roadmap for those who disagree with the literal interpretation provided by the three circuit courts.  If the case is appealed and if the 9th Circuit follows the BAP, a clear conflict will exist among the circuits which might create a path for resolution of this issue.

After knocking down the literal argument, the BAP turned its attention to the controlling precedent of its circuit. It found that the controlling precedent relied on the Beard test for determining “what is a return?”  The BAP held that the 2005 amendment sought to codify the Beard test and prior 9th Circuit precedent.  This aspect of the decision is also important.  I disagree with the BAP on its interpretation of the goal of the 2005 language because the effort to change the code sprang not from an effort to codify the case law imposing the Beard test but to creating an easily administrable rule.  The Beard test involves a fact intensive look at the circumstances of each case.  The taxing authorities do not want this both because it requires more resources than they want to devote to this issue and it makes the issue one which will require frequent litigation to resolve the fact intensive question.  This result is not what the taxing authorities sought in pushing for the amendment but may be what they got if the literal language is rejected.

Finally, the court looked at the argument the IRS now pushes. This is an easily administrable position and one which is much more lenient than the literal language argument but one that the BAP did not buy.  The IRS argues that once it has made an assessment of the tax for a year, any return filed after that assessment is not a return for purposes of triggering the two year rule in 523(a)(1)(B)(ii).  The BAP rejected this because it did not agree that the trigger point is the assessment date.  The liability goes back to the end of the tax year and does not start with the assessment.  The assessment of the tax, almost always done in these cases after the issuance of a notice of deficiency to a taxpayer who has refused to filed the return, does not have any special meaning in the statutory scheme of 523.  The IRS position has the attraction of easy administrability and the opportunity for a taxpayer to correct the unfiled return situation long after the close of the tax year, but it is hard to find support for the position in the language of the statute.

So, the BAP takes us back to the pre-2005 legislation on this issue with the only impact of the legislation, in the opinion of the BAP, being the codification of the position the 9th Circuit had previously staked out (along with several other circuits.)  If the BAP position prevails, taxpayers are clear winners vis a vis the literal interpretation test because they have time to fix their failure to file and still obtain the benefit of a discharge.  In pre 2005 cases most taxpayers who waited for the IRS to make an assessment before filing a late return lost in their attempt to get the liability discharged.  Taxpayers will still lose their discharge cases under the BAP opinion in most cases where they wait until after assessment to file the late return but the clear losers if the BAP opinion prevails are the tax administrators who must do more fact investigations and face more litigation when trying to resolve the discharge issue created by a late filed return.

Who Won the Sanchez Case?

Today we welcome first time guest blogger Bob Nadler. Bob is the perfect guest for this post about an innocent spouse issue because he authors “A Practitioner’s Guide to Innocent Spouse Relief.”  The ABA Tax Section published second edition of his book last year.  He also co-wrote the chapter on innocent spouse issues in the 6th Edition of “Effectively Representing Your Client before the IRS.” For over a decade Bob has represented low income taxpayers as an attorney at the Legal Aid Society of Middle Tennessee and the Cumberlands. Before becoming a representative of low income taxpayers, Bob worked for the Office of Chief Counsel, IRS for over 30 years in its Nashville office and was a valued colleague for me there as he is now as a clinician. Keith 

In sports, sometimes a team loses an important game and later is awarded the victory because the other team was disqualified. That is what may happen in the recently decided case,  Sanchez v. Comm.  In Sanchez, the taxpayer sought innocent spouse relief in the Tax Court and lost her case because the Court held no joint return was filed.  But the underlying assessment of a joint tax may have been erroneous.  If the assessment is found to be invalid the taxpayer will probably have no tax liability.

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Background 

The taxpayer and her spouse were married in 1988 and separated in November 2006. The taxpayer filed for divorce in 2007 and it became final in 2011.

For all years before 2006, the taxpayer and taxpayer’s husband (hereafter the TPH) filed joint returns. They relied upon an accountant, who communicated solely with the TPH.  Although she did not review the returns, the taxpayer did sign the prior year returns.

The TPH separately filed his 2006 income tax return in October 2007 and claimed a filing status of single. He did not claim the taxpayer as a dependent.  The taxpayer did not file an income tax return for 2006.  The taxpayer first became aware of the TPH’s return after it was selected for examination.

The Court noted in the opinion that the record was unclear if the taxpayer had a duty to file a separate 2006 income tax return.

After the IRS proposed a deficiency, the examiner informed the taxpayer and the TPH that it would benefit them if they filed a joint return. The benefit was the tax due would be less.  The taxpayer and the TPH signed a Form 4549 agreeing to the proposed adjustments to tax.   One of the adjustments involved a change in filing status from single to joint filing status.  In agreeing to the adjustments, the taxpayer agreed to joint and several liability.   The IRS accepted the agreement and assessed the tax as a joint tax.

On May 16, 2011, the taxpayer filed a claim for innocent spouse relief on Form 8857.

The IRS disallowed the claim and the taxpayer filed a petition in Tax Court.

The Court held that no joint return was filed.

A Joint Return is an Element of section 6015.

As the Court noted, section 6013(a) provides that a married couple may elect to file a joint return.    If a joint return is filed, both spouses are jointly and severally liable for the tax.  If a joint return has been filed, a taxpayer can file a claim for relief from joint and several liability.  A claim for innocent spouse relief request is normally initiated by filing a Form 8857 with the IRS.

Section 6015 provides for three types of innocent spouse relief.   All three subsections require that a joint return must have been filed.  See IRC sections 6015(b), (c) and (f). If no joint return has been filed, the taxpayer is not jointly and severally liable and the Court does not acquire jurisdiction to consider a claim for innocent spouse relief.

Was a Joint Return Filed in the Sanchez Case?

The threshold issue in the Sanchez case was whether a joint return was filed by the taxpayer and her spouse.    Whether married taxpayers file a joint income tax return is a question of fact.   As the Court noted in Estate of Campell, “Married taxpayers must intend to file a joint return.”  Many fact scenarios can arise.  For example, sometimes one spouse has not signed the return.  Another situation, which was presented in this case, is where one spouse files separately and then later the second spouse agrees to file a joint return.   The right to make a joint return after one spouse files a separate return is subject to certain exceptions not presented in the Sanchez case.  See IRC sec. 6013(b)(2).

The Court recognized the taxpayer’s right to file a joint return after her spouse’s separate return had been filed, but the Court concluded that the taxpayer’s efforts to file a joint return were not sufficient to constitute an election.

At the outset, it is surprising that the issue of whether a joint return was filed even arose in Sanchez.  Normally, you would expect this issue to arise in a case where a taxpayer contends that he or she either did not file a joint return or never intended to file a joint return.  For example, if one spouse insists that the other spouse improperly signed his or her name.  These cases often involve opposing testimony and might turn on a number of factors including whether the taxpayer tacitly approved the spouse signing their name to the original return.  It is unusual, in my experience, for the issue of a joint fling to arise when both the IRS and the taxpayer agree there was a joint filing.

In Sanchez, the court rejected the taxpayer’s argument for the following reasons: the Court held that the consent, Form 4549, signed by the taxpayer and her spouse agreeing to the joint and several liability should not be treated as a joint return.

The original return in the Sanchez case was audited and the revenue agent proposed a deficiency. During discussions with the spouse, who filed the original return, and the taxpayer, the revenue agent explained that if the spouse and the taxpayer agreed to file a joint return, the proposed deficiency would be reduced.  Although the full nature and extent of the discussions is not known, apparently the taxpayer concluded that it was in her best interests to agree to a joint filing.  It is not clear from the reported case, but it appears that the taxpayer may not have had any income in the taxable year.  So, in making the computation of taxable income, the revenue agent proposed making adjustments relating to the TPH’s income and the revenue agent also proposed making an adjustment to the filing status claimed on the original return.  Because the taxpayer was agreeing to joint filing, the filing status on the Form 4549 was changed from “single” to “joint”.  It is routine for the IRS and taxpayers to resolve cases through the use of Form 4549.  Further, it is not uncommon for a change in the filing status of taxpayers to be included on a Form 4549.

Under the Beard test, a document must meet four tests to be a return:  (1) purport to be a return, (2) be executed under penalty of perjury, (3) contain sufficient data to allow the calculation of tax, and (4) represent an honest and reasonable attempt to satisfy the requirements of the law.   In Sanchez, the Court rejected the Form 4549 in large part because the Form 4549, signed by the parties, did not contain language regarding perjury.   Notwithstanding the absence of a jurat, the author believes that the IRS and the taxpayer made an honest and reasonable attempt to satisfy the requirements of the law.

While the Court rejected the Form 4549 as sufficient to establish a joint filing, there is much to suggest that signing the Form 4549 is sufficient. First, the parties made mutual promises.  The IRS allowed the spouse and the taxpayer to benefit from the more favorable tax rates for joint filers.  On the other side, the taxpayer agreed to joint and several liability for the taxes.  It does not matter if the taxpayer fully understood the consequences of agreeing to the joint return.  What matters is that she understood that she was filing a joint return and receiving consideration – a lower tax – for her consent.   It is a fair bargain and it should be binding on the IRS and the taxpayer.

Certainly both the IRS and the taxpayer went forward with the belief that the taxpayer had elected a joint filing. Based upon the taxpayer’s agreement to be bound by the joint filing, the IRS assessed the tax and began collection activity.  On the other side, believing that she owed the taxes, the taxpayer eventually filed for innocent spouse relief.  The IRS accepted the Form 8857 for processing.  It is a condition for processing a request for innocent spouse relief that the taxpayer has filed a joint return.   If the IRS did not believe that there had been a joint filing, it would not have made a final determination denying innocent spouse relief.  The final determination was the basis for the court proceeding in the Sanchez case.

But the court has now ruled that no joint return was filed and there is no appeal from a small case and the Court’s decision will soon be binding on both parties.

Tax Consequences 

Normally, after a decision in an S case, the amount of a deficiency, if any, is established.  But that is not the case in the Sanchez case.  The tax liability was not before the court – only the innocent spouse issue.   Because the filing of a joint return is a prerequisite to the Court granting appropriate relief under IRC section 6015(e), the Court never reached the merits of the Service’s final determination denying innocent spouse relief.  The Court’s decision denied the taxpayer a right to review, but the decision appears to have created other rights.

At the end of the opinion, the court wrote:

…it is appropriate to state that nothing in this Summary Opinion should be taken to comment as to the assessment made against petitioner on the basis of the consent.

Although the court’s comment does not address the tax consequences of the decision, the tax consequences appear to heavily favor the taxpayer.  While she did not achieve a favorable result on her request for innocent spouse relief, she did not leave the court without a potential remedy.  While an S case cannot be cited as precedent and may not be appealed, the decision is final as between the parties. See  IRC section 7463(b).

The court ruled that the taxpayer did not file a joint return with her spouse.  The decision has significant legal impact on the taxes assessed pursuant to the consent.   As assessment based upon a joint filing no longer exists.  Moreover, the statute of limitations for filing a joint return has probably expired.  See IRC section 6013(b)(2)(A).  It is hard to imagine that the IRS would take the position that petitioner remained liable for the taxes based upon the reported income of the taxpayer and her spouse.  If the statute of limitations on assessment is still open, it is far more likely that the IRS will split the joint account into two separate accounts and recompute each individual’s separate tax based upon their separate income and expense items.  But, the year involved is 2006 and it is unlikely that the statute of limitations on assessment is still open.

If the IRS stubbornly continues to pursue collection, it seems to me that the taxpayer could file a petition in Tax Court alleging that the IRS had not followed the deficiency procedures and was collecting the tax based upon an illegal assessment.  The Tax Court would almost certainly rule in the taxpayer’s favor.

At the end of the day, it turns out that the taxpayer in Sanchez, not the IRS, may be the ultimate winner in this dispute.

Tenth Circuit Ups the Ante on Late Filed Returns

Like a virus jumping from one species to another recent 10th Circuit decision in Mallo v. United States  has moved the issue of the discharge of late filed returns from a state to a federal issue.  Because of the unforgiving nature of the position adopted by the 10th Circuit, the decision causes concern for any taxpayer who misses the filing deadline, even by one day (or minute or hour) and later wants to discharge the taxes for that period.

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I wrote about this issue in a post generally describing the ongoing disarray in the discharge area in 2013. Unfortunately, the situation has not gotten any better and, with the 10th Circuit’s decision, it has gotten worse.  This post primarily will describe the Mallo case in shrill terms and offer one possible way around the predicament in which the Mallos now find themselves.  Before I get to the shrill part of the post, I will explain briefly how we got to this point.  I think the problem all started with an attorney who dreamed up a slick idea to help his client get past the discharge provisions and Department of Justice attorneys who countered with an equally slick argument that eventually spiraled into a new code provision creating havoc no one could have imagined at the beginning of this process.

Bankruptcy Code § 523(a)(1)(B)(i) excepts from discharge taxes (federal, state or local) for which the individual taxpayer fails to file a return. This provision does not create much controversy and everyone agrees that if the person has failed to file a necessary return all of the unpaid tax for that period passes through bankruptcy without the benefit of a discharge with the person still owing the taxes at the end of bankruptcy.  Bankruptcy Code 523(a)(1)(B)(ii) excepts from discharge taxes (federal, state or local) “with respect to which a return, or equivalent report or notice, if required was not filed or given after the date on which such return, report or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition.”  This subparagraph basically requires a taxpayer who files a return late to wait at least two years after filing the late return before filing bankruptcy if the taxpayer wants to discharge the liability for that period.  The idea behind the provision relates to the need for taxing authorities to have a decent amount of time to collect a tax before Congress will allow it to fall off the books.

Into this scheme comes Mr. Hindenlang. He had not filed his return for a year for which he owed federal taxes.  I imagine that he visited his bankruptcy lawyer who told him that if he filed bankruptcy at that point, even though the taxes were old, he could not get rid of them through bankruptcy.  After not filing his return, the IRS had gone to the trouble to compute his liability for the year at issue using the procedures of IRC 6020(b). Someone, however, came up with the bright idea that if Mr. Hindenlang sent to the IRS a Form 1040 for the year at issue and filled out that form using exactly the information that the IRS used in recreating his return he could then wait two years and one day and file bankruptcy and discharge the liability.  So, he waited the requisite period and then filed bankruptcy arguing in the bankruptcy case that the taxes were discharged because he now technically met the requirements of Bankruptcy Code 523(a)(1)(B)(ii).  The argument made sense if the late filed Form 1040 is a return for purposes of the statute and the argument also seemed to fit with the reason for the exception to discharge which was to give the taxing authority ample time to collect before discharging the tax.

The IRS, however, did not take this laying down and it, or its lawyers, could be just as clever as Mr. Hindenlang and his lawyer. It argued that the Form 1040 submitted by Mr. Hindenlang did not meet the definition of return because looking at the factors established by the Tax Court in the Beard case the taxpayer did not really possess the intent for this document to be a return. The IRS won that case but with an argument that required it to make a case by case determination.  It ultimately prevailed in some circuits while losing in the 8th Circuit and settling for some additional language in the 2005 Bankruptcy Reform Act.  The new language that was intended to settle this issue has spawned a new level of problems.

The new language, which comes in an unnumbered paragraph at the end of 523(a) provides: “For purposes of this subsection, the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”  This first sentence of the new language has taken some courts in a different direction concerning the discharge of taxes reported on late returns.  The 5th Circuit in the McCoy case held that this language makes any return that fails to meet the filing requirements, including the time for filing a return, a period for which the liability cannot receive a discharge. The IRS rejected this view, correctly in my opinion, of the new language because of the inability to reconcile this view with the two-year rule of Bankruptcy Code § 523(a)(1)(B)(ii). It looked like this interpretation would only apply to state or local liabilities where the state or the locality, like Mississippi in McCoy, chose to apply this draconian rule.

Like a virus crossing from one species to another, however, the Mallo case marks the crossing of this view into federal tax liabilities. The crossing into a new species of case did not occur because the IRS sought this result.  Rather, the IRS made its official argument now that “a debt assessed prior to the filing of a Form 1040 is a debt for which [a] return was not ‘filed’ and therefore cannot be discharged in bankruptcy.”  Citing the well-reasoned Rhodes case from Georgia that I blogged previously, the 10th Circuit rejected the argument of the IRS and, on its own, adopted the 5th Circuit’s view in McCoy quoting from an earlier 10 Circuit opinion stating “we cannot reject an application of the plain meaning of the words in a statute on the ground that we are confident that Congress would have wanted a different result. . . . In short, courts, out of respect for their limited role in tripartite government, should not try to rewrite legislative compromises to create a more coherent, more rational statute.”  Okay.

Late filing taxpayer in the 10th Circuit might want to start taking up a collection to pay someone to file a cert petition in Mallo.  Their problem will be the lack of a conflict on this view at the Circuit level unless the Supreme Court looked back to pre-2005 cases.  They might use the money to lobby their favorite Congressperson to change the law again and try to make it clearer what it intended to say in the first place.  I believe the National Taxpayer Advocate will include this issue in her annual report to Congress next week as one of the major problems and maybe that will give them a greater than 0% chance of getting Congress to enact legislation.

So, what do you do if you are faced with a case against the IRS over a discharge issue outside the 10th Circuit and you are worried that your court might do what the 10th Circuit did and impose the plain meaning of the unnumbered paragraph on your client to deny discharge.  I spoke to Ken Weil about this case.  Ken co-authors the bankruptcy chapter in Effectively Representing Your Client before the IRS and served on the tax advisory committee to the reform commission appointed by Congress following the 1994 Act whose recommendations formed the basis for the 2005 amendments to the bankruptcy code including this one.  Ken suggested entering into a stipulation that a return filed late is not per se a violation of the “applicable filing requirements” rule and that portions of McCoy and Mallo applying such a one-day late rule do not apply. He credited this suggestion to Morgan King who practices bankruptcy and tax law in California. I cannot say if that strategy will work.  I can only say that a very deadly strain of argument previously confined to state tax issues has now crossed over to federal taxes and individuals who did not file their returns before the due date had better start thinking of some arguments if they ever want to use bankruptcy as a basis for relief.