Discharging the Failure to File Penalty in Bankruptcy

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The recent case of United States v. Wilson highlights one more reason for timely filing your tax return.  Mr. Wilson requested an extension of time to file his 2008 tax return until October 15, 2009; however, he did not actually file until 2011.  On July 24, 2012, he filed a chapter 7 petition.  His was the rare chapter 7 case that actually had assets available to distribute to creditors.  His 2008 liability got paid by the chapter 7 trustee; however, the estate did not have enough funds to pay the failure to file or failure to pay penalties.  In a chapter 7 case penalties get paid at the very end of the line.  So, having these liabilities go unpaid in the bankruptcy case provides no surprises.

After the bankruptcy ended, the IRS did not write off the penalties. Instead, it sought to collect them by offsetting Mr. Wilson’s subsequent California state refund and by levying on his social security benefits.  Mr. Wilson thought that the bankruptcy discharged the penalties and brought an action in bankruptcy court to enjoin the IRS from collecting on these penalties and to obtain the return of his money.  In response, the IRS conceded that the failure to pay penalty was discharged but argued, successfully, that the failure to file penalty was not.  The district court overturned the bankruptcy court in holding for the IRS on a narrow interpretation of Bankruptcy Code section 523(a)(7) and the rules regarding the discharge of penalties.

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The discharge rules for taxes reside in 523(a)(1). Generally, if a tax liability meets the priority criteria of section 507(a)(8) then bankruptcy will not discharge the tax.  For income taxes to meet the priority criteria generally the taxes must have been due to be filed within three years of the date of bankruptcy filing with the due date including extensions to file.  Taxes assessed within 240 days of the bankruptcy petition and taxes not yet assessed but still assessable can also have priority status subject to certain exceptions.  The 2008 taxes of Mr. Wilson had priority status because he filed bankruptcy less than three years after the extended due date for the filing of the 2008 return – October 15, 2009.

The rule for discharging penalties, however, resides in a different subsection of 523. Penalties can never achieve priority status (not counting the trust fund recovery “penalty”) and have their own separate subparagraph (7) for determining dischargeability.  Section 523(a)(7) provides that ‘[a] penalty imposed on unpaid taxes accruing more than three years before the filing of the bankruptcy petition” is discharged.  The question facing the court in Wilson concerns the meaning of “accruing more than three years before.”  One possible interpretation is that penalties like the failure to file and the failure to pay accrue each month with each continuing month’s failure.  If this were the test for accruing, the lookback would go from the date of the bankruptcy petition, to the penalty imposed for a month occurring within the three year period.  The debtor would discharge some of the accruing penalties for the months more than three years prior to the filing of the bankruptcy petition but would still owe the penalty for the months that ran within the three year period.  Courts have rejected this approach.

Another approach would be to look at the due date for filing the return to which the penalties relate in order to determine if the due date occurred more than three years before the filing of the bankruptcy petition. If the due date occurred more than three years before the filing of the petition, the penalty receives the discharge.  Here the due date for paying the taxes occurred on April 15, 2009.  That date was more than three years before the filing of the bankruptcy petition.  The IRS conceded that it should have discharged the failure to pay penalty because this penalty ran from the due date of the return.  It argued that its failure to discharge and write off the failure to pay penalty did not impact the case because the amount of the failure to file penalty exceeded the amount that it had collected post-bankruptcy.  The court did not engage in a discussion of sanctions against the IRS for violating the discharge injunction and, so, tacitly seemed to agree with the position of the IRS.

Now, the tricky part of the case because the language of 523(a)(7) does not talk about due dates or extended due dates. Here the bankruptcy case was filed more than three years after the original due date of the tax return but less than three years after the due date for filing the tax return as extended.  The taxpayer argued that the extended due date mattered for calculating the priority of the tax itself because the language of 507(a)(8)(A)(i) concerning the impact of the extension was very explicit in that section establishing the priority of tax claims.  In contrast, the language of 523(a)(7) provides no mention of extended due date.  So, the taxpayer argued that the original due date of the return should mark the time for the running of the three year period in 523(a)(7) in the absence of explicit language in the statute regarding extensions and the failure to file penalty for 2008 should have been discharged.  At least one court prior to the bankruptcy court in this case had reached that conclusion.

The IRS argued that the extended due date marked the due date for the 2008 return for purposes of determining the discharge of the failure to file penalty. Since the extended due date fell within the three year period before the filing of the bankruptcy petition, the taxpayer cannot discharge the failure to file penalty.  The district court, reversing the bankruptcy court, agreed with the IRS.  It stated that Section 523(a)(7)(B) “makes dischargeable any tax penalty imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition.”  The transaction or event giving rise to this penalty was Mr. Wilson’s failure to file by the extended due date since he had permission not to file by the original due date.  The district court acknowledged that the issue was close.  This fact pattern will not come up with great frequency but is something to consider when deciding the timing of a bankruptcy filing.  Generally, the taxpayer in Mr. Wilson’s case who timely files a return by the extended due date will want to wait for three years past the extended due date in order to discharge the taxes.  Since he did not timely file his return by the extended due date, the date for discharging the taxes themselves ran (subject to the McCoy line of cases discussed in earlier posts) two years from the late filing of the 2008 return.  So, he was not focused on the extended due date in thinking about discharge timing.  If the holding in Wilson is followed by other courts, others in this position must think about the impact of the extended due date for filing the return on the ability to discharge the failure to file penalty which makes the calculation of when to file a bankruptcy petition to maximize the tax benefits just a bit more complicated.

Comments

  1. Barry Goldwater says:

    Tax not paid by April 15, 2009, with the extension, therefore extension invalid and return due by April 15, 2009.

    Game. Set. Match.

    • Under the statute, “[t]he Secretary may grant a reasonable extension of time for filing any return”. 26 USC § 6081(a). The Secretary has promulgated regulations that describe, in part, when this power will be exercised. According to 26 CFR 1.6081-4(a), a 6-month extension “will be allowed” if the taxpayer satisfies the requirements of 26 CFR 1.6081-4(b). The requirements of 26 CFR 1.6081-4(b) do not require the taxpayer to pay the tax (on time or otherwise). The regulations further provide that the Commissioner “may” terminate an extension for apparently any reason, but he is not required to do so. 26 CFR 1.6081-4(d).

      What is the legal basis for your argument that failing to pay the tax means that the extension is not valid?

    • Oops!! After a careful review, we see “Barry” stepped over the line.

      One needs only reasonably estimate, not pay, his tax liability to secure a valid return filing time extension.

      “An automatic extension of time for filing a[n income tax return] granted under paragraph (a) of this section will not extend the time for payment of any tax due on such return.” 26 C.F.R. § 1.6081-4(c). From this language, you can see the income tax return filing time extension grant can precede tax payment.

      If one had any doubt,

      “To satisfy this paragraph (b), an individual must—

      (1) Submit a complete application on Form 4868, “Application for Automatic Extension of Time To File U.S. Individual Income Tax Return,” or in any other manner prescribed by the Commissioner.” 26 C.F.R. § 1.6081-4(b)(1).

      and

      “Although you are not required to make a payment of the tax you estimate as due, Form 4868 does not extend the time to pay taxes. If you do not pay the amount due by the regular due date, you will owe interest. You may also be charged penalties. For more details, see Interest and Late Payment Penalty on page 2. Any remittance you make with your application for extension will be treated as a payment of tax.”

      –From 2015 Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return.

      Point to Cathy. Misconduct penalty to “Barry.” Match proceeds.

  2. Barry Goldwater says:

    The point remains that the extension could be held invalid if the estimated tax liability on the Form 4868 is not accurate. I’m just trying to advocate for this bankrupt late filer. The odds are decent that this taxpayer, a late filing bankrupt, did not do a stellar job reporting his estimated tax liability on Form 4868. There is no discussion in the case at all as to the validity of the extension.

  3. In this tennis match, I must call “return ace!”

    “Wilson obtained an extension to file his 2008 tax return from April 15, 2009 to October 15, 2009.” U.S. v. Wilson at 1. “‘[T]he “transaction or event’ with respect to which the penalty in this case was imposed was Wilson’s failure to file by the October 15, 2009 deadline.” Id. at 3. To obtain that later filing deadline, Mr. Wilson was required to show on his tax return filing extension application “the full amount properly estimated as tax for the taxable year.” See 26 C.F.R. § 1.6081-4(b)(4).

    The above cites show that, contrary to “Barry’s” speculation, Mr. Wilson satisfied his regulatory duty. Indeed, the IRS never terminated his filing extension. See 26 C.F.R. § 1.6081-4(d). No one questioned whether Mr. Wilson’s filing extension was valid; no one can now question whether it is valid.

    A penalty shall be imposed for any racket abuse.

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