Ninth Circuit Reenters the Late-Filed-Return Field

On Wednesday I quickly put up a copy of the opinion in Smith with the promise of further discussion.  Today, we are fortunate to have commentary on the case by guest blogger Ken Weil.  Ken blogged with us earlier this year on George Washington’s birthday.  Ken has his own practice in Seattle that focuses on representing individuals with tax debt and resolving that debt through administrative action with the IRS or through bankruptcy. He has written a book on his specialty area, Weil, Taxes and Bankruptcy, (CCH IntelliConnect Service Online Only) (3d ed. 2014). He is a one of the top experts at the crossroads of personal bankruptcy and taxes. We are fortunate to have him back with us again. Keith

Case law continues percolating in the late-filed-return field.  On July 13, the Ninth Circuit decided Smith v. United States (In re Smith), No. 14-15857, Pacer Docket Entry 51. (9th Cir. 2016).  In Smith, the Ninth Circuit reaffirmed its position that, even after the bankruptcy law changed in 2005, a subjective test is still applied to determine whether a document filed by a taxpayer is an honest and reasonable attempt to comply with the tax law.  Smith, supra at p.7; and see, Beard v. Comm’r, 82 T.C. 766, 775-778 (1984), aff’d, 793 F.2d 139 (6th Cir. 1986) (four-part test used to determine whether the document in question is a valid tax return; one of the four parts is whether the taxpayer made an honest and reasonable attempt to comply with the tax law).  This blog piece discusses the subjective and objective tests as methods for determining whether a taxpayer made an honest and reasonable attempt to comply with the law, the previous confusion surrounding the Ninth Circuit’s leading case in the area, the Smith decision, and the interaction of Smith with an earlier 2016 Ninth Circuit Bankruptcy Appellate Panel (BAP) case that rejected application of the one-day-late rule.

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Subjective and objective tests.

Mr. Smith filed his 2001 tax document seven years after it was due and three years after the IRS assessed tax due.  Smith, supra at p.7.  In affirming the district court’s determination that Mr. Smith had not made an honest and reasonable attempt to comply with the tax law, the Ninth Circuit held that United States v. Hatton (In re Hatton), 220 F.3d 1057 (9th Cir. 2000) still applied even after the 2005 Bankruptcy Code amendments.  Smith, supra at p.7.  Hatton used a subjective test and not an objective test to determine whether a document would pass the honest and reasonableness prong of the Beard test.  Under the subjective test, one looks beyond the four corners of the document to determine whether the taxpayer has made an honest and reasonable attempt to comply with the law.  Prior to Smith, the most recent circuit court to look beyond the four corners of the document was the Eleventh, which was blogged hereJustice v. United States (In re Justice), 817 F.3d 738 (11th Cir. 2016).  The objective test limits the applicable inquiry to the four corners of the filed document to determine whether it qualifies as a return.  The leading case in support of the objective test remains Colsen v. United States, 446 F.3d 836 (8th Cir. 2006).  The use of the terms “subjective test” and “objective test” are co-opted, at least in part, from Martin v. United States (In re Martin), 542 B.R. 479, 482 (9th Cir. B.A.P. 2015)(blogged here)(Hindenlang is broad in scope and takes at least a partially subjective focus; the test used by the bankruptcy court was narrow in scope and exclusively objective in focus) and Colsen, 446 F.3d at 840.

Confusion with Hatton.

Hatton had made for somewhat confusing precedent.  In Hatton, the taxpayer flunked two prongs of the Beard test.  The document purporting to be a return was not filed under penalty of perjury and it was filed very late and only after collection pressure from the IRS so that it flunked the subjective test.  Did this dual failure mean that there was still room for the objective test in the Ninth Circuit, especially since the Ninth Circuit BAP had previously applied the objective test?  United States v. Nunez (In re Nunez), 232 B.R. 778 (9th Cir. B.A.P. 1999) (applying the objective test).  Martin, 542 B.R. at 490 swept away any remaining confusion.  It stated clearly that both Hatton reasons for rejecting the document as a return had to be given equal consideration:  “When alternate grounds are given for a holding, neither ground constitutes non-binding dicta.”  Id. (citation omitted).  Martin then applied the subjective test and found the document in question was not an honest and reasonable attempt to comply with the law.  The alternate-grounds rule is also helpful in understanding Smith.  As will be seen in the following paragraphs, the Ninth Circuit was careful to limit its holding to one reason.

The decision in Smith, and, the Court’s refusal to address ancillary arguments.

Like Martin, Smith applied the subjective test.  It held “that Hatton applies to the bankruptcy code as amended….”  Id. at p.7.  The court observed that two Circuit courts, the Tax Court, and both parties all agreed the four-factor Beard test still applied after that the new definition of return in § 523(a)(*) was added to the Bankruptcy Code.  Id. at p.5.  Mr. Smith’s delay in filing made it an easy decision for the court to affirm the district court’s ruling that the tax was nondischargeable.  See, id. at p.6 (“these are not close facts”).  Although it agreed with Martin, Smith never cited Martin.  The failure to cite Martin is an interesting choice, and, this omission is discussed again under the one-day-late rule below.

In Smith, the government argued, as it almost always does, for a per se rule.  The per se rule states that any document filed after the IRS assessment is not a document that will qualify as a return.  The leading case supporting the per se rule is United States v. Hindenlang (In re Hindenlang), 164 F.3d 1029 (6th Cir. 1999).  The Smith Court felt the facts before it were overwhelming, and, it did not need to answer the government’s per se argument.  “We need not decide the close question of whether any post-assessment filing could be ‘honest and reasonable’ because these are not close facts.”  Smith, supra, at p.6 (emphasis in original).  Thus, the government’s per se argument was set aside for now.

Because it held the purported document was not a return, the Court also declined to address the government’s argument that the tax was not associated with a return.  The government had argued that a return was not filed when it assessed the deficiency.  Id. at p.7, n.1; and see, 11 U.S.C. § 523(a)(1)(B) (tax for respect to which a return is made).  Martin addressed this issue, basically stating that the government’s argument proves too much.  Tax debt arises under bankruptcy law at the end of the applicable tax year and almost always exists before an assessment is made and even before a return is filed.  Martin, 542 B.R. at 491.

Impact of Smith on the one-day-late rule in the Ninth Circuit.

The facts in Martin are similar to the facts in Smith, i.e., tax documents filed only after an IRS audit and assessment.  Unlike Smith, Martin addressed the one-day-late rule, and, it rejected the one-day-late rule with a persuasive attack on its underpinnings.  Martin, 542 B.R. at 483-489.

Practitioners in the Ninth Circuit should be acutely aware of the First, Fifth, and Tenth Circuit decisions in support of the one-day-late rule.  McCoy v. Miss. State Tax Comm’n (In re McCoy), 666 F.3d 924 (5th Cir. 2012); Mallo v. IRS (In re Mallo), 774 F.3d 1313 (10th Cir. 2014); and Fahey v. Mass. Dep’t of Rev. (In re Fahey), 779 F.3d 1 (1st Cir. 2015).  Those cases apply the “applicable filing requirements” language of 11 U.S.C. § 523(a)(*) to mean that a return filed late, even by one second, is not a valid return for bankruptcy purposes.  It is clear that the Smith panel purposely side-stepped the one-day-late rule.  The one-day-late rule is never mentioned in the opinion.  This also means Martin’s persuasive attack on the one-day-late rule is also not mentioned.  (And, yes, I understand that the government did not advocate for it.)

In the Ninth Circuit, although BAP decisions are not binding, they are persuasive and generally held in high regard.  State Compensation Ins. Fund v. Zamora (In re Silverman), 616 F.3d 1001, 1005, n.1 (9th Cir. 2010) (Ninth Circuit has never held that bankruptcy courts are bound by BAP decisions, but, BAP opinions are treated as persuasive authority and promote uniformity of bankruptcy law throughout the Circuit); and see, B. Camp, “Bound by the BAP:  The Stare Decisis Effects of BAP Decisions,” 34 San Diego L. Rev. 1643 (1997) (yes, that is Bryan Camp, who posts here).  For all practical purposes, assuming the Smith case goes no further, whether by a request for an en banc hearing or a petition for certiorari, the one-day-late rule will not apply in the Ninth Circuit, at least for now.  It will take a state-court tax case to undo the one-day-late rule.  And, then, the case will need to be before a bankruptcy judge who does not feel bound by BAP decisions or an independent-thinking district court judge.

What happens if the Third Circuit in Davis follows the First, Fifth, and Tenth Circuits and accepts the one-day-late rule?  Keith posted on this recently.  Will the IRS capitulate?  If so, what happens in the Ninth Circuit?  Will the IRS feel strongly enough to litigate the issue in the face of Martin?

Mr. Smith’s counsel must feel that the subjective test is wrong and the Ninth Circuit should have reversed Hatton.  Although the objective test is very much the minority position, there are strong arguments in its favor.  Those arguments are well-stated in Colsen, 446 F.3d at 840-841, and, they do not need to be restated here.  But, from the perspective of containing the one-day-late rule, further appeals, whether a request for an en banc hearing or a petition for certiorari, could easily do more harm than good.  This is doubly so because the IRS still is not pressing the one-day-late rule.  One need look no further than Mallo to see what could happen.  Every case that asks an appeals court to look at the subjective versus objective test is another opportunity for a court to rule in favor of the one-day-late rule.  It is relatively easy for a judge to say that the literal language of § 523(a)(*) must be applied and timeliness is an applicable filing requirement.  It takes much more work to do what Judge Kurtz did and systematically explain why the one-day-late rule does not make sense.  While Mr. Smith and his counsel might disagree, in general, delinquent taxpayers in the Ninth Circuit are very fortunate that the Martin and Smith courts ruled as they did.

Trivia.

Here is one final piece of trivia.  The taxpayer’s first name in Smith is Martin.

 

Will Bankruptcy Get Your Passport Back?

Today, we welcome guest blogger Kenneth C. Weil. Ken has his own practice in Seattle that focuses on representing individuals with tax debt and resolving that debt through administrative action with the IRS or through bankruptcy. He has written a book on his specialty area, Weil, Taxes and Bankruptcy, (CCH IntelliConnect Service Online Only) (3d ed. 2014). In 1994 Congress passed the first major set of reforms to the Bankruptcy Code of 1978 but it knew that more reform was necessary. It set up a bankruptcy commission to look into the needed reforms and the reform commission established a tax advisory panel to assist it with the tax aspects of the reforms. Ken served on the tax advisory panel and has continued to be a leading thinker at the intersection of tax and bankruptcy. 

He serves in the leadership of the Bankruptcy and Workouts (B&W) Committee of the ABA Tax Section. The ABA Tax Section met in Los Angeles in late January where Ken participated in a B&W Committee panel with Bankruptcy Judge Mark Wallace of the Bankruptcy Court for the Central District of California, Santa Ana Division. As part of that panel he presented information regarding the new passport revocation/denial rule. I thought this information might be of interest to the blog readers and persuaded Ken to write something for us. Keith

The Operative Language

New I.R.C. § 7345(a) authorizes the State Department to deny issuance, revoke, or limit a passport if the IRS certifies to the State Department that an individual has seriously delinquent tax debt (SDTD). The operable verbs in § 7345(a) are deny, revoke and limit. Denial and revocation are straight-forward. Limitation is not as clear. By way of example, FAST Act § Section 32101 (e) provides a time-limitation clause for return to the United States for citizens whose passports are being revoked.

For certification to occur, there must be SDTD, which is a defined term with four components. Section 7345(b)(1)(A) provides that the tax debt must have been assessed and be legally enforceable before it can be SDTD. (The requirement of assessment means the standard for SDTD is very different from a claim in bankruptcy, which Bankruptcy Code section 101(5) defines broadly). In addition, Section 7345(b)(1)(B) and (C) require both an “age” component and a size component before tax debt can be SDTD. As to the “age” component, for the assessed and legally enforceable tax debt to be converted into SDTD, the tax liability must have been subject to a notice of federal tax lien (NFTL) and the accompanying administrative rights for seeking a collection due process (CDP) hearing are exhausted or have elapsed, or, the tax liability must have been the subject of a levy. Also, the “qualifying” tax debt must exceed $50,000, including penalties and interest, as indexed for inflation. This means there must be $50,000 of SDTD not $50,000 of tax debt.

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Even if tax debt qualifies as SDTD, there are events that take the debt out of that classification. Section 7345(b)(2) sets out the events that prevent debt from being SDTD. These events are the taxpayer is (i) in an installment agreement (IA), (ii) making payments under an offer in compromise (OIC), (iii) in a pending CDP hearing or has requested one, or (iv)seeking innocent spouse relief (ISR).

Certification can be reversed. Section 7345(c)(1) provides that certification shall be reversed if the debt “ceases to be seriously delinquent tax debt by reason of subsection (b)(2).” In other words, the events in the previous paragraph will support reversal. Certification can also be reversed if the certification were erroneous or the debt is fully satisfied. This means once certification has occurred a partial payment that takes the SDTD below $50,000 will not be grounds for certification reversal.  Rules for the date by which the certification must be reversed are found Section 7345(c)(2).

Certification information transferred from the IRS to the State Department is limited to the taxpayer’s identity information and the amount of the SDTD. I.R.C. § 6103(k)(11).

Examining Fast Act § 32101 More Closely

A close examination of Fast Act § 32101 raises some interesting nuances and a number of unanswered questions.

Seriously delinquent tax debt. The trigger for certification is not $50,000 of tax debt. It is $50,000 of SDTD. To be SDTD, the tax debt must have been subject to a levy or a NFTL with exhausted/elapsed CDP rights. If the individual has some debt that “qualifies” as SDTD and some debt that does not because the collection process has not progressed far enough, only the “qualifying” debt is used to reach the $50,000 total.

Different rules for liens and levies. There is a slight difference in treatment between liens and levies. Tax debt will not convert into SDTD when the NFTL is filed, if CDP rights remain. The actual phrase used in Section 7345(b)(1)(C) is the administrative rights must “have been exhausted or have elapsed.” The best guess is that tax debt is SDTD if the taxpayer has “only” equivalency hearing rights. In contrast, a levy is sufficient to create SDTD.

CDP-hearing-notice rights that are sent because of a NFTL filing must warn of the possibility of a denial, revocation, or limitation of a taxpayer’s passport. In slight contrast, notices of intent to levy must provide that warning. I.R.C. § 6331(d)(4)(G). Presumably, because the notice is provided in the notice of intent to levy, the requirement of an additional notice was not added to the CDP-hearing notice that accompanies the final notice of intent to levy.

Legally unenforceable. The requirement of legal enforceability in § 7345(b)(1) creates difficult issues in the intersection of bankruptcy and § 7345.

Legally unenforceable: discharge granted but NFTL not released. It is unclear whether the tax debt is legally unenforceable if it has been discharged in bankruptcy but the NFTL is not released. Does the NFTL mean the debt is still legally enforceable? Will it make a difference if the tax debt is discharged, the NFTL remains attached to an asset, and the value of the applicable assets is well below $50,000 even though the discharged debt is well above $50,000? Does it make a difference if the value could, at some point, rise above $50,000? If the taxpayer disagrees with the determination that the debt is legally enforceable, then, judicial recourse is available.

Legally unenforceable: repayment plans in bankruptcy. There is no clear answer whether payments pursuant to plans in Chapters 11, 12, or 13, which presumably make the debt temporarily unenforceable but still owing, bar certification. Consider whether special provisions can be added to plans in Chapters 11, 12, or 13 to provide for payment of the tax debt so that the passport will not be certified for revocation, or, if already certified, so that the certification will be reversed. Normally, a special class is not allowed in Chapter 13 to pay unsecured, nondischargeable tax debt. Copeland v. Fink (In re Copeland), 742 F.3d 811 (8th Cir. 2014), held that discrimination to pay nondischargeable tax debt was not allowed; but, discrimination was allowed if the discrimination was proposed in good faith and the degree of discrimination was directly related to the basis or rationale for the discrimination. If the taxpayer needs a passport to work, then, a special class of debt should be allowed. Will this be a sufficient payment plan to prevent denial of issuance or reversal of certification?

If payments under a plan are considered legally unenforceable, postpetition tax debt where property revests in the debtor under the terms of a Chapter 13 may also create a problem. In re Markowicz, 150 B.R. 461 (Bankr. D. Nev. 1993) found that postconfirmation earnings not committed to a plan were not part of the bankruptcy estate, and, the IRS’s postpetition levy to collect postpetition tax did not violate the automatic stay. Similarly, In re DeBerry, 183 B.R. 716 (Bankr. M.D.N.C. 1995) granted the IRS relief from stay to pursue collection of postpetition taxes outside Chapter 13 plan where all plan payments had been made. In such an instance, will some of the tax be considered legally unenforceable or subject to an IA and some legally enforceable?

When certifications will not be made. Some events remove tax debt from the definition of SDTD. If tax debt is not SDTD, then, certification will not be made. These events are the taxpayer is (i) in an IA, (ii) making payments under an OIC, (iii) in a pending CDP hearing or has requested one, or (iv) seeking ISR.

Submission of an OIC is not a listed event. To be an exception, the OIC must have been accepted so that the debt is no longer owed or the taxpayer must be making payments under the OIC. Given the length of time the IRS takes to process offers, this is troubling.

What happens if a revenue officer decides to levy social security at 15% and takes no further action? Will the ongoing levy, which operates like an IA, be sufficient to qualify as an IA under the § 7345(b)(2) exceptions?

What happens if the debtor has insufficient income to warrant an IA? Should currently uncollectible status (CNC) be considered the equivalent of being in an IA? Must the taxpayer be in an IA that pays a de minimis amount to avoid certification, e.g., one dollar a month? A passport might be very important to someone on CNC status, e.g., if one lives near the border or has close family outside the United States.

Certification and the automatic stay. Is certification barred by the bankruptcy automatic stay? Governmental actions that are used to enforce their police and regulatory power are not subject to the automatic stay because of the exception to the stay found in 11 U.S.C. § 362(b)(4). Clearly, the passport rule is a coercive rule to enforce collection. Will it be viewed as a police and regulatory action similar to the criminal collection statutes in Nevada? In Nevada, criminal prosecutions to collect casino debts are not considered a violation of the discharge injunction or the automatic stay. Nash v. Clark Cty Dist. Attorney (In re Nash), 464 B.R. 874 (9th Cir. BAP 2012) held that the Clark County District Attorney had not violated the discharge injunction when enforcing the criminal statute even though the statute was clearly designed to collect unpaid casino debts for the benefit of the casino. Does the automatic stay analysis change if the tax debt is otherwise dischargeable and likely to become legally unenforceable?

Judicial review. Section 7345(e) grants judicial review of certification to the Tax Court and district courts but not to bankruptcy courts. Section 7345(d) provides that notice of certification shall be given to the taxpayer and the notice shall include information about the right to contest the certification.  Notice of reversal of certification must also be given to the taxpayer.

If the taxpayer and the government disagree whether the debt remains legally enforceable after bankruptcy, there may be a back-door entrance into bankruptcy court. Denial or revocation of a passport might subject the taxing authority to an action for a violation of the discharge injunction under 11 U.S.C. § 524. Damages, including attorney’s fees, are notoriously difficult to collect because of the exceptions in section 7433 of the Internal Revenue Code. Given the uncertainty of the new law, one can certainly envision the IRS arguing that its position was substantially justified.