Update On The “Late Return” Dischargeability Litigation: 9th Circuit To Hold Oral Argument in Smith Case

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We welcome back A. Lavar Taylor who updates us on developments in the Ninth Circuit regarding whether a late-filed return is a return for purposes of the discharge rules in the Bankruptcy Code. Les

Those of you who are private practitioners who deal with the question of whether a “late-filed” tax return is or is not a “return” for purposes of section 523(a) of the Bankruptcy Code undoubtedly rejoiced when you read the recent opinion of the Ninth Circuit Bankruptcy Appellate Panel in United States v. Martin, 542 B.R. 479 (9th Cir. BAP 2015), issued on December 17 of last year. Keith Fogg previously discussed that opinion here, which also contains links to the underlying cases as well as links to prior PT posts on the issue. At long last, an appellate court rejected the position adopted by the Fifth Circuit (McCoy v. Miss. State Tax Comm’n (In re McCoy), 666 F.2d 924 (5th Cir. 2012), the Tenth Circuit (Mallo v. I.R.D. (In re Mallo), 774 F.3d 1313 (10th Cir. 2014), and the First Circuit (Fahey v. Massachusetts Dep’t of Revenue (In re Fahey), 779 F.3d 1 (1st. Cir. 2015).

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From my own perspective, the Bankruptcy Appellate Panel’s opinion in the Martin case seems to get “right” most everything that the three Court of Appeals opinions got wrong. The “one day late” interpretation of section 523(a) adopted by the three Court of Appeals opinions is nonsensical from a practical standpoint. That interpretation actually creates a disincentive for taxpayers, who for any reason fail to file a tax return on time, to promptly get into compliance by filing their “late” return(s) as soon as possible. Why is that so? Consider the following hypothetical, which might take place in a jurisdiction that is subject to the “one day late” rule set forth in McCoy.

Taxpayer comes to you in December of 2015 and tells you that they have not filed their 2014 federal income tax return. They have a long, sad story, involving a sick family member, a car accident and the loss of their home to a foreclosure sale. The foreclosure sale generated a large capital gain, which in turn has generated what will be a large income tax liability for 2014 once their 2014 tax return is filed. The taxpayer tells you their 2014 tax liability is far more than they will ever be able to pay and asks you whether it will ever be possible to discharge their 2014 tax liability in bankruptcy if they are not able to resolve the 2014 tax liability through an offer in compromise.

You advise them that, if they immediately file their 2014 tax return, they will not ever be able to discharge their 2014 income tax liability in bankruptcy because their late-filed Form 1040 can never qualify as a “return” for purposes of section 523(a) of the Bankruptcy Code. You also tell them that they probably will be better off if they wait for the IRS to open up an audit of their 2014 tax year (as the IRS will certainly do since the lender issued a Form 1099 to your client as the result of the foreclosure sale), then do nothing in response to the audit notice and wait for the IRS to issue a notice of deficiency, then file a Tax Court petition, and finally enter into a stipulated Tax Court decision with the IRS agreeing on the amount of taxes owed. The reason they will probably be better off is that the stipulated Tax Court decision very likely will qualify as a “return” for purposes of the Bankruptcy Code. Once the Tax Court decision has been entered, they can wait two years and then possibly discharge the tax liability through a chapter 7 bankruptcy.

If the taxpayer in this hypothetical believes that filing bankruptcy will likely be the only way that they might be able to resolve their 2014 income tax liability, the taxpayer might not immediately file their 2014 income tax return but instead might wait for the IRS to show up and issue a notice of deficiency and then file a Tax Court petition and settle the case. A rule which encourages taxpayers to engage in this type of conduct is utterly absurd. Yet, outside of the Ninth Circuit, many courts are adopting such a rule.

The Smith Case: Description

Inside the Ninth Circuit, the Ninth Circuit Bankruptcy Appellate Panel’s opinion in the Martin case will not be the law in the Ninth Circuit for much longer. On May 12 of this year, the Ninth Circuit is scheduled to hear oral argument in the case of  IRS v. Smith (In re Smith), 527 B.R. 14 (N.D. Cal. 2014), appeal pending (9th Cir. No. 14-15857). The Smith case was decided in favor of the IRS at the District Court level, so the appeal to the Ninth Circuit is by the taxpayer.

The facts of the Smith case are fairly typical for cases involving a late-filed income tax return. Smith failed to timely file his 2001 federal income tax return. The IRS began an audit of Smith’s 2001 tax year. The IRS prepared a SFR and issued a notice of deficiency for the 2001 year to Smith on March 27, 2006. Smith did not file a Tax Court petition, and the IRS assessed the liability as determined by the IRS. In May of 2009, Smith filed a Form 1040 for the year 2001 reporting a higher income tax liability than the liability determined by the IRS. Smith waited two years after he filed the Form 1040 and then filed a chapter 7 bankruptcy petition. He obtained a discharge and then filed an adversary proceeding to determine whether his 2001 tax liability was discharged.

The Bankruptcy Court held that the taxes were discharged, but the District Court reversed. The reasoning of the District Court is interesting, because the Court purported to follow the test set forth in Beard v. Commissioner, 82 T.C. 766, 774-79, 1984 (1984), aff’d, 793 F.2d 139 (6th Cir.1986)), and then misapplied that test. The Court concluded as follows:

In examining the holdings of the various courts, the reasoning therefore, and the language of section 523(a)(1)(B) itself, the Court finds that the majority position on this issue is the correct one. Since the hanging paragraph in Section 523(a)(1) does not completely define the term “return,” it is appropriate for the Court to look to long-established authority concerning the definition of “return” under “applicable nonbankruptcy law,” primarily the Tax Code.10 Similarly, the hanging paragraph does nothing to undermine the four-factor test or years of jurisprudence following Beard. Consistent with the Tax Code’s standards for a “return,” as stated in Beard and the Ninth Circuit’s decision in Hatton, the meaning of “return” must take into account the late-filers’ evidence of a good faith attempt to comply with the tax laws. Where, as here, the taxpayer and bankruptcy debtor fails to comply with self-assessment and payment of tax obligations until years after the IRS has initiated action, created a substitute return, assessed and begun collection proceedings, the Court simply cannot find his conduct to be “an honest and reasonable attempt to comply with the tax law.” This approach does not mean, as Debtor argues, that the “honest and reasonable attempt” factor creates a per se rule barring taxpayers from filing returns once the IRS has created a substitute return. To the contrary, this prong of the test is meant to consider each case on its particular facts, an approach which necessarily precludes a per se determination.

Thus, the Court did not apply the rule that had been adopted by McCoy and discussed McCoy only in footnote 6 of its opinion. In that footnote the Court noted that the IRS had not argued that the rule set forth in McCoy should apply and indicated that the Court was not following McCoy. Neither Mello nor Fahey had been decided by the Courts of Appeal when the District Court issued its opinion.

The Smith Case: Analysis

In my view, the District Court was correct in applying the Beard test but completely misapplied the fourth factor set forth in Beard. The “honest and reasonable attempt to satisfy the requirements of the tax law” discussed in Beard focused exclusively on the document sent to the IRS, not on the conduct of the taxpayer prior to sending that document to the IRS. The Beard Court stated as follows:

The Supreme Court test to determine whether a document is sufficient for statute of limitations purposes has several elements: First, there must be sufficient data to calculate tax liability; second, the document must purport to be a return; third, there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must execute the return under penalties of perjury.

It is important to consider the factual circumstances under which this test has been applied. In Florsheim Bros. Drygoods Co. v. United States, 280 U.S. 453 (1930), at issue was whether the filing of a “tentative return” or the later filing of a “completed return” triggered the statute of limitations. A corporation had filed a tentative return along with a request for an extension of time to file a return which was later filed. The Court found that the filing of the tentative return was not in the nature of a “list,” “schedule,” or “return” required by tax statutes. It was designed to meet a peculiar exigency and “Its purpose was to secure to the taxpayer a needed extension of time for filing the required return, without defeating the Government’s right to prompt payment of the first installment  [of tax].” The statute plainly manifested a purpose that the period of limitations was to commence only when the taxpayer supplied the required information in the prescribed manner — the completed return.

The Court recognized that the filing of a return that is defective or incomplete may under some circumstances be sufficient to start the running of the period of limitation. However, such a return must purport to be a specific statement of the items of income, deductions, and credits in compliance with the statutory duty to report information and “to have that effect it must honestly and reasonably be intended as such.” (Emphasis added.) Thus, the filing of the tentative return was not a return to start the period of limitation running.

This issue of whether the document was a return for the statute of limitation purposes was again before the Court in Zellerbach Paper Co. v. Helvering, 293 U.S. 172 (1934). Justice Cardozo, speaking for the Court, said:

Perfect accuracy or completeness is not necessary to rescue a return from nullity, if it purports to be a return, is sworn to as such * * * and evinces an honest and genuine endeavor to satisfy the law. This is so even though at the time of filing the omissions or inaccuracies are such as to make amendment necessary. [Zellerbach Paper Co. v. Helvering, supra at 180. Citations omitted.]

It is apparent from the language quoted immediately above that the reasons for the taxpayer’s delay in filing a Form 1040 with the IRS are NOT relevant for purposes of determining whether that particular Form 1040 is a “return” under the Beard test.

The circumstances surrounding the preparation of the Form 1040 will normally be relevant to determining whether the taxpayer has engaged in an “honest and genuine endeavor” to comply with the law. For example, if the taxpayer, in preparing the Form 1040, merely parroted the numbers on the IRS SFR instead of relying on the taxpayer’s own books and records, the taxpayer may not have engaged in an “honest and genuine endeavor” to comply with the law. But the fact that the taxpayer ignored IRS notices, including a notice of deficiency, and did not file a Form 1040 until the IRS starting taking collection action is not relevant to the question of whether the taxpayer has met this particular requirement of the Beard test.

The fact that the Form 1040 is filed late, whether before or after the IRS has made an SFR assessment, may have other consequences under the Bankruptcy Code, either under the “late filing” rule set forth in section 523(a)(1)(B)(ii) or the “attempt to evade or defeat” rule set forth in section 523(a)(1)(C). But the delay in filing the Form 1040, and the reasons for that delay, should be ignored for purposes of determining whether the Form 1040 is a “return,” unless the delay is somehow relevant to the contents of the Form 1040. The District Court’s ruling is thus based on an incorrect reading of the Beard test.

What the Future Holds

No one knows what the Ninth Circuit will do in the Smith case, but we can expect a ruling sometime prior to the end of this year, likely during the late summer or early fall months. For those of us practicing in the Ninth Circuit, or in Circuits other than the three Circuits that have already ruled on this issue, what do we tell our clients who are affected by the judicial disarray on this issue? Realistically, we must tell them is that, if they file bankruptcy now, we don’t know what is going to happen and they are at risk that their tax liabilities will not be discharged. That is true even for taxpayers living in Circuits other than the First, Fifth, Ninth and Tenth Circuits.

If the Ninth Circuit issues an opinion that is inconsistent with the opinions of the three other Circuits that have ruled on this issue, it is possible that this issue will be resolved by the Supreme Court sometime in 2017. Of course, the Ninth Circuit could still rule against the taxpayer while disagreeing with the other Circuits. The chances of Supreme Court review may be greater if the Ninth Circuit splits with the other Circuits by ruling for the taxpayer.

If the Ninth Circuit follows McCoy, then a review of the Ninth Circuit opinion by the Supreme Court is unlikely. The only remaining hope for taxpayers will be either that another Circuit that has not yet ruled on this issue rules in a way that creates a split in the Circuits or that there is a legislative change to the statute. In addition, if the Ninth Circuit follows McCoy, a short term practical question will be whether the Department of Justice and the IRS abandon their position that the rationale used to decide McCoy is wrong. That possibility, coupled with the possibility of Supreme Court review if the Ninth Circuit does not follow McCoy, is why it may be unwise for any practitioners practicing outside of those Circuits who have ruled on this issue to advise their clients who are contemplating using bankruptcy to discharge tax liabilities where the underlying returns were late filed anything other than: “We just don’t know whether your tax liabilities (other than penalties, see McKay v. United States, 957 F.2d 689 (1992), ) will be discharged.”

 

Comments

  1. Does this mean that an untimely filed return, say a return filed 5+ years after it was due, for which there was no IRS assessment during the period in between, may be dischargeable given the December 17th opinion? I had some trouble following the interwoven references and reasoning.

  2. As a non-lawyer I remain confused. Would the Colson argument hold true for “other cases” in the 8th Circuit? ie could someone win again in the 8th using Colson or doesn’t presidence apply? I would think anyone filing for tax bankruptcy in the 8th Circuit would use this argument even if other Circuits have ruled the other way.

    • It is possible and perhaps probable that the 8th Circuit would reach the same decision it did in Colson if faced with the same facts in a post 2005 bankruptcy case. Essentially, the 9th Circuit just reaffirmed its pre 2005 case law. Unless the 8th Circuit decided to join the three circuits adopting the one day late rule, I would expect it to follow Colson.

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