The First Circuit in Fahey joins the Fifth and the 10th in holding that the hanging paragraph at the end of Bankruptcy Code Section 523 excepts from discharge the tax liability for any year in which the taxpayer files the return late – even by one minute. We have written about this issue before here and here . The issue is not going away and would seem to be headed to the Supreme Court if Congress does not step in to fix the language it created in 2005 which causes this problem.
At approximately the same time the First Circuit joined the others in interpreting that any late return gets excepted from discharge, the bankruptcy court in the Southern District of Florida issued a well-reasoned explaining why it does not. In re Coyle, 524 B.R. 863 (Bankr. S.D. Fla. 2015). The court in Coyle adopted the approach taken by the IRS that the Circuit court holdings cannot be reconciled with Section 523(a)(1)(B)(ii) allowing discharge of late filed returns after the passage of two years. If Coyle or another case can get Circuit approval, the necessary conflict will exist to make a Supreme Court decision likely although the administrative importance of the issue argues for acceptance of cert on the most recent decision.
read more...The issue is getting attention from many quarters at this point. The Bankruptcy and Tax Committee of the ABA Tax Section drafted a legislative proposal on this issue that the ABA sent to Congress last fall. [The National Taxpayer Advocate suggested a legislative proposal in her annual report.
The First Circuit case, which is really four cases combined for appeal all containing essentially the same facts, looks at the issue from a state law perspective. Massachusetts Department of Revenue sought to prevent the debtors from discharging their taxes in the situation where they did not timely file their returns (each case involved failure to timely file for multiple years), subsequently filed the missing returns, waited two years after filing to cross the hurdle created by Bankruptcy Code section 523(a)(1)(B)(ii) and then filed a bankruptcy petition. The First Circuit first looked at the language of section 523 (a)(1)(B) and said that if it stopped there this case would present little difficulty except for the hurdle of defining “what is a return.” It then looks at the 2005 amendment to section 523 adding the hanging paragraph designed to clear up the confusion surrounding the issue of what is a return.
Looking at the hanging paragraph for guidance on what is a return it finds that to meet the definition of a return the document must “satisfy the requirements of applicable nonbankruptcy law (including filing requirements).” The First Circuit then looks at Massachusetts law to determine whether timely filing is a “filing requirement’ under state law and finds the answer is “plainly yes.” The Court addresses the ever present concern that this reading of the statute would “vitiate in its entirety the two-year provision of section 523(a)(1)(B) rendering it superfluous. It finds this concern incorrect because of the exception in the hanging paragraph allowing late returns filed pursuant to IRC 6020(a) to qualify as returns that could lead to discharge. The First Circuit acknowledges that very few returns end up being filed under the provisions of 6020(a) and that the IRS has total control over the use of that provision to file a late return. Nonetheless, it viewed Congress as making a strong statement about timely filing. While I disagree with the conclusion, the Court gave careful thought to all of the arguments presented by the debtors and the amici in their briefs.
As I have written before, Congress did not intend this result and should step up to fix the unintended consequences that the language of the ill-fated statutory change designed to resolve litigation that the language has spurred. I will not spend any more time talking about the bad situation from a legal perspective but want to focus instead on the administrative problems caused when discharge issues exist. I will do this from the perspective of the IRS but you can multiply the problem the IRS faces by the number of states with return filing requirements. The administrative importance of this issue for tax administrators cries out for quick relief.
When a debtor finishes a bankruptcy cases, the IRS must look at all of the periods for which liability exists and make a discharge determination. If the bankruptcy discharged the debt, the IRS must write that debt off of its books and never try to collect it again (subject to certain exceptions related to liabilities for which the IRS may pursue specific property based on its lien interest.) If the debt did not meet the discharge criteria, then the IRS leaves the debt on its book, removes the freeze code on the account caused by the automatic stay and sends the debt back into the collection stream.
The problem created by uncertainty in the application of the discharge provisions is that taxes, or whatever liability is impacted by an uncertainty, go back into the collection stream. Because the statute of limitations on collection of taxes lasts ten years, the lingering impact of uncertainty lasts a long time and becomes difficult, if not impossible, to unwind. Unless the IRS keeps accurate records on the cases with unfiled returns involving the Hindenlang or the McCoy issue, it will have great difficulty going back through its closed bankruptcy cases to identify the ones in which it decided to leave a liability on the books due to its position regarding discharge at a particular moment in time. To the extent that the IRS will have difficulty doing this, I imagine that the problem becomes even more difficult for states which may have fewer resources to apply to the problem. Some states have a statute of limitations on collection that runs longer than the ten year statute applicable to federal tax debts which again makes the unwinding of any discharge determination even more difficult.
The thirteen states covered by the three circuits ruling on the hanging paragraph so far have an answer for how to treat late filed returns. The other 37 states do not have an answer. The answer may change if Congress or the Supreme Court reverse the decisions. If these decisions are reversed, it may take some years. Taxpayers who pay during the intervening years may need to file protective claims in order to preserve their right to the return of money collected on the debts should they ultimately be determined to be discharged. The IRS has taken the legal position that the hanging paragraph does not mean what three circuits have now said it means and in one of those circuits the decision specifically addressed federal tax debt. Does the IRS continue not to pursue these liabilities in the face of circuit precedent allowing it to do so? How many circuits does it take before the IRS reverses its position? If it does reverse its position will it code these cases so it can abate these liabilities should legislation or case law reverse the current circuit trend?
Uncertainty in the application of the discharge provisions makes for very difficult administration as well as difficult times for the impacted debtors. When uncertainty on this scale exists in a discharge provision, quick action needs to occur in order to prevent large scale administrative disruption and dire consequences to debtors who thought bankruptcy provided a path to a fresh start. If the courts have misinterpreted the intention of the statutory change, Congress should step in quickly. In the absence of Congressional action, this issue seems to have sufficient administrative importance to warrant Supreme Court review even in the absence of a circuit conflict.
This is a mess. It really needs to be fixed and apparently we’ll need to rely on Congress. As it stands now people who are late or are the subject of an SFR are put on the same level as people who commit fraud. The argument that a subsequently filed return serves no purpose, which is part of the rationale in these cases also doesn’t hold water. Frequently after an SFR is filed, the subsequent return is used to lower the taxpayer’s liability. And if you want to put the client in an installment agreement, the IRS requires a return.
In practice at the federal level this really isn’t that big of a deal. The IRS does not follow McCoy (and now Mallo and Fahey) and routinely writes off tax liabilities pursuant to Chief Counsel Notice 2010-16, so there really isn’t any uncertainty with respect to federal taxes. Now the States on the other hand appear to relish the McCoy approach.
Yesterday, DOJ Tax filed a supplemental authority letter in the Martin Smith case in the 9th Circuit, which involves the issue of the circumstances under which taxes arising from a late filed Forms 1040 can be discharged in a chapter 7 case. That letters alerts the 9th Circuit to the new Circuit Court opinions. Importantly, that letter also states that DOJ continues to disagree with the approach taken in Fahey.
Since the Fahey opinion was issued, I’ve not spoken with anyone in IRS to confirm that they are continuing to disagree with the rule set forth in Fahey. But I would be surprised if the official IRS position is not the same as DOJ’s position.
Nevertheless, it is imperative that private practitioners warn their clients who are considering filing bankruptcy for purposes of discharging federal income tax liabilities associated with late filed returns that they are at risk that the IRS and/or DOJ could change their official position on this issue at any time. Which means that, for clients who filed returns even a day late, it really is a mess. They face uncertainty because no one can properly advise them that they are not at risk that their taxes will not be discharged as the result of filing their Form 1040 late, even by one day.
The biggest problem with the Fahey line of reasoning is that it encourages taxpayers who did not file on time, and who might later seek to discharge their tax debts in bankruptcy, to NOT file returns but instead to wait for the IRS to open up a non-filer audit and then to NOT agree to the results of that audit but instead to ask the IRS to issue a 90 day letter so that they can file a Tax Court petition and enter into a stipulated Tax Court decision. That type of agreed Tax Court decision likely DOES constitute a “return” for purposes of the BK Code. So the Fahey rule actually encourages people who for any reason miss a return filing deadline, even by one day, to never file Forms 1040.
The Fahey rule treats more favorably those who never file a Form 1040 and who later go to Tax Court to get a stipulated decision than those people who accidentally file their return a few days late. Talk about an absurd result!
This article made it sound like they believe the supreme court will side with the lower courts on upholding the lower court rulings and the 1 minute rule. I hope I am wrong? Please let me know your thoughts
I did not mean to suggest I think the Supreme Court will agree with the interpretation of BC 523(a) taken by the three circuits that have decided the discharge issue interpreting that any late return can never be discharged. I have no prediction on how the Supreme Court would rule on this issue. Congress should fix the statute to make it clear it did not intend the result reached by these courts. The ABA Tax Section has sent to Congress language that could easily fix the problem.
I have two questions for the group.
First, if a taxpayer files under current law and his untimely filed IRS debts are not discharged, but the SC later disagrees with the FC, is there an opportunity for the taxpayer to return to Court for resolution?
Second, it seems as if the FC and other Courts interpreted “return” as a verb rather than a noun–focusing on when it is filed rather than the document’s intended purpose. On what planet is such an interpretation consider logical? Clearly the IRS and States accept the documents as valid even when filed years late. Why then have the Courts singled out one specific circumstance, BK for special treatment?