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Mr. Smith Continues to Suffer from His Failure to File and Other Updates on Late Filed Returns

Posted on May 17, 2018

I have not written about the one day late rule in bankruptcy cases for some time. The litigation has cooled off, but the final fate of the issue remains unresolved. See prior posts on the issue here, here, here, here, and here if you need a reminder of the problems taxpayers suffer in bankruptcy when they fail to timely file their returns. While the tide seems to have turned against the one day rule which set up an absolute bar to discharge, taxpayers in circuits other than the 1st, 5th, and 10th still suffer the consequences of filing late as well. Mr. Smith is one.

Mr. Smith brought the case that is currently the leading opinion regarding the discharge of taxes on a late filed return in the 9th Circuit. Though the 9th Circuit declined to adopt the one day rule, it still found that Mr. Smith did not discharge his tax liability in a case in which the IRS had filed a substitute for return before he filed Form 1040 for the year at issue. In a case decided on March 7, 2018, the District Court for the Northern District of California turned back Mr. Smith’s latest effort to rid himself of the liability stemming from failing to timely filing his 2001 return and having the IRS do it for him.

In addition to recounting Mr. Smith’s latest travail, I discuss two recent lower court opinions on the failure to timely file issue.

Mr. Smith failed to timely file his 2001 return, eventually leading to the IRS preparing a substitute for return. Seven years after his return was due and three years after the IRS assessed a liability based on the SFR, he filed a Form 1040 reporting about $40,000 more than the IRS assessed. After submitting the Form 1040, he waited more than two years before filing his bankruptcy petition. The IRS agreed with Mr. Smith that the $40,000 liability shown on the late filed Form 1040 was discharged but argued that the liability shown on the SFR was not. The 9th Circuit agreed with the IRS.

Having taken his case to the Circuit Court and lost, Mr. Smith now returns to the bankruptcy court with new arguments in an attempt to rid himself of the tax assessment created by the SFR. First, he argues that since the 9th Circuit found his Form 1040 was a nullity he is entitled to “an abatement of taxes since the IRS lacked authority to assess the additional tax amount of $40,095 based on the Form 1040” he filed seven years late. Second, he argues that because he is forever barred from filing a 2001 return, he should receive declaratory judgment relief that he need not comply with I.R.C. 6012. Third, he moves for a class action seeking a declaratory judgment for all taxpayers who failed to timely file a return resulting in an SFR who lacked reasonable cause and another class action for those taxpayers who filed Form 1040 that did not constitute a return.

The bankruptcy court found that Mr. Smith lacked standing to bring this action. It also found there is no actual controversy with respect to the $40,095 assessment. Additionally, the court pointed out that even if he had standing to sue, I.R.C. 6404(b) states that “no claim for abatement shall be filed by the taxpayer in respect of any assessment of any tax imposed under Subsection A.” Further, the court found that the Anti-Injunction Act also bars the relief he sought and no waiver of sovereign immunity exists. The arguments put forth by Mr. Smith basically allowed the bankruptcy court to touch almost all procedural bases for dismissing a case.

The bankruptcy court shows no sympathy for Mr. Smith since he created his own problem, he moves to almost tax protestor like arguments, and he provides the court with no legal basis for granting the relief he sought. The case demonstrates the frustration of owing a non-dischargeable tax especially when it would have been relatively easy for the taxpayer to avoid the problem. The case also shows the limitations of trying alternative arguments to the straightforward discharge argument under B.C. 523(a)(1)(B) as well as the limitations of seeking to bring a class action to stop the IRS by seeking a declaratory judgment.

Smith shows the limitations of continuing to fight about the discharge when taxpayer files a late return. Two cases on this issue were recently decided, Word v. IRS and IRS v. Davis, in which taxpayers filing late returns did not receive a discharge. These cases deserve brief mention in the continuing saga of the two decade old issue.

In Wood, the taxpayers filed a chapter 7 petition on May 29, 2015. The issue turned on whether their 2010 return was filed. Mr. Wood passed away before the trial occurred. Mrs. Wood testified that they routinely prepared and filed their returns over a 20 year period and that Mr. Wood, a CPA, would prepare it, discuss it with her, and then file it. She presented a filed extension and a copy of the return signed by her and her husband on September 19, 2011; however, the IRS denied ever receiving the return. The IRS put on testimony of a bankruptcy specialist who searched the IRS records and found no evidence of a return. The Court found that Mrs. Word’s testimony about what happened could not overcome the IRS records regarding lack of receipt. Mrs. Wood was hampered in presenting her case because her husband had handled the mailing of the return. The Court expressed sympathy but could not get past the absence of evidence to overcome the presumption of regularity in the IRS records.

Based on the fact that the issue arises in the bankruptcy context, I presume that the taxpayers filed the return, or planned to file the return, without remittance or with only partial remittance; however, I would have liked some discussion about that fact. It seems that she should have known about the remittance aspect of the case and that would have made her story more convincing. The couple also owed for 2009 and may have filed the 2009 return without remittance as well since no mention is made in the opinion of audits. Almost no returns have prior credits exactly equal to the liability shown on the return. Taxpayers generally talk about the monetary consequences of filing a return and anticipate results based on those consequences, e.g., anticipating a refund check or anticipating an immediate bill. The discussions surrounding the money may have provided her with more detail about the mailing of the return with which she could have persuaded the bankruptcy court or the absence of those discussions may have been persuasive.

The Wood case does not present the same issue as Smith and the line of cases involving late filed returns. Rather, it presents the straightforward issue of whether the taxpayers filed a return. Although a slightly different issue, the issue of whether the taxpayer filed a return in the first place regularly presents itself in these cases.

In Davis, the IRS brings an appeal of a bankruptcy court decision and the district court reverses based on the Third Circuit’s recent decision regarding late filed returns. Mr. Davis failed to timely file his 2005 and 2006 returns. The IRS prepared SFRs and made assessments based on the SFRs. Subsequently, he filed Forms 1040 for the two years, waited more than two years, and filed his chapter 7 bankruptcy petition on July 12, 2012. After receiving his chapter 7 discharge, he filed a chapter 13 petition on August 11, 2014. The fight over the impact of the chapter 7 discharge arose in the chapter 13 case when the IRS filed a proof of claim asserting a tax due on 2005 and 2006. The bankruptcy court held that filing the Forms 1040 and waiting two years before filing bankruptcy allowed him to discharge the taxes. Subsequent to the bankruptcy court’s decision discharging the tax debt for the late filed returns, the Third Circuit issued its opinion in Giacchi v. United States, 856 F.3d 244 (3d Cir. 2017). In that opinion, blogged here, the Court found that filing a Form 1040 after the IRS made an assessment based on an SFR did not meet the part of the Beard test requiring “an honest and reasonable attempt to comply with tax law.” The Third Circuit did not say that a debtor in these circumstances could never satisfy the fourth prong of the Beard test, but it provided no guidance on how a debtor might do so.

The IRS argued in the Davis appeal that his case did not involve close facts and the district court agreed. The most interesting aspect of the case may not involve the application of Giacchi, but how the IRS was able to take the appeal. I have not gone back to read the motions filed but it appears that the debtor may have kept open the time for the IRS to bring an appeal of the bankruptcy court decision by seeking to directly appeal to the Third Circuit in the original case and then failing to follow through, but in the process keeping the door sufficiently open to allow the IRS to appeal the adverse bankruptcy decision to the district court. The short shrift the district court gives to the arguments of Mr. Davis suggests that in the Third Circuit the fact pattern of an SFR assessment prior to the filing of the Forms 1040 may be fatal to the attempt to discharge the liability.

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