Some time ago I wrote about discharging income taxes in bankruptcy. I stated that there is a three-part test for determining their dischargeability, and started with the following executive summary:
For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:
- (The three-year rule) The tax return for the tax year in question must have been due (including extensions) – but not necessarily actually filed – at least three years before the filing of the bankruptcy papers,
- (The two-year rule) The debtor must have actually filed a legitimate, nonfraudulent tax return for that tax year at least two years before the filing of the bankruptcy papers, and
- (The 240-day rule) The taxing authority cannot have assessed the tax during the 240 days prior to filing the bankruptcy papers.
The second requirement, the so-called two-year rule, has been the subject of extensive litigation throughout the country, with a wide range of inconsistent outcomes. Therefore, I suspect that the Supremes will eventually be asked to consider the matter.
My focus today is on what happens if the taxing authority files something called a substitute for return on behalf of the debtor/taxpayer. For linguistic simplicity, I will refer to the taxing authority as the IRS, though the discussion applies, mutatis mutandis, if the taxing authority is a state taxing authority such as California’s Franchise Tax Board.
I. Substitute For Return
Projections of tax return filings prepared by the Internal Revenue Service (IRS) research staff show that a grand total of 239.3 million tax returns are expected to be filed with the IRS during Calendar Year (CY) 2012. This number represents an increase of 1 percent from the estimated CY 2011 filings of 236.8 million returns. After CY 2012, the grand total return filings are projected to grow at an average annual rate of 1 percent and are expected to reach 253.5 million returns by 2018.
As Jerry Lee Lewis might sing, “A whole lotta filing goin’ on.”
Therefore, it takes the agency a lot of time to process the returns, so they won’t know if you failed to file a return for a while. However, if you are required to file a return and don’t do so, eventually the IRS will file a return on your behalf using the data it has on your income for the given tax year. Such a return is called a substitute for return (“SFR”). The relevant statutory authority for this practice is 26 U.S.C. § 6020:
(a) Preparation of return by Secretary
If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.
(b) Execution of return by Secretary
(1) Authority of Secretary to execute return
If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.
(2) Status of returns
Any return so made and subscribed by the Secretary shall be prima facie good and sufficient for all legal purposes.
The difference between sections (a) and (b) is that in (a) the IRS prepares the return and the taxpayer agrees to it and signs it, while in (b) the IRS prepares the return without the cooperation of the tax payer.
According to the IRS Manual, a return filed under 26 U.S.C. § 6020(a) is considered a legitimate return filed by the taxpayer, whereas a return filed under 26 U.S.C. § 6020(b) is an SFR. See IRS Manual 184.108.40.206.2 – 220.127.116.11.2.1.
Once the SFR is complete, the IRS will enter the unpaid tax liability into its system. That process is called assessment.
II. Is An SFR A Return For Bankruptcy Discharge Purposes?
The simple answer is, no. The Bankruptcy Code excludes from discharge an income tax debt for a tax year:
with respect to which a return, or equivalent report or notice, if required—
(i) was not filed or given; or
(ii) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition . . .
11 U.S.C. § 523(a)(1)(B) (emphasis added).
In sum, Congress says that if you didn’t file a return at all, you cannot discharge the income tax debt in bankruptcy.
The more interesting question is whether the tax debt is dischargeable in bankruptcy if you filed a return after the IRS filed an SFR.
III. Is A Return Filed After An SFR A Return For Bankruptcy Purposes?
A. The IRS’s Position
The Chief Counsel Notice states that if the debtor files a Form 1040 after the Service made an assessment, then it is only a return for bankruptcy purposes to the extent it reported new, previously unassessed liabilities. If the debtor files a return after the assessment of a substitute for return under IRC § 6020(b), only the additional income and tax on the return filed after the SFR is subject to discharge.
IRS Manual 18.104.22.168.1.2.5.
Thus, if the IRS files an SFR under 26 U.S.C. § 6020(b), and you subsequently file a return, only the portion of the tax shown on the return that exceeds the tax on the SFR is dischargeable in bankruptcy (subject, of course, to the three-year, two-year, and 240-day rules mentioned above).
B. The Case Law
1. The Fifth Circuit’s McCoy Rule: One-Day Late And You Lose
The most draconian approach to this question is found in the Fifth Circuit’s McCoy rule, found in In re McCoy, 666 F. 3d 924 (5th Cir. 2012). Before discussing the McCoy ruling, I pause to note that the reporter volume number is 666. Coincidence? You decide.
In McCoy, the debtor sought to discharge state income taxes for which she had filed her returns after the due date. The Court held:
Unless it is filed under a “safe harbor” provision similar to § 6020(a), a state income tax return that is filed late under the applicable nonbankruptcy state law is not a “return” for bankruptcy discharge purposes under § 523(a).
In re McCoy, 666 F. 3d at 932.
Thus, in the Fifth Circuit an income tax debt is never dischargeable in bankruptcy if the debtor didn’t file the return on time, regardless of whether an SFR was filed. Draco would be proud.
2. The Eighth Circuit’s Colsen Rule: A Filed Return Is A Return
The Eighth Circuit took a much more humane approach in In re Colsen, 446 F. 3d 836 (8th Cir. 2006).
In Colsen the debtor failed to file tax returns, so the IRS filed SFRs for the relevant years, and assessed the tax liabilities. Mr. Colsen subsequently filed returns for the years in question, and four years later he filed for Chapter 7 relief. During the pendency of his case he initiated an adversary proceeding in the Bankruptcy Court to determine the dischargeability of the tax debts.
The IRS asserted that the late filed returns were not returns within the meaning of the Bankruptcy Code, but the Bankruptcy Court disagreed and ruled in Mr. Colsen’s favor. The Bankruptcy Appellate Panel for the Eighth Circuit affirmed, and Lord Vader ― oops, I mean the IRS ― appealed.
The Eighth Circuit Court of Appeals affirmed, holding:
The government’s essential position is that because Mr. Colsen’s 1040 forms were filed after the IRS’s assessment, they do not evince an honest, genuine attempt to satisfy the law and thus he has not satisfied the requirement that returns be filed in order for tax liabilities to be dischargeable. But we have no evidence to suggest that the forms appeared obviously inaccurate or fabricated; indeed, Mr. Colsen’s 1040 forms contained data that allowed the IRS to calculate his tax obligation more accurately: The information contained in the forms was honest and genuine enough to result in thousands of dollars of abatements of tax and interest.
In re Colsen, 446 F. 3d at 840-41.
Thus, in the Eighth Circuit a tax return filed after an SFR is still a return for bankruptcy purposes.
3. The Sixth Circuit’s Hindenlang Rule: Post SFR Return Is Not A Return
In In re Hindenlang, 164 F. 3d 1029 (6th Cir. 1999) the Sixth Circuit took a middle of the road approach, concluding that a late-filed tax return can still constitute a “return” within the meaning of § 523(a)(1)(B) up until the time the IRS makes an assessment and commences collection efforts for that tax year. After that the debtor loses.
The Court held:
The Bankruptcy Code does permit debtors who have filed late returns to obtain discharges of tax liability in certain situations. Even in this case, the IRS does not challenge the discharge of Hindenlang’s 1989-91 taxes, for which Forms 1040 were also filed first in 1992, because no assessment had been made by the IRS. . . . We hold as a matter of law that a Form 1040 is not a return if it no longer serves any tax purpose or has any effect under the Internal Revenue Code. A purported return filed too late to have any effect at all under the Internal Revenue Code cannot constitute “an honest and reasonable attempt to satisfy the requirements of the tax law.” Once the government shows that a Form 1040 submitted after an assessment can serve no purpose under the tax law, the government has met its burden.
In re Hindenlang, 164 F. 3d at 1034 (emphasis added).
Thus, in the Sixth Circuit a late-filed return is a return for bankruptcy dischargeability purposes unless it was filed after an SFR and assessment.
4. The Ninth Circuit’s Inconsistent Case Law
The Ninth Circuit Court of Appeals has not yet ruled on whether a late filed return, or a return filed after an SFR, is a return for bankruptcy dischargeability purposes. However, two lower courts in the Ninth Circuit have ruled on the matter, and reached diametrically opposite conclusions.
(i) The Eastern District Of California’s Martin Decision
On the one hand, in In re Martin, 508 B.R. 717 (Bankr. E.D. Cal. 2014) the Bankruptcy Court for the Eastern District of California followed the Eighth Circuit’s Colsen decision and ruled in favor of the debtors.
The Martins filed their returns after the IRS assessed the taxes. Once enough time had passed to satisfy the three-year, two-year, 240-day rules, the debtors filed for Chapter 7 protection. The Martins then filed an adversary proceeding to determine that the tax debts were dischargeable. The IRS filed a motion for summary judgment based on the assertion that the returns filed by the Martins were not returns within the meaning of 11 U.S.C. § 523(a)(1). The Court held:
Based on the foregoing, the court finds and concludes that the Martins’ Form 1040 tax returns for the years 2004, 2005, and 2006 were “returns” within the meaning of § 523(a)(1)(B)(i) and § 523(a)’s hanging paragraph. The court declines to adopt either the Fifth Circuit’s one-day-late result or the Sixth Circuit’s post-assessment approach urged by the IRS to define what constitutes a tax return for purposes of determining dischargeability of the tax debt. Instead, the court relies on the Eighth Circuit’s no-time-limit interpretation to conclude that the “requirements of applicable nonbankruptcy law (including applicable filing requirements)” do not include a temporal restriction. Accordingly, the IRS’s Motion will be denied, and the court will enter judgment in favor of the Martins declaring that their 2004, 2005, and 2006 federal income tax debt was discharged in this chapter 7 bankruptcy.
In re Martin, 508 B.R. at 736.
Thus, according to the Martin Court, a return filed after an SFR and assessment is a return for bankruptcy dischargeability purposes.
(ii) The Northern District Of California’s Smith Decision
On the other hand, the District Court in In re Smith, Case No. 13-CV-871 YGR (N.D. Cal. 2014) held:
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.” . . . In sum, Debtor’s belated Form 1040 for Tax Year 2001 does not meet the definition “return” under established tax law. It follows that the tax liability assessed by the IRS for Tax Year 2001 is a “tax . . . with respect to which a return . . . was not filed or given,” and is not dischargeable in bankruptcy pursuant to section 523(a)(1)(B)(i).
Thus, according to the Smith Court, a return filed after an SFR and assessment is not a return for bankruptcy discharge purposes.
(iii) The Martin And Smith Decisions Are Not Binding Precedent
The doctrine of stare decisis teaches that the holdings of a court are binding on itself and all courts below it.
As there are no courts below the Bankruptcy Court, the Martin holding is only binding on the court that issued that decision.
The bankruptcy appellate holding of a (federal) District Court is binding only on that District Court and the Bankruptcy Court from which the appeal was taken. As the Ninth Circuit Court of Appeals held:
At present, there is no controlling case law directly on this point. However, we now make clear that a bankruptcy court is not bound by a district court’s decision from another district. . . . Were we to hold that bankruptcy courts are bound by all district court decisions within the circuit, rather than only the decision of the district judge to whom their ruling has been appealed, bankruptcy courts would be subject to a potentially non-uniform body of law.
If you are in the Ninth Circuit and have tax debts for years in which you filed returns after an SFR and assessment, you can appeal to the reasoning in Martin and Colsen, but know that the IRS is moving district-by-district, and circuit-by-circuit, developing case law that may make it difficult to win.
If you are a debtor in the Central District of California, who has income tax debt for years in which you filed a return after an SFR and assessment, and you wish to litigate the matter, contact an extremely knowledgeable and highly skilled bankruptcy attorney to guide you through the process.