Some time ago I wrote about discharging income taxes in bankruptcy. I subsequently wrote about discharging income taxes in bankruptcy for a tax year in which the debtor filed a return after the taxing authority ― for simplicity I will generically label the authority as the IRS, though the discussion applies to other taxing authorities ― filed a substitute for return and assessed the tax.
A fellow bankruptcy attorney of the highest caliber, who is also a good friend, read the substitution for return post ― Yippee! I always love hearing that people are reading the blog ― and drew my attention to a brand new decision of the Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) in the appeal of one of the cases I discussed in substitute for return post. He suggested that I write a follow up post. Following the rule always to take requests from the audience (please try the veal piccata, and be sure to tip the wait staff), I offer the following update.
To set the stage for this post I will begin with a précis of the aforementioned (does anyone other than an attorney use the word “aforementioned”?) two previous posts. If you want more detail, read those two posts.
I. The Three-Part Tax Dischargeability Test
For a tax to be dischargeable in bankruptcy, it must satisfy three requirements:
1. (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,
2. (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
3. (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. It is the afflatus for this post.
II. Substitute For Return
Under the right circumstances you might never have to pay taxes (the key statement is at 1:19). The rest of us have to pay taxes, and as part of the process we have to file tax returns. 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”). Once the SFR is complete, the IRS will enter the unpaid tax liability into its system. That process is called assessment. Unless you willing participate in the preparation of the SFR, the SFR is not a tax return for tax dischargeability.
III. Is A Return Filed After An SFR A Return For Bankruptcy Purposes?
This is the question that spawned the previous post. The three positions that circuit courts of appeal have taken are:
A. The Fifth Circuit’s McCoy Rule: One-Day Late And You Lose
According to the Fifth Circuit’s holding in In re McCoy, 666 F. 3d 924 (5th Cir. 2012), 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.
B. The Eighth Circuit’s Colsen Rule: A Filed Return Is A Return
According to the Eighth Circuit’s holding in In re Colsen, 446 F. 3d 836 (8th Cir. 2006), a tax return filed after an SFR is still a return for bankruptcy purposes.
C. The Sixth Circuit’s Hindenlang Rule: Post SFR Return Is Not A Return
In In re Hindenlang, 164 F. 3d 1029 (6th Cir. 1999) (Oh! The humanity! Wait, it’s Hindenlang, not Hindenburg. Never mind.), the Sixth Circuit held that a late-filed return is a return for bankruptcy dischargeability purposes unless it was filed after an SFR and assessment.
D. 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, in 2014 two lower courts in the Ninth Circuit ruled on the matter, and reached diametrically opposite conclusions.
1. 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.
2. 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 that a return filed after an SFR and assessment is not a return for bankruptcy discharge purposes.
IV. The BAP’s Recent Martin Holding
The latest case in the Ninth Circuit dealing with the question is hot off the presses (I burned my fingers reading it). It is United States v. Martin (In re Martin), 2015 Bankr. LEXIS 4237, No. EC-14-1180-KuKiTa (B.A.P. 9th Cir. Dec. 17, 2015), the BAP’s decision in the appeal of the Eastern District of California’s Martin decision. For simplicity, for the rest of the post I will refer to the BAP’s decision as Martin.
Before the Martin Court provided a nice review of the relevant Ninth Circuit law, it observed that even the IRS doesn’t take the Fifth Circuit’s absurdly harsh position:
Indeed, in this case and in other cases, the IRS expressly has rejected the literal construction and has stated that the literal construction leads to “overly harsh” results. In re Wogoman, 475 B.R. at 250. Instead, the IRS has advocated for its less draconian approach focusing on whether the taxpayer filing occurred before or after an IRS tax assessment. Id.
Martin at 10.
That sentiment may lead the Ninth Circuit (because you know that they will eventually consider the question, unless the Supremes deal with it first) to reject the Fifth Circuit’s holding.
Or perhaps our epicene Congress will do something constructive for a change and amend the Bankruptcy Code to state unambiguously that a return that is filed at any time is a return for dischargeability purposes (while still retaining the three-part dischargeability test). Please write to your senators and representatives and ask them to do this. In the meantime, let’s return to the BAP’s Martin decision.
A. The Beard Test
Both sides in the Martin case appealed to the so-called Beard test in Beard v. Commissioner, 82 T.C. 766, 774–79 (1984), aff’d 793 F.2d 139 (6th Cir. 1986), which was adopted by the Ninth Circuit in its pre-BAPCPA holding in In re Hatton, 220 F. 3d 1057 (9th Cir. 2000):
In order for a document to qualify as a return: “(1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law.”
In re Hatton, 220 F.3d at 1060-61 (quoting Hindenlang, 164 F.3d at 1033).
Notice that in the Beard test there is no reference to an SFR or a tax assessment, which suggests that the Eighth Circuit’s Colsen holding is the correct one, at least under pre-BAPCPA law (BAPCPA is the Bankruptcy Abuse Prevention and Screw The Consumer Protection Act of 2005, which made sweeping changes to the Bankruptcy Code using the besom of destruction ― see Isa. 14:23).
B. The Hanging Paragraph
The Martin Court then turned to the “big” BAPCPA tax return change in the Code: The hanging paragraph at the end of 11 U.S.C. § 523(a):
For purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.
The hanging paragraph consists of two sentences. The first appears to support the Fifth Circuit’s draconian holding because, according to 26 U.S.C. § 6027(a), tax return filing requirements have a temporal component ― file by April 15. But see IRS Publication 17)
Due date of return. The due date to file your tax return is April 18, 2016. The due date is April 18, instead of April 15, because of the Emancipation Day holiday in the District of Columbia—even if you do not live in the District of Columbia. If you live in Maine or Massachusetts, you have until April 19, 2016. That is because of the Patriots’ Day holiday in those states.
Thus, from the Fifth Circuit’s perspective, if you don’t file your return on time, you have not filed a return that satisfies all of the filing requirements, so it isn’t a return for bankruptcy purposes.
However, the Martin Court noted that what the first sentence of the hanging paragraph took away, the second sentence partially gave back. For example, an SFR prepared under 26 U.S.C. § 6020(a), i.e., a return prepared by the IRS, but with the cooperation of the taxpayer (as opposed to a return prepared under 26 U.S.C. § 6020(b), without the taxpayer’s cooperation), is a return for bankruptcy discharge purposes. A § 6020(a) return is prepared after the filing deadline, and yet it is still a return for bankruptcy purposes; so it clearly falls outside of the Fifth Circuit’s vicious juggernaut.
Based on this observation the Martin Court concluded that the Fifth Circuit’s position naturally introduces a gross unfairness into the analysis:
[U]nder the literal construction of the hanging paragraph, a debtor taxpayer who is one month or one day or even one hour late in filing his or her return will have his associated tax debt excepted from discharge, whereas a debtor taxpayer who never bothers to file his or her own return can discharge his or her associated tax debt if the IRS fortuitously prepares a return on that person’s behalf.
Martin at 17-18.
The Court also stated that the Fifth Circuit’s position forces an unjustified redundancy into the statute:
[A]ccording to the literal construction adherents, even though the first sentence of the hanging paragraph already excludes all late-filed returns from the definition of “return,” Congress felt it necessary (supposedly for the sake of clarity) to repeat one tiny aspect of this exclusion one sentence later – the exclusion with respect to § 6020(b) returns, which by definition are untimely.
Id. at 19.
However, under the case law (emphasis in original):
“[i]t is a cardinal principle of statutory construction that a statute ought, upon the whole, to be so construed that, if it can be prevented, no clause, sentence, or word shall be superfluous, void, or insignificant.”
Id. at 19-20 (quoting TRW Inc. v. Andrews, 534 U.S. 19, 31 (2001)).
Therefore, the imposition of redundancy into the statute by the Fifth Circuit’s McCoy holding constitutes indefensibly poor statutory construction.
C. The 11 U.S.C. § 523(a)(1)(B)(ii) Problem
The Fifth Circuit’s position also renders 11 U.S.C. § 523(a)(1)(B)(ii) virtual surplusage because it reduces its broad language ― that was unchanged under BAPCPA ― to the very narrow 26 U.S.C. § 6020(a) context. To see this, consider (emphasis added):
A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
(1) for a tax or a customs duty — . . .
(B) with respect to which a return, or equivalent report or notice, if required — . . .
(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)(ii)).
Notice that the return must be both untimely filed and filed less than two years before the bankruptcy papers are filed for this provision to render the tax nondischargeable. Therefore, if the return was filed late, but more than two years before the bankruptcy filing, this provision would not create an impediment to discharge of the tax.
Regarding 11 U.S.C. § 523(a)(1)(B)(ii) the Martin Court observed:
After BAPCPA, at least under the literal construction, the once-expansive coverage of this subparagraph has been dramatically reduced to an infinitesimal scope – a scope bordering on and approaching zero. As the literal construction adherents would have it, this subparagraph post-BAPCPA only would apply to § 6020(a) returns, since § 6020(a) returns are the only type of untimely returns that fall within the definition of “return” under the literal construction.
Martin at 20-21.
And 26 U.S.C. § 6020(a) is limited solely to the unusual situation where the IRS prepares the return with the taxpayer’s cooperation:
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.
In sum, restricting 11 U.S.C. § 523(a)(1)(B)(ii) to the case of 26 U.S.C. § 6020(a) renders it meaningless. As the Martin Court held:
The literal construction also renders § 523(a)(1)(B)(ii) all but meaningless. The literal construction adherents explain away this concern by suggesting that, while “meaningless” is not okay under the cardinal rule disfavoring interpretations that render part of a statute superfluous, “all but meaningless” is fine.
Martin at 21.
Ultimately, the Fifth Circuit’s radical changing of the meaning of 11 U.S.C. § 523(a)(1)(B)(ii) under the post-BAPCPA regime flies in the face of the Supreme Court’s jurisprudence:
The Supreme Court disfavors interpretations of ambiguous Bankruptcy Code provisions (and amendments) that impose major changes in pre-existing practice in the absence of at least some discussion in the legislative history. See Dewsnup v. Timm, 502 U.S. 410, 419 (1992).
Based on this line of reasoning, the BAP explicitly rejected the Fifth Circuit’s McCoy holding.
Of particular interest was the BAP’s rejection of the Sixth Circuit standard that a return filed after assessment is not a return for bankruptcy purposes. Thus, the BAP followed the Eighth Circuit’s holding with the requirement that the debtor meet the Beard test for the two-year rule to be satisfied.
However, the BAP vacated the Bankruptcy Court’s holding that the Martins’ tax debts were discharged because the Bankruptcy Court had used a modified version of the Beard test instead of the Beard test as accepted by the Ninth Circuit. Instead it remanded the case back to the Bankruptcy Court for a proper application of the Beard test.
As you may have guessed, I am very interested in this question, and will let you know of any further developments as I learn of them.
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.