One of the hallmarks of our bankruptcy system is the individual discharge of pre-bankruptcy debts. However, there are some exceptions to the coveted discharge for a variety of public policy reasons.
One of those exceptions to discharge is for certain tax debts. The basic rule is that “stale” tax debts can be discharged, but “fresh” tax debts cannot be discharged. Despite this simple rule, another exception applies for tax debts if a tax return was not filed.
Courts continue to confront the issue of how this rule works when a taxpayer files a late tax return. Compounding the issue is bankruptcy legislation changes enacted in 2006 that added the following language to the bankruptcy code, known as the “hanging paragraph”: “[f]or purposes of this subsection, the term ‘return’ means a return that satisfies the requirements of applicable non bankruptcy law (including applicable filing requirements).” 11 U.S.C.
Two recent cases (and several cases before them) addressed this exact question.
The Third Circuit, in In re Giacchi, No. 15-3761 (3rd Cir. May 5, 2017), framed the issue as whether Forms 1040 filed after the IRS already assessed the taxpayer’s liability constituted “returns” under 11 U.S.C. § 523(a)(1)(B). The Third Circuit held that the late Forms 1040 did not constitute returns.
The Third Circuit focused on the language of § 523(a)(1)(B), which provides in relevant part, “any . . . debt for a tax . . . with respect to which a return, or equivalent report or notice, if required, . . . was not filed or given.” Thus, the critical question was whether “belatedly filed forms constitute ‘returns.’”
Focusing on the BAPCPA changes to § 523, the court adopted the oft-cited Beard standard for tax returns, which sets forth the four elements of a proper tax 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.”
Here, the court noted that “[f]orms filed after their due dates and after an IRS assessment rarely, if ever, qualify as an honest or reasonable attempt to satisfy the tax law.” In other words, according to the court, “[o]nce the IRS assesses the taxpayer’s liability, a subsequent filing can no longer serve the tax return’s purpose, and thus could not be an honest and reasonable attempt to comply with the tax law.”
The court rejected the Eighth Circuit’s approach, which focuses on the content of the filing, not necessarily its timing. As the Third Circuit noted, “the timing of the filing of a tax form is relevant to determining whether the form evinces an honest and reasonable attempt to comply with tax law.”
The court also rejected the debtor’s second main argument that, because the IRS abated, in part, the tax assessment due to late filings, those documents served some tax purpose. The court responded that because the IRS had to initially estimate the tax liability, the taxpayer “cannot now seek to benefit from the IRS’s imprecise estimate.”
In sum, the court found that, in this case, “belated filings after assessment are not an honest and reasonable effort to comply with the tax law under the Beard test and, as such, the filings do not constitute returns.” Consequently, the tax debts for those years were not discharged according to 11 U.S.C. § 523(a)(1)(B).
It is important to note, though, that the Third Circuit failed to squarely address the “one-day-late rule,” as expressed by several other courts.
More recently, another bankruptcy court confronted this issue. The Bankruptcy Court for the Northern District of California, in In re Van Arsdale, No. 14-04035 (Bankr. N.D. Cal. May 18, 2017), likewise rejected a debtor’s attempt to discharge a federal tax debt for a year in which returns were not timely filed.
In that case, the IRS argued that a document filed after the IRS files a substitute for return does not constitute a return and is not an honest and reasonable attempt to address a tax obligation. The court gave “some credence to the argument that filing a tax return after a SFR devalues the significance of the tax return, and puts into play whether the late filed return reasonably complies with the debtor’s tax obligations.” The court did, however, reject a per se bright line rule: “While this court rejects the suggestion of a per se rule, the preparation and filing of a SFR rarely helps the debtor taxpayer’s cause.” The court granted the IRS’s motion, concluding that the document was not a “return.”
As demonstrated by these two recent cases, taxpayer-debtors continue to face an uphill battle to discharge these kinds of tax debts.