Late-filed Tax Return Leads to Nondischargeability of Tax Liability

The discharge of tax liabilities can often be a big factor in someone’s decision to file for bankruptcy.  If you can develop a plan so that tax liabilities are discharged in a bankruptcy filing, that can be immense for a debtor (because otherwise tax liabilities remain nondischargeable).  There are tests, however, for when tax liabilities may be discharged in bankruptcy.  Additionally, the question that has been circulating around the country is, specifically, what constitutes a tax return?  In this case out of the 9th Circuit, the debtor’s filing of a tax return seven years after it was due was not considered a tax return, and so the tax liabilities were not discharged in his bankruptcy case.

In this case, the debtor did not file his 2001 tax returns.  Thereafter, after notices to the debtor received no response, the IRS generated an SFR (substitute for return) as it normally does for people who don’t file returns.  The IRS then mailed out its normal set of delinquency notices and demands to the debtor.  Seven years after the tax return was due, the debtor filed a tax return for 2001.  Then the debtor entered into an installment agreement with the IRS to pay off his delinquency in monthly payments.  Unfortunately, the debtor lost his job, and then filed for bankruptcy.

At the bankruptcy court level, the debtor sought a determination that the tax liability from the 2001 tax year was dischargeable, and the bankruptcy court agreed.  The IRS appealed to the federal district court, which reversed the bankruptcy court and found that the tax liability from 2001 was not dischargeable.  The debtor then appealed that decision to the Appeals Court for the 9th Circuit.

The issue on appeal was whether the return filed by the debtor (in 2008) for tax year 2001 constituted a “return.”  According to 9th Circuit law, to qualify as a tax return, the filing must: (1) purport to be a return; (2) be executed under penalty of perjury; (3)  contain sufficient data to allow calculation of tax; and (4) be an honest and reasonable attempt to satisfy the requirements of the tax law.  Specifically, in this case, element 4 was in dispute: whether the debtor’s filing of a Form 1040 eight years after it was due, and three years after the IRS had sent him notices of assessment, was an honest and reasonable attempt to satisfy the requirements of the tax law.

Ultimately, the court found that it was NOT an honest and reasonable attempt to satisfy the tax law.  The court found that the debtor’s ultra-late filing (especially after the IRS went through the trouble of calculating his liability and trying to collect) was a “belated acceptance of responsibility” and not a reasonable and honest attempt at compliance.  Essentially, the court reasoned that the debtor didn’t file anything concerning that tax year until he absolutely had to and when it was in his best interest.  Further, the IRS spent years trying to communicate with the debtor, and he never responded.  The court, however, declined to extend its opinion to state that ANY late-filed return can ever constitute a tax return (thankfully!).  In re Smith (9th Cir., July 2016).

Ultimately, the takeaway is that you should timely file your tax returns.  Even if there is a liability for a tax year, you could deal with that liability directly with the IRS, or seek to have it discharged in bankruptcy.  These late-filed return cases are usually riddled with bad facts, and the courts are shrinking back the kinds of tax liabilities that may be discharged in bankruptcy.

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