Tax Debt is Discharged in Bankruptcy because IRS May Have Lost Tax Return!

Tax debts are one of those tricky things in bankruptcy where if everything wasn’t done right, then the debt doesn’t get discharged.  The debtor has to file any missed returns.  There are time periods that have to be cleared.  Each tax year has to be considered on its own.  In a very interesting case, a debtor was seeking an order declaring about $75,000.00 is estimated tax debt to be discharged in her bankruptcy case.  The IRS opposed this application and argued that the debtor never filed any return for the tax year in question (2006).  What happened during the trial of this case was very, very interesting!

In this case, out of the Bankruptcy Court for the Northern District of Iowa, the debtor was seeking an order declaring that her bankruptcy discharge applied to any and all outstanding tax debt.  Particularly, the debtor, during this case, conceded that she did not timely file her tax returns for the years 2000, 2001, 2004, 2005, 2006, 2007 and 2008.  For each of those years, the IRS engaged in its usual practice of sending notices to the debtor, but she did not respond.  As is the standard practice for the IRS, when a tax return is not filed by taxpayer, the IRS will prepare and file a “Substitute for Return,” (which is similar to an estimated return prepared and filed by the IRS on the taxpayer’s behalf), which the IRS did in this case for all of those tax years.

Around September 2010, the IRS started garnishing the debtor’s wages.  She contacted the IRS and was told that the garnishment would stop if she filed returns for all of those years.  She was given two different addresses to mail the late returns to.  The debtor stated that she mailed the returns for 2000, 2001, 2005, 2006 and 2007 to one address, and the returns for 2004 , 2008 (and 2009) to the second address, as advised by the IRS rep.

In May 2011, the debtor entered into an installment agreement with the IRS to pay the tax debt, which she later defaulted on.  She then filed her chapter 7 bankruptcy case in February 2013, and the discharge order was entered in May 2013.  She then started this case in June 2015.

In its answer to the case, the IRS stated that all of the debtor’s tax debt was considered discharge except the debt relating to tax years 2006 and 2007.  Subsequently, the IRS amended its answer to state that only the 2006 debt was not discharged, because the IRS later discovered the 2007 return.  The question to be answered by the court was whether the debtor actually filed a return for 2006.

During the case, the debtor never actually presented a copy of the 2006 late-filed return.  She stated, as described above, that she sent a bunch of returns to the IRS in the same package.  She did not know why the 2006 return was the only one missing.  She also introduced a letter from the IRS, dated November 2011, discussing a potential installment agreement.  In that letter, which was concerning tax years 2000, 2001, 2005, 2006 and 2007, it said could not enter into an installment agreement because her 2009 (current tax year) return was missing.  The letter said nothing about the 2006 return missing.

The IRS, on the other, provided the testimony of an IRS employee who was familiar with account transcripts and the codes entered.  She testified that for all of the years in question, the account transcripts noted the entering of the SFR, and the subsequently received tax return except for year 2006, and that could only mean that the IRS did no receive a return for that year.  She also testified that in her thirty years of work with the IRS, she never experienced or observed the IRS losing a return.

The court ruled in favor of the debtor.  First, although the debtor didn’t actually present a copy of the alleged 2006 return into evidence, the IRS did not object to her testimony, nor did the court find any reason to not find the debtor’s testimony credible.  Secondly, and very notably, the court found that the IRS originally said that the debts for 2006 and 2007 were not dischargeable.  Subsequently, the IRS said that it found a return for 2007, so the 2007 was dischargeable.  The debtor testified that it mailed the returns for 2000, 2001, 2005, 2006 and 2007 in the same packet.  The IRS recorded receipt of the 2000, 2001 and 2005 returns in October 2010, but didn’t record receipt of the 2007 return until June 2011, some eight months later.  Further, the IRS did not explain how or why this return was misplaced.  Thus, the court inferred, that it is possible that the IRS may have misplaced the 2006 return, and that the IRS did not prove that the debtor did NOT send in her 2006 return.  McGrew v. IRS (In re McGrew, 13-149-TJC), AP-15-9024-TJC (Bankr. N. D. Iowa, October 2016).

Conclusion and Takeaway

This case is very helpful for debtors in bankruptcy trying to discharge tax debt.  First, the court declined to adopt the approach that a late-filed return can never be a return for bankruptcy discharge purposes, which is a position adopted by several courts across the country.  Secondly, the case shows a great defense in a bankruptcy proceeding if a debtor receives a response from the IRS concerning tax debt, which is to force the IRS to show that a return was not filed.  The debtor’s credible testimony, along with the IRS’ failure to account for a misplaced return, allowed the court to infer that the debtor may have filed her 2006 return.

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