Individual debtors with old tax debts relating to late-filed tax returns may be surprised to find that those tax debts may not be dischargeable under section 523(a) of the Bankruptcy Code due to the lateness of the tax filing. There is a current Circuit split regarding whether a late tax filing constitutes a “return” at all, which is critical to the dischargeability inquiry. The Ninth Circuit weighed in last week in In re Smith, 2016 WL 3749156 (9th Cir. July 13, 2016), further cementing the split. Individuals considering whether to file bankruptcy to obtain a discharge of old tax debts would be well-advised to assess the current legal landscape and plan accordingly.
Section 523(a)(1)(B)(i) Exemption From Discharge For Tax Debts
Section 523(a)(1)(B)(i) of the Bankruptcy Code exempts from discharge any debt for a tax “with respect to which a return, or equivalent report or notice, if required . . . was not filed or given.” In other words, a debtor may not obtain a discharge for taxes where it has failed to file a required tax return. For a late-filed tax return, the issue becomes whether it is a “return” at all.
Prior to the 2005 BAPCPA amendments, the Bankruptcy Code did not define “return.” Courts generally adopted the Tax Court’s definition of return set out in Beard v. Comm’r of Internal Revenue, 82 T.C. 766 (1984), which is commonly articulated as a tax filing that: (1) purports to be a return; (2) is executed under penalty of perjury; (3) contains sufficient data to allow calculation of tax; and (4) represents an honest and reasonable attempt to satisfy the requirements of the tax law. Where a debtor files a late Form 1040 or similar tax form, elements one through three generally will be satisfied. It is element four that has been the subject of significant dispute.
In the 2005 BAPCPA amendments, Congress defined “return” in a new hanging paragraph at the end of section 523(a). Under this definition, a return is “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).” This new definition has given rise to a significant split in authority regarding late-filed tax returns.
The Majority View.
Under the majority view followed in the Fourth, Sixth, Seventh, Eighth, Ninth, and Eleventh Circuits,1 the Beard test governs the “return” inquiry. As elements one through three are usually satisfied where a tax payer files an appropriate tax form, even if late, the inquiry inevitably becomes whether the debtor’s late filing represents an honest and reasonable attempt to satisfy the tax law requirements. The timing of the late filing is generally considered relevant,2 as is the debtor’s justification for the late filing, whether the IRS has already assessed the past-due taxes, and whether the late filing serves the purposes of the tax system.
The Ninth Circuit’s recent In re Smith decision is instructive. There, the debtor failed to timely file his 2001 federal tax return. The IRS calculated the debtor’s 2001 tax liability based on information gathered from other sources, and in 2006 assessed a deficiency against him. In 2009, the debtor filed a Form 1040 for the 2001 tax year and thereafter sought to reach a compromise with the IRS on the 2001 taxes. Unable to do so, the debtor filed his chapter 7 petition and sought a discharge of the 2001 taxes. The bankruptcy court granted the discharge, and the district court reversed.
In affirming the district court, the Ninth Circuit considered the fourth Beard element and ruled that the debtor’s “belated acceptance of responsibility” was not a reasonable attempt to comply with the tax laws where, without justification, he waited three years after the IRS assessment and seven years after the tax return due date to file his Form 1040. To the court, this simply was not a close case. Because the debtor’s late-filed Form 1040 did not constitute a “return,” the debtor’s 2001 tax debt was exempt from discharge under section 523(a)(1)(B)(i).
The test adopted by the majority is fact-intensive, but provides an avenue for the honest but unfortunate debtor to obtain a discharge of tax debts where there is some justifiable excuse for the untimely tax filing. This is not the case under the minority view.
The Minority View.
Under the minority view adopted in the First, Fifth, and Tenth Circuits, tax debts are not dischargeable if the tax return is filed after the applicable deadline—even if late by a single day.3 The rationale for this so-called “one-day-late rule” is that, under the plain language of the BAPCPA amendments’ new definition, a tax filing is only a return if it satisfies the requirements of the applicable nonbankruptcy law, “including applicable filing requirements.” Under this view, the applicable filing requirements include filing deadlines. Thus, late tax filings simply do not constitute returns for purposes of section 523(a).
The minority view is quite hostile even to the most honest debtor seeking to discharge tax debts for which he or she filed a late return. But, to these courts, Congress has determined that debtors who miss tax filing deadlines simply are not entitled to a discharge of the associated tax debts.
The Ninth Circuit’s In re Smith decision reaffirms the stark divide between the majority and minority views on the dischargeability of tax debts where the debtor failed to timely file a return. Unless and until the split is resolved by the Supreme Court, an individual debtor with significant tax liabilities should consider carefully whether a bankruptcy filing is appropriate in light of the current legal landscape.