Can a Late Tax Return be Discharged in Bankruptcy?

Late Filed Returns and Discharging Back Taxes

A State of Uncertainty 

On December 29, 2014, the Court of Appeals for the Tenth Circuit, (In re Mallo, 2014 WL 7360130 (10th Cir. 2014)), followed the Fifth Circuit (In re McCoy, (CA 5 2012) 666 F.3d 924) and several other tax bankruptcy court cases which held that late-filed tax returns cannot be discharged in bankruptcy.  Unfortunately, this draconian result known as the One-Day-Late Rule could preclude the taxpayer’s goal of eliminating back taxes in bankruptcy and obtaining a fresh start.

How do I eliminate taxes in bankruptcy? 

In bankruptcy, back taxes are either secured or unsecured claims.  If the IRS or state taxing authority files a tax lien, then the tax claim is secured and paid first from the taxpayer’s assets.  If the tax claim is unsecured, then its treatment will be contingent upon whether the IRS’s claim is classified as a priority or a general claim.

Section 507(a) of the bankruptcy code consists of 10 classes of priority claims.  Generally speaking, most taxes fall within priority class number 8 which is classified as “Certain Claims of Governmental Units”. Priority taxes are non-dischargable in a Chapter 7 and must be paid in full in a Chapter 11 or Chapter 13.  For taxes to avoid priority status, the following is required.

  1. The back taxes must be related to a non-trust fund tax (i.e. income taxes);
  2. The bankruptcy petition must be filed more than three years after the return was due to be filed plus extensions;
  3. The bankruptcy petition must be filed more than 240 days after the tax was assessed;
  4. The debtor cannot commit tax fraud or willfully attempt evade taxes; and
  5. The bankruptcy petition must be filed more than two years after the return was filed

Late Filed Tax Returns and Bankruptcy

Prior to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), as long as an unfiled tax return was filed more than two years before the filing of a bankruptcy petition,  back taxes could be dischargeable.  With BAPCA, Congress amended §523(a) and added an unnumbered paragraph to the end of the bankruptcy code section known as the “hanging paragraph”.  The hanging paragraph states the following:

. . . 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) . . .but does not included a return made pursuant to 6020(b) of the Internal Revenue Code of 1986, or a similar State of local law.

The 5th Circuit Court of Appeals in the case In re McCoy, 666 F.3d 924 (5th Cir. 2012) and the 10th Circuit in the case In re Mallo, 2014 WL 7360130 (10th Cir. 2014), reviewed the above paragraph and, in particular, the term “applicable filing requirements”.  The 5th and 10th Circuit held that if a return was filed late, then the tax liability cannot be eliminated in bankruptcy.  Accordingly, if you file a tax return late and the IRS deems that you had reasonable cause for the late filing, you nevertheless cannot discharge your back taxes in bankruptcy.

Proving reasonable cause and not willful neglect is the standard utilized when getting rid of tax penalties on a late-filed return.  For example, if a hurricane hit on the tax deadline day and you could not make it to the post office, then you may be able to demonstrate reasonable cause and not willful neglect with regard to non-filing of your taxes.  It is certainly understandable that you filed your tax return late if a hurricane or some external force made it impossible to file your taxes.

The 5th and 10th Circuit, however, do not see it that way and have created the One-Day-Late Rule. Those Circuits have held that if you file bankruptcy to get rid of your taxes on a late filed tax return, then the tax claim is considered priority and thus non-dischargeable no matter what your reason for the late filed return.

Confusion over Eliminating Back Taxes in Bankruptcy 

Other circuits do not interpret “applicable filing requirements” to mean that a late filed return can never be dischargable.  These circuits have held that the term “applicable filing requirements” in the hanging paragraph means “what” was filed, as opposed to, “when” a tax return was filed.  Applicable filing requirements would mean that the return was filed under the penalties of perjury, in the correct place, in proper form, and substantially complete.  The Office of Chief Counsel takes the position, Chief Counsel Notice 2010-16, 2010 WL 3617597, and Chief Counsel Advisory 20104408 (Nov. 5, 2010), that a late filed tax return can be dischargeable.  Chief Counsel takes issue with, amongst other things, the statutory construction of the hanging paragraph.  In particular, the second sentence of the hanging paragraph providing that an IRC § 6020(b) return is not considered a return because an IRC §6020(b) return, known as a substitute for return, is always prepared after the due date.  Chief Counsel noted that “it is the cardinal rule in statutory construction that a statute should be construed so that no clause, sentence or word is superfluous.”

The confusion over whether or not taxes can be discharged on late filed tax returns was a topic addressed in the National Taxpayer Advocate Fiscal Year 2014 Objectives Report to Congress.  In the report, the Taxpayer Advocate recommended that Congress clarify whether a late filed return could be discharged in bankruptcy.

Filing Your Taxes Timely 

In light of all the confusion and uncertainty, the above bankruptcy tax dispute creates another important incentive for filing your tax return timely.  Should you need a fresh start in bankruptcy, then filing a timely tax return provides insurance, especially if you reside in the 5th and 10th Circuit, that your back taxes can be discharged in bankruptcy.

Help with Tax Motivated Bankruptcies 

The Law Offices of Todd S. Unger, Esq. LLC can assist bankruptcy attorneys with clients who have significant back taxes.  Tax Attorney, Todd Unger Esq. has been retained and consulted with on complicated bankruptcy estates seeking to efficiently discharge back taxes.  If you are a bankruptcy attorney or CPA that requires a better understanding of the intersection between bankruptcy and tax, contact the Law Offices of Todd S. Unger, Esq. or call today at (877) 544-4743.