Discharging Income Taxes – A Scavenger Hunt Through the Codes; The Real McCoy?

The need to determine whether a debtor’s fresh start will include the discharge of income tax liability is fairly common task for consumer bankruptcy practitioners.
This task involves a fact gathering statutory analysis reminiscent of a scavenger hunt.

The following is my scavenger hunt through the statutes which sets forth my understanding of the process for determining when incomes taxes may be discharged in a consumer debtor’s Chapter 7 case.  My analysis should not be relied upon by readers as advice.

We begin the hunt for income tax discharge with the most obvious stop, Bankruptcy Code Section 727(a) where we find that “The court shall grant the debtor a discharge, unless –“ and 727(b) “Except as provided in section 523 of this title, a discharge under section (a) of this section discharges the debtor from all debts that arose before the date of the order for relief under this chapter…” 11 U.S.C. § 727.

The next stop on the hunt for income tax discharge is section 523 which provides in relevant part that:
(a) A discharge under section 727 . . . of this title does not discharge an individual debtor from any debt—
(1) for a tax or a customs duty—
(A) of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed;”

The hunt is temporarily redirected from 523 at this juncture to visit the relevant sections of 507(a)(8) where we gather specifies time periods causing income tax debt to be characterized as “priority unsecured debt” and not subject to discharge:
“(A) … for a tax year ending on or before the date of the filing of the petition —
(i) for a return … which is last due … [within] three years before the [petition] date …;
(ii) assessed within 240 days before the … petition [date] exclusive of [tolling periods]…”

Taking stock of the fruits of our hunt, thus far, we have gathered that there may be a possibility of discharging income tax debt from a tax year more than three years before the petition date that was also assessed more than about 8 months before the Chapter 7 petition date.

Our hunt picks up again with section 523(a) which gives the next clue:

“(B) with respect to which a return, or equivalent report or notice, if required—…”

We must traverse to the end of section for BAPCPA’s new definition of “return”:
“For purposes of this subsection, 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) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.
11 U.S.C. § 523(a)(*) (emphasis added).

We pause here for a breather and reflect that BAPCPA added this definition of “return” to replace a four part test set forth in Hindenlang that appears to have expressed the spirit of debtor’s cooperation as a prerequisite to finding a “return” existed:

In order for a document to qualify as a return [under § 523]: (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.
Hindenlang, 164 F.3d at 1033 (internal quotation marks and citation omitted).

Detouring briefly away from 523, we visit the Internal Revenue Code and gather from IRS § 6020 a similar expression of the spirit of debtor’s cooperation (or not) reflected in the two distinct types of tax returns the IRS prepares when a debtor does not prepare and file her own return. Where the debtor cooperates with the IRS 6020(a) applies and where the debtor does not cooperate 6020(b) applies:

Section 6020(a) of the Internal Revenue Code provides:
If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.
26 U.S.C. § 6020(a).

Section 6020(b) of the Internal Revenue Code provides:
(1) Authority of Secretary to execute return.—If any person fails to make
any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.
(2) Status of returns.—Any return so made and subscribed by the Secretary
shall be prima facie good and sufficient for all legal purposes.

26 U.S.C. § 6020(b).

Leaving 523(*) and heading back to 523(a)(1) we inventory our items and decide that income tax debt arising from a tax year over three years prepetition, assessed about 8 months or more prepetition, resulting from debtor’s cooperation in providing information to the taxing authority necessary for a proper assessment of the debt, may be covered by debtor’s 727 discharge.

Nearing the end of our scavenger hunt we return to section 523(a)(1) and pick up where we left off. Referring to the “return”, this section provides the final clues:

(i) was not filed …; or
(i) was filed … after the date on which such return, report or notice was last due, under applicable law or under any extension, and … [within] two years .. of the … [petition] date… ; or
(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax;
11 U.S.C. § 523(a)(1).

These clues condition discharge of income tax debt to non-fraudulent based assessments resulting from tax “returns” filed more than two years before the petition date.

We gather from a return visit to the IRS, through I.R.S. Chief Couns. Notice No. CC-2010-016 at 2 (Sept. 2, 2010), that income tax debt assessed from a late filed tax return, where the IRS has not yet filed a return for the debtor, may be discharged:
Read as a whole, section 523(a) does not provide that every tax for which a return was filed late is nondischargeable. If the parenthetical “(including applicable filing requirements)” in the unnumbered paragraph created the rule that no late-filed return could qualify as a return, the provision in the same paragraph that returns made pursuant to section 6020(b) are not returns for discharge purposes would be entirely superfluous because a section 6020(b) return is always prepared after the due date. It is a cardinal principle of statutory construction that a statute should be construed so that no clause, sentence or word is rendered superfluous. Kawaauhau v.
Geiger, 523 U.S. 57, 62 (1998) (refusing to read one provision of the Bankruptcy Code to render another superfluous).

We also gather, from this last stop on the hunt, that when debtor’s late filed tax return results in an additional assessment exceeding the amount of income tax assessed from a previous return prepared by the IRS, the newly assessed amount may be discharged:
A Form 1040 is not disqualified as a “return” under section 523(a) solely because it was filed late. Regardless of whether a Form 1040 filed after assessment is a “return” for tax purposes, the portion of a tax that was assessed before the Form 1040 was filed is nondischargeable under section 523(a)(1)(B)(i).

At the end of our hunt we are left with an unanswered question.

If state law does not provide a statute equivalent to IRS § 6020(a) and a consumer debtor cooperates by proving information to the state taxing authority (more than two years prepetition), that results in an assessment of income tax debt (more than 8 month prepetition), for a tax year more than three years prepetition, has the debtor filed a “return” and is the debt therefore discharged under 727?

One answer to this question was provided by the 5th Circuit Court of Appeals on January 4, 2012 through its decision In re McCoy. The 5th Circuit held unless the debtor’s return is filed under a “safe harbor” provision similar to IRC § 6020(a), a Chapter 7 debtor’s state income tax return that is filed late under Mississippi Law is not a “return” for bankruptcy discharge purposes.

The McCoy court read the 523(*)’s language “the term ‘return’ means a return that satisfies the requirements of applicable non-bankruptcy law (including applicable filing requirements).” to require an on-time tax return filing by the debtor.
A more equitable interpretation of 523(*)’s phrase “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements)” is that applicable non-bankruptcy law’s applicable filing requirements for a “return” are met through debtor’s honest cooperation in causing the taxing authority to receive the information necessary for a State Government to assess a debtor’s income tax liability. This more equitable interpretation is consistent with the plain language of 523(a)(1)(B)(ii) that prohibits discharge of a late filed return which is also filed within two years of the Chapter 7 petition date.

An honest and cooperative debtor that produces information to a state or federal taxing authority (more than two years before the petition date) resulting in an income tax assessment (more than 8 month prepetition) for a tax year more than three years prepetition, should be deemed to have filed a “return” and should received a discharge of that debt (except the portion of the debt that the state assessed before the debtor filed her return) as past of the consumer debtor’s Fresh Start.


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