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9th Circuit Bankruptcy Appellate Panel Decision on Unfiled Returns Takes Issue Back to the Future

Posted on Dec. 30, 2015

I have written several times, here, here, here, here and here, on the case law that has developed after the 2005 amendments to section 523 of the bankruptcy code addressing the ability to discharge taxes when the taxpayer files the return late.  In 2015 two circuit courts, Mallo in the 10th and Fahey in the 1st, followed In re McCoy in the 5th and held that when an individual taxpayer files a return late, even one day late, the tax liabilities related to that return can never qualify for discharge.  These courts reach this result based on a literal interpretation of the unnumbered paragraph added to the end of 523(a)(hereinafter 523(a)(*)) in 2005.

A 9th Circuit bankruptcy panel, in the case of Martin v. United States examines and rejects the emerging case law applying a literal interpretation to 523(a)(*).  The court not only works its way through the literal interpretation argument but addresses and rejects the IRS’ current position resulting in an opinion that essentially finds the law unchanged by the 2005 legislation.

Before discussing the opinion, it is worth pausing for a moment to discuss bankruptcy appellate panels so that the opinion can have some context as it relates to the three circuit level opinions that currently exist. Bankruptcy courts reside beneath federal district courts in the pecking order for precedent.  Without getting into the constitutional issues created by the 1978 Bankruptcy Code and the resolution of those issues, it is safe to say that bankruptcy judges are not Article III judges and that their opinions, when appealed, go to the district court before going to the circuit court and then to the Supreme Court.  In 1978 Congress gave circuits the option of creating bankruptcy appellate panels as a place to appeal the decision of a bankruptcy judge.  In 1994 Congress said all circuits would have such panels.  The bankruptcy appellate panels consist of three bankruptcy judges.  The decision of the bankruptcy appellate panel goes to the appropriate circuit court.  There is more that could be said about these panels but for purposes of this discussion, I simply want to place them on the map of federal courts for those not familiar with bankruptcy procedure.  So, the opinion that this post will discuss will now go to the 9th Circuit if appealed and does not itself create a conflict among the circuits.

The opinion has an interesting format because it leads off talking about misguided nature of the opinions holding that a return filed one day late must forever be denied a discharge. After the clear statement in the opening paragraphs, the court circles back to the facts before working its way through the legal arguments.  Because I very much agree with the views of the BAP regarding the literal reading of the 2005 amendment, the opening paragraphs made for enjoyable reading.

The facts of the case essentially mirror those of all cases of this genre. The taxpayers did not file returns for several years.  The IRS sent them notices about that fact.  They did not act in response to the notices.  The IRS eventually sent the Martins notices of deficiency for the years at issue.  The notices of deficiency inspired them to go to a preparer and get the returns prepared; however, they defaulted on the notices allowing the IRS to assess the liabilities.  The Martins then filed the missing returns and the IRS abated its assessments to reflect the liabilities reported on the late filed returns.  The Martins waited two years after filing the late returns and filed a chapter 7 bankruptcy.  They sought a determination that the liabilities on the late returns were discharged.  The IRS objected.

In deciding the case the BAP looked at three possible bases for reaching the correct conclusion. First, it examined the interpretation of discharge developed by the three circuits making the literal interpretation of 523(a)(*).  Second, it examined 9th Circuit law that had developed prior to 2005 on the issue of unfiled returns and finally, it addressed the argument advanced by the IRS regarding the effect of an assessment prior to the filing of the late return – an argument developed post 2005.

As mentioned above the BAP rejected the literal reading of 523(a)(*). I t found that such a reading did violence to the statutory scheme of discharge developed in 1978 with the passage of the bankruptcy code.  In addition, it found that the literal interpretation did not make sense even within the new paragraph added in 2005 and that the literal interpretation of that paragraph could not be resolved with the language of 523(a)(1)(B).  The opinion provides a roadmap for those who disagree with the literal interpretation provided by the three circuit courts.  If the case is appealed and if the 9th Circuit follows the BAP, a clear conflict will exist among the circuits which might create a path for resolution of this issue.

After knocking down the literal argument, the BAP turned its attention to the controlling precedent of its circuit. It found that the controlling precedent relied on the Beard test for determining “what is a return?”  The BAP held that the 2005 amendment sought to codify the Beard test and prior 9th Circuit precedent.  This aspect of the decision is also important.  I disagree with the BAP on its interpretation of the goal of the 2005 language because the effort to change the code sprang not from an effort to codify the case law imposing the Beard test but to creating an easily administrable rule.  The Beard test involves a fact intensive look at the circumstances of each case.  The taxing authorities do not want this both because it requires more resources than they want to devote to this issue and it makes the issue one which will require frequent litigation to resolve the fact intensive question.  This result is not what the taxing authorities sought in pushing for the amendment but may be what they got if the literal language is rejected.

Finally, the court looked at the argument the IRS now pushes. This is an easily administrable position and one which is much more lenient than the literal language argument but one that the BAP did not buy.  The IRS argues that once it has made an assessment of the tax for a year, any return filed after that assessment is not a return for purposes of triggering the two year rule in 523(a)(1)(B)(ii).  The BAP rejected this because it did not agree that the trigger point is the assessment date.  The liability goes back to the end of the tax year and does not start with the assessment.  The assessment of the tax, almost always done in these cases after the issuance of a notice of deficiency to a taxpayer who has refused to filed the return, does not have any special meaning in the statutory scheme of 523.  The IRS position has the attraction of easy administrability and the opportunity for a taxpayer to correct the unfiled return situation long after the close of the tax year, but it is hard to find support for the position in the language of the statute.

So, the BAP takes us back to the pre-2005 legislation on this issue with the only impact of the legislation, in the opinion of the BAP, being the codification of the position the 9th Circuit had previously staked out (along with several other circuits.)  If the BAP position prevails, taxpayers are clear winners vis a vis the literal interpretation test because they have time to fix their failure to file and still obtain the benefit of a discharge.  In pre 2005 cases most taxpayers who waited for the IRS to make an assessment before filing a late return lost in their attempt to get the liability discharged.  Taxpayers will still lose their discharge cases under the BAP opinion in most cases where they wait until after assessment to file the late return but the clear losers if the BAP opinion prevails are the tax administrators who must do more fact investigations and face more litigation when trying to resolve the discharge issue created by a late filed return.

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