I have previously written on several occasions, here, here, here, here, and here, about the interpretation of the bankruptcy code concerning the discharge of taxes related to tax years for which the taxpayer files a late return. Three Circuits have ruled that when a taxpayer files a late return, even a moment late though that is rarely the case, the taxes related to that return can never be discharged because of the language added to Section 523(a) of the Bankruptcy Code in 2005. Though the IRS does not yet agree with the determination of the Circuit courts, its representative has stated that it may have to reconsider that position if more Circuits adopt the strict reading of Section 523(a). At present, taxpayers living outside the 1st, 5th or 10th Circuits can generally discharge their federal taxes even if they have filed a late return as long as they did not cause the IRS to prepare a substitute for return (SFR) with respect to the period. If the IRS had to go to the trouble of preparing an SFR, it will take the position that any tax liability for the period is excepted from discharge.
Enter the next case in this saga. On June 29, 2016, the District Court for the District of New Jersey, which is within the 3rd Circuit, entered an order certifying the issue to the 3rd Circuit from the bankruptcy court.
Mr. Davis filed a Chapter 7 petition on July 24, 2012. He listed the IRS as a creditor for just over $100,000. Before he filed his Chapter 7 petition, the IRS prepared SFRs for him for 2005 and 2006 since he had not had time to prepare his own tax returns. After the IRS prepared the SFRs, sent the notice of deficiency, waited for the 90-day period to file a petition in Tax Court to run and assessed the liabilities for these two years, Mr. Davis freed up some time and filed Forms 1040 for each of the years on January 28, 2010. The Forms 1040 he filed reduced the liability by small amounts in each year. He waited more than two years after filing the Forms 1040 before filing his Chapter 7 bankruptcy petition. The IRS treated the 2005 and 2006 liabilities as excepted from discharge for the reasons discussed in the prior blog posts and not because of a strict reading of Section 523(a) of the Bankruptcy Code.
Probably because the Chapter 7 case did not get Mr. Davis where he wanted to be with respect to his federal tax obligations, he filed a Chapter 13 petition on August 11, 2014. Seems like he could have saved a lot of time and trouble by filing his returns on time or even working with the IRS when it undoubtedly began a long chain of correspondence with him about the unfiled returns, but that’s not what happened. The IRS filed a proof of claim for over $60,000 of which a small portion was secured, a small portion was priority (for a later year) and the largest portion was general unsecured. Mr. Davis disputed the debt from 2005 and 2006 arguing that it was discharged in his prior bankruptcy. The bankruptcy court granted his motion. The bankruptcy court relied on an earlier decision in the bankruptcy courts of New Jersey, In re Maitland, 531 B.R. 516 (Bankr. N.J. 2015) which had rejected the decisions of the three Circuit courts. The Davis court also rejected the IRS argument that the Forms 1040 filed after an SFR did not cause the exception to discharge to apply. Finding Maitland persuasive, the bankruptcy court held that “there is no timeliness requirement when determining if a filing constitutes a return for purposes of discharge” and ruled that the late filed Forms 1040 filed more than two years before the first bankruptcy petition met the requirements of Section 512(a)(2)(ii) for purposes of meeting the requirements of returns to be discharged. The IRS filed a notice of appeal to the district court and Mr. Davis moved for certification for direct appeal to the Third Circuit.
Normally, a decision of a bankruptcy court gets appealed to the local district court; however, 28 U.S.C. 158(d)(2) provides that a litigant may appeal the decision of a bankruptcy court directly to a Circuit court if the district court certifies (1) that the matter “involves a question of law as to which there is no controlling decision of the court of appeals for the circuit or of the Supreme Court of the United States or involves a matter of public importance; (2) the judgment order, or decree involves a question of law requiring resolution of conflicting decisions, or (3) an immediate appeal from the judgment, order, or decree may materially advance the progress of the case or proceeding in which the appeal is taken”
The IRS opposed the certification which surprises me from the perspective that getting this issue resolved will reduce its exposure for a large drawer full of potentially discharged cases on which it is violating the discharge injunction. It is certainly not clear that a resolution would result in a holding that the IRS is violating the discharge injunction on a wholesale basis but since that is, at least, a possibility, I would think that the IRS would want to resolve this issue as quickly as possible and seek certification in as many cases as possible. The IRS opposition to certification points to exactly the problem with the position it has taken since Hindenlang. It argues here that the issue is not a purely legal issue and that’s the rub because the IRS bankruptcy specialists sure want to treat it as if it is a purely legal issue to which they can apply mechanical tests. The IRS seems to argue to the district court that the discharge issue here is “heavily dependent on the particular facts of the case.” Why it would want to make such an argument is mind boggling. Does it think that its bankruptcy specialists are making case by case decisions? Does it want them to do so? The IRS should be desperately seeking a legal decision. It has tens of thousands of these cases to review and cannot possibly make a heavily dependent factual determination. I did not go and read the IRS brief but only the characterization of its position. The district court says that the IRS characterized the bankruptcy court’s decision as fact dependent. Maybe that is the distinction between my concerns and its arguments but it should want the court to treat it as a legal decision rejecting its argument.
Because this case is between the IRS and the debtor, the issue of the one moment late rulings of the three circuit courts will not necessarily be argued to the 3rd Circuit. The 3rd Circuit, however, will not be blind when it starts researching this issue and when it reads the last paragraph of the district court order. In the Mallo case the 10th Circuit got to the one moment late issue even though only the IRS was before it. The Third Circuit will quickly discover that there is a very simple way to dispose of this case that does not turn on intent or the bankruptcy court’s view of the timeliness requirement vis a vis SFRs. So, this may be the next case to address the issue regarding the late filing of a tax return and the discharge of the liabilities for the year(s) when the returns are filed late.