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Discharge of Late Filed Return Takes a Turn in Taxpayer’s Favor – Has the Objective Test of Colson Migrated Out of the 8th Circuit?

Posted on July 14, 2020

In the case of In re Starling, 125 AFTR2d 2020-2587 (Bankr. S.D.N.Y 2020) the bankruptcy court holds against the IRS in a case involving the filing of a Form 1040 after an assessment based on a substitute for return.  The case runs contrary to lots of case law but none at the Second Circuit level.  I anticipate the IRS will appeal this aspect of the case and maybe others.  Thanks to Christine Speidel for bringing the case to my attention and Ken Weil for providing me with background research as we discussed the case.  I have posted many times on this issue but not since the beginning of 2020.  Look here for a collection of the posts.

The case also involved a claim for damages under IRC 7433. The bankruptcy court determined that the debtor could not obtain damages from the IRS because he failed to exhaust administrative remedies; however, it determined that the private debt collector who sent notices to the debtor after a referral of the debt from the IRS did owe damages, since it lacked the immunity available to the IRS on this issue.

Mr. Starling failed to file his 2002 individual income tax return despite notices from the IRS requesting that he do so.  Eventually, the IRS prepared a substitute for return and made an assessment of tax for 2002 in 2005.  Two years later, the taxpayer filed a Form 1040.  Six years after filing the Form 1040, Mr. Starling filed a chapter 13 bankruptcy petition.  After completion of the plan payments Mr. Starling received a discharge in May 2016.  Although he had paid the priority claim of the IRS through his plan, Mr. Starling found that the IRS did not consider the 2002 year discharged.  In the chapter 13 case the 2002 taxes would have been classified as general unsecured claims because of their age and as general unsecured claims would generally have been eliminated when Mr. Starling received his discharge.  This seems to have been his expectation.

The IRS did not believe the 2002 taxes were discharged because it made its assessment based on an SFR. I am almost certain that the IRS instructions coded into its computer and given to its bankruptcy employees would treat the 2002 debt in this manner everywhere in the country except in the 8th Circuit. Because it believed that the 2002 debt survived the bankruptcy discharge and because it remained unpaid, the IRS referred the debt to one of the private debt collectors (PDC) with whom it has a contract, and the PDC sent Mr. Starling letters seeking payment on the outstanding liability. Sending those types of collection demand letters regarding a discharged debt would violate the discharge injunction in BC 524.

Because Mr. Starling felt that his chapter 13 discharge eliminated the 2002 liability, he brought a contested matter seeking a determination regarding discharge and seeking contempt against the IRS for violating the discharge injunction. The IRS defended the action arguing that the exception to discharge in BC 523(a)(1)(B)(ii) applied to the 2002 liability because Mr. Starling filed the Form 1040 for 2002 after the IRS had processed a substitute for return and made an assessment based on the substitute. Since the IRS had already processed a return for Mr. Starling for 2002, it argued that the subsequent submission of the Form 1040 for that year failed the Beard test and, therefore, did not trigger the late filed exception in B.C. 523(a)((1)(B).

The issue here has existed for over 20 years since the 6th Circuit’s decision in the Hindenlang case. In that case the court decided that the filing of a Form 1040 after the assessment of the liability could serve to trigger a discharge but the late return must have been filed prior to an IRC 6020(b) assessment triggered by the IRS. Most courts look at the issue agreed with Hindenlang but the 8th Circuit in Colson did not. The split in authority and the uncertainty resulting from the split caused the IRS to push for and Congress to adopt an amendment to B.C. 523 in 2005 intended to resolve this situation. Unfortunately, the 2005 amendment did not resolve the uncertainty but injected more uncertainty into the situation. Instead of two theories regarding what should happen in this situation, the amendment created a third without resolving the original dispute.

The three possible outcomes, in order of likelihood from least likely to most likely, are 1) the debtor’s objective filing of the Form 1040 after the IRS makes the SFR assessment begins the two year period described in B.C. 523(a)(1)(B) allowing debtor to obtain a discharge by waiting two years after filing the delinquent Form 1040 before filing a bankruptcy petition – the Colson view which is the prevailing view in the 8th Circuit; 2) the debtor’s filing a return late, even one day late, prevents the debtor from ever obtaining a discharge for the taxes related to the late return based on an interpretation of the flush language of the 2005 amendment to BC 523(a) in the unnumbered paragraph at the end of that provision – the one day late rule which is the prevailing view in the 1st, 5th and 10th Circuits and most recently repudiated by the 11th Circuit in In re Shek, 937 F.3d 770, 776 (11th Cir. 2020) (providing a definition of applicable to overcome the one day rule).; and 3) the debtor can file a late return and discharge it by waiting two years before filing bankruptcy after the filing of the late return but the late return must be filed prior to an IRC 6020(b) assessment triggered by the IRS – the Hindenlang view.

The bankruptcy court in Starling chooses the path less travelled and essentially follows Colson. This potentially presents large problems for the IRS if it stands because it requires the IRS to reprogram its computers and issue supplemental instructions to its bankruptcy staff for all bankruptcies in the Southern District of New York. For that reason and for the reason that the Colson theory has not caught on elsewhere, I expect an appeal to the district court on this issue. Because the IRS does not agree with the one-day rule, it will appeal arguing that a subjective test should apply and that Mr. Starling knew when he filed the Form 1040 that the IRS had already assessed his taxes for 2002, causing his Form 1040 not to meet the Beard test based on his knowledge of the circumstances.

So far, there may only be one case applying the subjective test in which a debtor has prevailed on the Beard test that has not been reversed on appeal.  That case is Briggs, Sr. v. United States (In re Briggs, Sr.), 511 B.R. 707 (Bankr. N.D. Ga. 2014).  At trial, the tax was found dischargeable.  The District Court affirmed.  Briggs, Sr. v. United States (In re Briggs, Sr.), N.D. GA. No. 15-2427 (June 7, 2017).  In Briggs, the debtor thought his business partner had filed his return.  Their custom was for the business partner to prepare the return, the debtor to sign it, and the business partner to file it.  The business partner did not file the return.  The IRS’s notice of deficiency was mailed to the business partner’s address and not the debtor’s, so the debtor did not know the return was nonfiled.  As part of a lawsuit, the debtor had done a forensic accounting to determine revenue and expenses.  Upon learning of the nonfiling and SFR assessment, taxpayer filed a return, which was found to be a valid return.

I previously wrote a post on Shek here.  Although Shek is an 11th Circuit case it involves state income taxes owed to Massachusetts.  Massachusetts convinced the 1st Circuit in the Fahey case that the flush language added to the end of BC 523 in 2005 means that a return filed one day late prevents it from ever receiving a discharge.  Shek did not involve an intervening substitute for return but a clean question of the application of the one-day rule.  Thanks to an amicus brief by University of Michigan law professor John Pottow, the 11th Circuit rejected the one day rule argument, finding that the language added in 2005 did not require this result.  

The Massachusetts Department of Revenue wisely, in my opinion, chose not to seek cert from the Supreme Court based on the direct split between the 1st (and 5th and 10th) Circuits and the 11th Circuit.  Because almost all of the Massachusetts Department of Revenue cases exist in the 1st Circuit, it had much to lose by taking the case to the Supreme Court and little to gain.  So, we must wait for another circuit decision before the Supreme Court will have the opportunity to fix the problem.  Of course, Congress could step in and try again to fix the problem without creating a fourth split in possible outcomes.  I know there are some debtor’s attorneys in the 1st Circuit looking for another chance to take on the Fahey decision.  Maybe the 1st Circuit will take another look at this issue and the next split will come there.

In addition to the issue of discharge, the bankruptcy court in Starling also addressed the issue of damages. Mr. Starling sought damages from the IRS for seeking to collect the tax liability after discharge. The bankruptcy court found that he could not obtain damages from the IRS, because he did not exhaust administrative remedies by making a request to the IRS before bringing the action. If he had made a request to the IRS, he likely could have recovered damages, because the IRS would have told him his position on the discharge issues was wrong.

Although the bankruptcy court could not award damages against the IRS because the waiver of sovereign immunity required exhaustion of administrative remedies, it decided that it could award damages against the PDC, which lacked the same sovereign immunity protection cloaking the IRS.  While I am not a fan of PDCs, I expect this aspect of the decision will also be appealed, both because of the argument regarding the applicability of the exception to discharge and the argument of the PDC’s relationship to the IRS and reliance on the IRS.

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