Sometimes taxpayers and the IRS just disagree on whether the taxpayer filed a return. The taxpayer faces a daunting task to prove the filing of a return. In a recent bankruptcy case, McGrew v. Internal Revenue Service, the court held that the taxpayer proved her case. Her success provides some insight into how a taxpayer might win this argument. I have some other thoughts based on cases I have seen over the years.
Last year we “celebrated” the 30th anniversary of the famous incident at the Philadelphia Service Center in which IRS employees who had too many cases to process and too little time to do it decided to take matters into their own hands and flush the returns down toilets, hide them in ceiling tiles and otherwise find creative things to do with tax returns. For stories and investigations concerning the little problem with returns the IRS had in 1985 see here, here, here and here. Thirty years is a long time and only a small percentage of IRS employees working today worked at the IRS in 1986. The Philadelphia Service Center has moved locations. The institutional memory of IRS workers concerning this incident seems no longer to exist. I had a conversation with two young attorneys from the Boston office this past year, neither of whom could even seem to contemplate the possibility that the IRS transcript could contain inaccuracies. The IRS employee testifying in the McGrew case, stated that she had no knowledge of the IRS ever losing a tax return. I find this amazing.
The IRS does a great job of keeping track of millions of pieces of paper with a focus on tax returns; however, anyone who thinks that the IRS never loses tax returns is naive. On the flip side, many taxpayers have a similar naiveté because they seem to think they can just waltz into court and assert the IRS has lost their returns and the court will easily buy that story. In the vast majority of cases, courts will reject such an argument, which makes the McGrew case interesting and instructive. Before I get to the facts of the McGrew case, I want to detour to my practice for testing for lost returns when I tried these cases for the IRS and to the bankruptcy issue lurking in this case.
Looking at State Tax Returns to Prove Federal Filing – or Lack Thereof
Taxpayers regularly asserted that the IRS lost their return when I worked for Chief Counsel’s office. I knew the possibility existed but doubted most of the taxpayers making the assertion. Because I practiced primarily in Virginia and because Virginia has a state tax scheme that mirrors the federal one, even requiring taxpayers to attach a copy of their federal return to their state one, my go-to place for checking on lost tax returns was the state. I figured the loss of one return by the IRS was low but possible. The loss of two or more returns, each allegedly timely filed, got much lower. The loss of the federal returns by the IRS and the state returns by an entirely different agency made the story one that was unbelievable. So, the first thing I did when a taxpayer said the IRS lost a tax return was ask if the taxpayer filed a state tax return with Virginia. If the taxpayer answered affirmatively, the state tax records were requested. In every case I can remember, the state tax records matched the IRS records. Taxpayers who alleged that the IRS lost their tax returns had to allege that the state also lost their returns for the same periods. That basically ended the inquiry into the allegedly missing returns. Courts found this coincidence too powerful to ignore. No discussion of the parallel state tax return filings exist in the McGrew case, and I do not know if that is because the taxpayer had no state filing obligation or no one checked on those returns.
One aspect of the McGrew case that makes the lost return story more believable is that the lost return was one of multiple late returns filed many years after the due date. When a taxpayer files a late return, the IRS may set that return to the side so that it can continue timely processing returns filed during the current cycle. My experience suggests that late-filed returns have a higher incidence of getting lost in the system. The post I wrote earlier this year about a friend and family client seeking an installment agreement involved two late returns that the IRS lost.
Special Rule for Late Returns in 8th Circuit
The other issue presented in this case is the bankruptcy issue of unfiled and late filed returns we have written about several time previously here, here and here. This case arises in the 8th Circuit and that is very fortunate for Ms. McGrew. The basic IRS position is that if it goes to the trouble of filing a substitute for return for a taxpayer, sends the notice of deficiency on which the taxpayer defaults, and later the taxpayer files a Form 1040, the Form 1040 filed in that circumstance does not satisfy the Beard test and does not trigger the two year rule in B.C. 523(a)(1)(B). The only circuit in which the IRS has lost that argument is the 8th Circuit. Because of the loss in the Colsen case in the 8th Circuit and because the IRS decided not to try to take that loss before the Supreme Court, taxpayers living in the 8th Circuit can file a Form 1040 after an SFR assessment and start the two year period running. That’s what happens in this case. So, do not get excited if you read this case and think filing returns after an SFR assessment will help your client. Unless you live in the 8th Circuit, you will face stiff opposition from the IRS if you try that and the courts elsewhere have almost uniformly ruled for the IRS. The IRS hoped that the 2005 amendment, which has caused so much consternation, would fix the Colsen problem, but it has only created additional problems.
Proving You Filed a Missing Return
Ms. McGrew did not file returns for many years. Her testimony mirrors the testimony of so many people who get into a pattern of non-filing. She did not have enough money to pay her taxes for 2000 so she did not file for fear of the consequence of non-payment, not realizing the problem of non-filing was worse. Then, having not filed in 2000 and not having the money to fix that problem, her non-filing snow-balled into a multi-year event. The IRS prepared SFRs establishing the liability for many of the missing years. After it probably sent her a multitude of letters over the period of a decade, it levied on her wages in 2010. The wage levy usually serves as a wake-up call in these situations and did for Ms. McGrew as well.
Motivated by the loss of about 80% of her wages each week and probably wanting to eat, she asked the IRS to stop the wage levy and allow her to pay her liability of many years through an installment agreement. The IRS told her she first needed to file the back returns before it would work with her on a collection alternative. So, she finally had the motivation she needed to fill out the back returns. She filled them out and sent them in batches to two different service centers. Most of the back returns she sent to the IRS were processed; however, the return for 2006 was never processed and that is the return at issue in this case.
Her case consisted of her testimony regarding the mailing of the back tax returns. Her testimony contained many details about the mailing. She also relied on two other facts. First, the IRS granted her an installment agreement in 2010 suggesting that it had the return because if the 2006 return were missing at that time the IRS should have denied the installment agreement request based on the missing return. Second, the IRS initially questioned her failure to file not only 2006 but also 2007. Then the IRS said it had found the 2007 return. The IRS relied on the testimony of a bankruptcy specialist who interpreted the IRS transcript. This specialist explained how the IRS records regarding the 2006 year showed that the IRS had not received the 2006 return. The bankruptcy specialist also testified that she had never known the IRS to lose a return.
The Court weighed the evidence and determined that Ms. McGrew did submit the 2006 return to the IRS and did wait more than two years after doing so before filing the bankruptcy petition. Therefore, Ms. McGrew received a discharge of her liability for 2006 together with the remaining years for which she late-filed her returns.