Like a virus jumping from one species to another recent 10th Circuit decision in Mallo v. United States has moved the issue of the discharge of late filed returns from a state to a federal issue. Because of the unforgiving nature of the position adopted by the 10th Circuit, the decision causes concern for any taxpayer who misses the filing deadline, even by one day (or minute or hour) and later wants to discharge the taxes for that period.
I wrote about this issue in a post generally describing the ongoing disarray in the discharge area in 2013. Unfortunately, the situation has not gotten any better and, with the 10th Circuit’s decision, it has gotten worse. This post primarily will describe the Mallo case in shrill terms and offer one possible way around the predicament in which the Mallos now find themselves. Before I get to the shrill part of the post, I will explain briefly how we got to this point. I think the problem all started with an attorney who dreamed up a slick idea to help his client get past the discharge provisions and Department of Justice attorneys who countered with an equally slick argument that eventually spiraled into a new code provision creating havoc no one could have imagined at the beginning of this process.
Bankruptcy Code § 523(a)(1)(B)(i) excepts from discharge taxes (federal, state or local) for which the individual taxpayer fails to file a return. This provision does not create much controversy and everyone agrees that if the person has failed to file a necessary return all of the unpaid tax for that period passes through bankruptcy without the benefit of a discharge with the person still owing the taxes at the end of bankruptcy. Bankruptcy Code 523(a)(1)(B)(ii) excepts from discharge taxes (federal, state or local) “with respect to which a return, or equivalent report or notice, if required was not filed or given after the date on which such return, report or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition.” This subparagraph basically requires a taxpayer who files a return late to wait at least two years after filing the late return before filing bankruptcy if the taxpayer wants to discharge the liability for that period. The idea behind the provision relates to the need for taxing authorities to have a decent amount of time to collect a tax before Congress will allow it to fall off the books.
Into this scheme comes Mr. Hindenlang. He had not filed his return for a year for which he owed federal taxes. I imagine that he visited his bankruptcy lawyer who told him that if he filed bankruptcy at that point, even though the taxes were old, he could not get rid of them through bankruptcy. After not filing his return, the IRS had gone to the trouble to compute his liability for the year at issue using the procedures of IRC 6020(b). Someone, however, came up with the bright idea that if Mr. Hindenlang sent to the IRS a Form 1040 for the year at issue and filled out that form using exactly the information that the IRS used in recreating his return he could then wait two years and one day and file bankruptcy and discharge the liability. So, he waited the requisite period and then filed bankruptcy arguing in the bankruptcy case that the taxes were discharged because he now technically met the requirements of Bankruptcy Code 523(a)(1)(B)(ii). The argument made sense if the late filed Form 1040 is a return for purposes of the statute and the argument also seemed to fit with the reason for the exception to discharge which was to give the taxing authority ample time to collect before discharging the tax.
The IRS, however, did not take this laying down and it, or its lawyers, could be just as clever as Mr. Hindenlang and his lawyer. It argued that the Form 1040 submitted by Mr. Hindenlang did not meet the definition of return because looking at the factors established by the Tax Court in the Beard case the taxpayer did not really possess the intent for this document to be a return. The IRS won that case but with an argument that required it to make a case by case determination. It ultimately prevailed in some circuits while losing in the 8th Circuit and settling for some additional language in the 2005 Bankruptcy Reform Act. The new language that was intended to settle this issue has spawned a new level of problems.
The new language, which comes in an unnumbered paragraph at the end of 523(a) provides: “For purposes of this subsection, the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).” This first sentence of the new language has taken some courts in a different direction concerning the discharge of taxes reported on late returns. The 5th Circuit in the McCoy case held that this language makes any return that fails to meet the filing requirements, including the time for filing a return, a period for which the liability cannot receive a discharge. The IRS rejected this view, correctly in my opinion, of the new language because of the inability to reconcile this view with the two-year rule of Bankruptcy Code § 523(a)(1)(B)(ii). It looked like this interpretation would only apply to state or local liabilities where the state or the locality, like Mississippi in McCoy, chose to apply this draconian rule.
Like a virus crossing from one species to another, however, the Mallo case marks the crossing of this view into federal tax liabilities. The crossing into a new species of case did not occur because the IRS sought this result. Rather, the IRS made its official argument now that “a debt assessed prior to the filing of a Form 1040 is a debt for which [a] return was not ‘filed’ and therefore cannot be discharged in bankruptcy.” Citing the well-reasoned Rhodes case from Georgia that I blogged previously, the 10th Circuit rejected the argument of the IRS and, on its own, adopted the 5th Circuit’s view in McCoy quoting from an earlier 10 Circuit opinion stating “we cannot reject an application of the plain meaning of the words in a statute on the ground that we are confident that Congress would have wanted a different result. . . . In short, courts, out of respect for their limited role in tripartite government, should not try to rewrite legislative compromises to create a more coherent, more rational statute.” Okay.
Late filing taxpayer in the 10th Circuit might want to start taking up a collection to pay someone to file a cert petition in Mallo. Their problem will be the lack of a conflict on this view at the Circuit level unless the Supreme Court looked back to pre-2005 cases. They might use the money to lobby their favorite Congressperson to change the law again and try to make it clearer what it intended to say in the first place. I believe the National Taxpayer Advocate will include this issue in her annual report to Congress next week as one of the major problems and maybe that will give them a greater than 0% chance of getting Congress to enact legislation.
So, what do you do if you are faced with a case against the IRS over a discharge issue outside the 10th Circuit and you are worried that your court might do what the 10th Circuit did and impose the plain meaning of the unnumbered paragraph on your client to deny discharge. I spoke to Ken Weil about this case. Ken co-authors the bankruptcy chapter in Effectively Representing Your Client before the IRS and served on the tax advisory committee to the reform commission appointed by Congress following the 1994 Act whose recommendations formed the basis for the 2005 amendments to the bankruptcy code including this one. Ken suggested entering into a stipulation that a return filed late is not per se a violation of the “applicable filing requirements” rule and that portions of McCoy and Mallo applying such a one-day late rule do not apply. He credited this suggestion to Morgan King who practices bankruptcy and tax law in California. I cannot say if that strategy will work. I can only say that a very deadly strain of argument previously confined to state tax issues has now crossed over to federal taxes and individuals who did not file their returns before the due date had better start thinking of some arguments if they ever want to use bankruptcy as a basis for relief.