Tardiness in Filing Income Tax Return Leads to Interplay Between Bankruptcy and Tax Law

While the bankruptcy process may bring a new beginning, the Bankruptcy Code provides — and some say rightfully so — debtors with much less protection against tax claims than other types of claims for public policy and much-applauded revenue reasons. Even though there is much to say about this topic[1], this article only narrowly addresses 11 U.S.C. § 523‌(a)‌(1)‌(B), which provides, among other things, an exception to discharge for tax debt with respect to which a return, if required, was not filed,[2] and focuses on the Eleventh Circuit’s opinion in Justice v. United States (In re Justice).[3]

By way of introduction, looking solely at the language of § 523‌(a)‌(1)‌(B)‌(i) (which, as previously mentioned, provides that tax liability is nondischargeable if a debtor failed to file a return), one could easily conclude that any return filed after the due date[4] would place the outstanding tax debts outside of the scope of nondischargeability.[5] Prior to enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), neither the Bankruptcy Code nor the Internal Revenue Code provided a definition of a “return.”[6] Nevertheless, courts attempted to prevent opportunistic late tax return filings for dischargeability purposes and attempted to fashion a definition of a “return” by adopting, from the realm of tax jurisprudence, the four-element test articulated in Beard v. Comm’r of Internal Revenue.[7] The Beard test provides that a document serves as a tax return if it (1) purports to be a return, (2) is executed under penalty of perjury, (3) contains sufficient data to allow calculation of tax, and (4) represents an honest and reasonable attempt to satisfy the requirements of the tax law.[8] The judicial labor under the Beard test is usually focused on the analysis of the fourth element.

In 2005, Congress created a definition of a “return” that could be applicable to bankruptcy cases by adding the hanging paragraph to § 523‌(a)‌(19), which states that the term “return” for purposes of § 523‌(a) “means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”[9] This amendment created confusion over what specifically was meant by “applicable nonbankruptcy law (including applicable filing requirements),” and thereafter disagreement followed.[10] Specifically, courts disagree on whether the hanging paragraph includes the timeliness requirements of the Internal Revenue Code and further disagree about whether applicable law includes analysis under the pre-BAPCPA Beard test.[11]

In the Justice opinion, the Eleventh Circuit addressed a situation in which a debtor who attempted to discharge his federal income tax liability for 2000-03 had filed Forms 1040 many years late by their respective due dates, providing no explanation for his tardiness and only after the Internal Revenue Service (IRS) had issued notices of deficiency and thereafter assessing tax deficiencies.[12] The dischargeability of the debtor’s tax liability hinged upon a determination as to whether his belatedly filed Forms 1040 constituted returns for purposes of § 523‌(a).[13]

The similar issue was address previously by First,[14] Fifth[15] and Tenth[16] Circuits (hereinafter “sister circuits”), which resolved these disputes by applying a BAPCPA definition of a “return.”[17] The Sister Circuits concluded that this definition mandates complying with the filing deadlines.[18] As such, this interpretation carries a harsh result, which is that even tax documents filed one day late do not comply with applicable filing requirements and cannot constitute returns, rendering pertinent tax debts nondischargeable.[19]

However, both parties in In re Justice requested — for different reasons, the authors presume — that the Eleventh Circuit’s one-day-late rule is an incorrect interpretation of the statute.[20] The Eleventh Circuit refused, concluding that such a finding was completely unnecessary as it could determine the issue of dischargeability by a different mechanism.[21] Specifically, the Eleventh Circuit observed that the BAPCPA-added definition of a “return” must satisfy “the requirements of applicable nonbankruptcy law,” which in turn incorporates the Beard[22] test and focused on its fourth disputed prong.

The IRS argued that any delinquency in filing a tax return is relevant to determining whether the taxpayer made an honest and reasonable effort to comply with the law (the “majority view”).[23] The debtor, on the other hand, advocated that the honesty and genuineness of the filer’s attempt to satisfy the tax laws should be determined from the face of the form itself, not from the filer’s delinquency or the reasons for it (the “minority view”),[24] even though such reasons could include the taxpayer’s subjective motivations — such as a desire to reduce assessed liability or to assure dischargeability by making certain that a return has been filed.

Adopting the majority view, the Eleventh Circuit concluded that the entire time frame of the taxpayer’s action and inaction, which included the time from the taxpayer’s delinquency through the time when the belated return was filed, was relevant.[25] The Eleventh Circuit firmly rejected limiting its analysis to reviewing solely the face of tax documents, which (in many cases) may constitute imaginative fiction, and stated that failure to file a timely return, at least without a legitimate excuse, shows the lack of reasonable effort to comply with the law.[26] To support its conclusion, the Eleventh Circuit observed that adopting a contrary approach would impede the congressional goal in enacting the exceptions to discharge in § 523: to ensure that only honest-but-unfortunate debtors receive the benefit of discharge.[27] Noticeably, “[t]‌his interpretation [also] comports with the common-sense meaning of ‘honest and reasonable.’”[28] Furthermore, the Eleventh Circuit pointed out that this approach is consistent with the foundation of the U.S. system of taxation, which relies on honest, confession-type self-reporting by taxpayers so that the IRS does not spend financial resources on burdensome, time-consuming and costly procedures to gather the relevant third-party information to assess outstanding taxes.[29] Accordingly, delinquency in filing undermines this self-assessment system.[30]

In addition, the Eleventh Circuit reviewed three primary arguments usually raised against the majority view and rejected them one by one. The first argument focuses on the assumption that a belated return can still be useful to the IRS because a later return can replace assessed estimates with facts.[31] The Eleventh Circuit nevertheless reasoned that the fourth prong of the Beard test is not about the document’s utility but the taxpayer’s efforts to comply with the self-reporting requirements of the tax system.[32] The second argument raises the importance of the document’s accuracy filed by the taxpayer, who has the best knowledge of his/her particular income and expenses.[33] Recognizing that accuracy, as long as it is honest, is one of the important benefits of self-reporting, the Eleventh Circuit again emphasized that it is not proper to overlook that a reporting form filed after the IRS has completed the process of assessment, without any assistance from the taxpayer, does not serve the basic purpose of self-reported tax returns that is not forcing the IRS to determine one’s tax liability on its own.[34] Such delayed action cannot constitute a reasonable and honest attempt to comply with the tax law.[35]

The third argument focuses on the overlap of the exceptions to discharge provided for in §§ 523‌(a)‌(1)‌(B) and 523‌(a)‌(1)‌(C) and an assumption that such a strict interpretation of the honesty requirement adopted by the majority view could render § 523‌(a)‌(1)‌(C) superfluous.[36] The Eleventh Circuit found this argument baseless for many reasons.

Section 523‌(a)‌(1)‌(C) excepts from discharge any tax debt “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” The Eleventh Circuit observed that the category of filings, which are not honest and reasonable, is much broader than the category of fraudulent returns and reasoned that Congress purposefully denied dischargeability in cases wherein a taxpayer’s actions might not rise to the level of hard-to-prove fraud but are sufficient enough not to qualify for “making an honest and reasonable effort” to comply with the tax laws.[37] Thereafter, the Eleventh Circuit emphasized that the applicability of the canons of statutory construction do not change the outcome of the case.[38] Specifically, the Eleventh Circuit observed that a prohibition on a reading that renders one redundant section of the statute superfluous is not absolute.[39] A competing canon provides that redundancies across statutes are not unusual events in drafting and so long as there is no positive repugnancy between the two sections, a court must give effect to both sections.[40] Noticing congressional intent in that nondischargeability should result from both fraudulent returns and returns with respect to which the taxpayer has not made honest and reasonable efforts to comply with the law, the Eleventh Circuit announced that there could be no positive repugnancy while following the majority view in interpreting the fourth prong of the Beard test.[41]

The Eleventh Circuit’s reasoning is undoubtedly in concert with § 523‌(a)’s purpose, which is excepting from discharge claims for a debtor’s misconduct. Bankruptcy allows people to rewrite their stories, but such a privilege is not always afforded: “Over-extending oneself, unforeseen contingencies, the inability to pay debt, or lack of business acumen are not reasons to deny a debtor’s discharge.”[42]

In contrast, fraud, criminal activity and misconduct can jeopardize the process.[43] As determined by the appellate jurisprudence, unexcused failure to timely file tax returns constitutes misconduct on a certain level — even if it results from procrastination. “Simply put, belatedly accepting responsibility for one’s tax liabilities, only when the IRS has left one with no other choice, is hardly how honest and reasonable taxpayers attempt to comply with the tax code.”[44] Accordingly, it is perfectly reasonable for Congress to limit dischargeability of tax debt when a taxpayer fails to timely file a return since Congress might reasonably want to reward taxpayers who cooperate with the IRS.[45] Thus, the Justice opinion is yet another important reminder from the judiciary that a debtor’s statutory right to a fresh start is not absolute and one must remain cognizant as to what it is that bankruptcy law attempts to accomplish.