The Supreme Court desperately needs to resolve an intractable split among the circuits by deciding whether a late-filed tax return can ever be discharged. Meanwhile, lower courts are laying down subsidiary rules that may be erroneous depending on how the split is resolved.
The latest case came from a bankruptcy court in California where the Ninth Circuit joined those sister courts that give a debtor at least a glimmer of hope about discharging the debt shown on a late-filed return. Other circuits hold that a tax debt can never be discharged under Section 523(a)(1)(B)(i) and the so-called hanging paragraph if the return was filed even one day late.
In the California case, the taxpayer earned about $60,000 in 2001 and should have filed his return in April 2002. He later testified that he “panicked” and “stuck his head in the sand” and didn’t file a return because he didn’t have money to pay.
The Internal Revenue Service filed a substitute return on his behalf in October 2003 showing a tax liability of about $12,000. Fearing criminal prosecution, the taxpayer hired a tax advisor and filed a return in August 2005, showing some $13,000 in taxes.
The taxpayer filed a chapter 7 petition in 2013 and received a discharge. In the adversary proceeding to determine the dischargeability of the tax liability, Bankruptcy Judge Charles Novack of Oakland, Calif., granted summary judgment for the IRS in an opinion entered on May 22.
The government argued that taxes can never be discharged if the debtor files a return after assessment by the IRS. Judge Novack said the Ninth Circuit Bankruptcy Appellate Panel rejected that argument in U.S. v. Martin (In re Martin) 542 B.R. 479 (BAP 9th Cir. 2015). In Martin, the BAP also presaged the decision by the Ninth Circuit itself in July 2016 rejecting the one-day-late rule by adhering to decisions by the Fourth, Sixth, Seventh, Eighth and Eleventh Circuits employing the four-part test resulting from a 1984 Tax Court decision known as Beard. The Ninth Circuit’s decision rejecting the one-day-late rule is Smith v. I.R.S. (In re Smith), 828 F.3d 1094 (9th Cir. July 13, 2016). To read ABI’s discussion of Smith, click here.
Although the IRS lost on its own bright-line test, the government won on everything else.
The IRS argued persuasively that the debtor failed the fourth test under Smith: Was the late-filed return an honest and reasonable attempt to satisfy his 2001 tax obligations?
Judge Novack said that claiming to panic was a “skimpy and insufficient” excuse. He also said that someone’s “decision to file a tax return should not be based on a desire to avoid criminal liability,” because the tax code “turns on voluntary tax returns and self-assessed taxes.”
Like several other courts, Judge Novack rejected the argument that the late return was honest and reasonable because the taxpayer reported a larger tax liability than the IRS had assessed.