Mallo and Perkins and The End of the Two Year Rule: Why Income Tax Debts May be Harder to Discharge in Bankruptcy Written by: Jeffrey M. Sklarz Green & Sklarz LLC New Haven, Connecticut Jeff is a member of Green & Sklarz LLC, a boutique law firm focusing on representation of businesses and individuals with complex financial problems, including bankruptcy, tax and commercial litigation needs. Jeff is presently Chair of the Government Powers Subcommittee of the ABA Business Law Section, Bankruptcy Business Bankruptcy Committee. Pursuant to 11 U.S.C. 523(a)(1)(B)(ii) 1 income tax debts may be discharged in bankruptcy so long as the applicable return was filed more than two years prior to the petition date. This is known, in bankruptcy parlance, as the Two Year Rule. 2 In 2005, an amendment was made to the Bankruptcy Code that, based on several recent Circuit Court of Appeals rulings, has been interpreted to virtually eliminate the Two Year Rule. This article discusses the recent Circuit Court of Appeals decisions and the need for legislative action to correct what appears to be misinterpretations of both the Bankruptcy Code and Tax Code. The 2005 Amendment to the Bankruptcy Code Before 2005, what constituted a valid tax return for purposes of a bankruptcy discharge was undefined. In 2005 the hanging paragraph that follows 11 U.S.C. 523(a)(19) (generally referred to as 523(a)(*) ) was added to ostensibly define the term return : For purposes of this subsection, the term return means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation 1 11 U.S.C. 523(a)(1)(B)(ii) provides that a discharge does not apply to any tax that was 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. 2 The other main requirements for dischargeability of income taxes are that the tax must have been due (including extensions) more than three years prior to the petition date (11 U.S.C. 507(a)(8)(A)(i)) and that no additional assessments have been made within the 240 days prior to the petition date (11 U.S.C. 507(a)(8)(A)(ii)).
to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law. (Emphasis added.) Sufficed to say, this amendment has only accelerated the pace of litigation over what constitutes a return for discharge purposes was drastic, and likely unintended, consequences. Under 523(a)(*), the key phase applicable filing requirements was not defined. Almost immediately, litigation over the meaning of applicable filing requirements commenced. Interpretations of 523(a)(*) fell into three camps (1) the provision codified the Internal Revenue Service s preferred approach that once a tax was assessed against a non-filer, that tax could not be discharged even if a self-filed return was later submitted and accepted; (2) applicable filing requirements meant that the return had to be timely filed and, if the return was filed even one day late, it would be deemed non-dischargeable (the One Day Late Rule ); or (3) that the provision codified the so-called Beard Test that had been the prevailing decisional law as to the validity of a return pre-2005. 3 Recently two Circuit Courts of Appeals, the Tenth 4 and First 5, have joined with the Fifth Circuit 6 and adopted the One Day Late Rule, thus calling into question the continued vitality of the Two Year Rule. While three Courts of Appeals have ruled the same way, their analysis appears flawed and out of step with the IRS analysis of the law, the Tax Code and Bankruptcy Code. Therefore, it is essential that a legislative fix be implemented in order to uphold the 3 Under the Beard Test, a document submitted to the IRS by a taxpayer qualifies as a return if it (1) purports to be a return; (2) is executed under penalty of perjury; (3) contains sufficient data to calculate the tax liability; and (4) represents an honest and reasonable attempt to satisfy the requirements of the tax law. In re Martin, 508 B.R. 717 (Bankr. E.D. Cal. 2014); Beard v. Commissioner, 82 T.C. 766 (1984) aff'd, 793 F.2d 139 (6th Cir. 1986). 4 In re Mallo, 774 F.3d 1313 (10 th Cir. 2014). 5 In re Fahey, 2015 WL 677033 (1st Cir., Feb. 18, 2015). 6 McCoy v. Miss. State Tax Comm n (In re McCoy), 666 F.3d 924, 929 (5 th Cir. 2012)
purpose of the Bankruptcy Code [which] is intended to give a fresh start to the honest but unfortunate debtor. Marrama v. Citizens Bank of Massachusetts, 549 U.S. 365, 381, 127 S.Ct. 1105, 1115, 166 L.Ed.2d 956 (2007). McCoy, Mallo and Fahey In McCoy, the taxpayer did not file her state tax returns Mississippi for 1993 through 2000. The Mississippi State Tax Commission ( MSTC ) had made no-file assessments, which the Fifth Circuit describes as the equivalent of 6020(b) returns, which are not considered returns under applicable nonbankruptcy law. On September 11, 2002, McCoy filed her 1998 and 1999 Mississippi income tax returns, and the MSTC assessed the tax due on her 1998 and 1999 returns immediately. McCoy filed for bankruptcy in Mississippi in 2007, listing all tax debts owed to the MSTC. Thereafter, McCoy filed an adversary proceeding against the MSTC seeking a determination that all of her taxes were discharged in her bankruptcy, including those taxes for 1998 and 1999 (for which she filed late, but self-filed, returns). In Mallo, the taxpayer failed to file federal income tax returns for the years 2000 and 2001. Accordingly, the IRS prepared a substitute for return ( SFR ) and assessed a deficiency against the taxpayer. In 2007, after the assessment, the taxpayer filed the delinquent returns. In 2010, they filed for bankruptcy and received a discharge. Thereafter, the Mallos brought an adversary proceeding against the IRS, seeking a declaratory judgment that their tax liability was discharged. The Mallos contended that the self-filed, post-assessment returns they filed meat that the taxes were dischargeable. In Fahey, a consolidated appeal, the taxpayers all filed late but self-filed returns. Thus, unlike both McCoy and Mallo the issue of whether a post-assessment self-filed return was not presented.
Why the Courts of Appeals Are Incorrect and a Legislative Fix is Required In all three cases, the courts held that applicable filing requirements includes timeliness. The courts reasoning was essentially the same: that under state and federal tax laws, returns were required to be filed by a date certain and, thus, timeliness was part of applicable nonbankruptcy law : [t]his command that returns shall be made by the due date certainly seems like a filing requirement. 7 The problem with this blanket statement is that the Bankruptcy Code contains the Two Year Rule. None of the courts explain, in any meaningful manner, why the Two Year Rule remains if taxes attributable to late filed returns may never be discharged. In Fahey, the First Circuit states that its interpretation of 523(a)(*) takes into account the Two Year Rule because taxes attributable to 6020(a) returns, a tax return prepared by the IRS and signed by the taxpayer, may be discharged. 8 This assertion is unsatisfactory, however, because the IRS is not required to produce 6020(a) returns and it is not at all clear that the state taxing authorities have any processes akin to a 6020(a) return. Indeed, even the IRS believes the 6020(a) return procedure is illusory as a safe harbor because [t]axpayers have no right to demand that the Service prepare a return for them under that provision. 9 Most importantly, Congress did not repeal the Two Year Rule when 523(a)(*) was amended. Therefore, the only logical way to harmonize the Two Year Rule and 523(a)(*) is to accept that the definition of return includes those filed pursuant to 6020(a) and (b), which, 7 Fahey, 2015 WL 677033, at *3; Mallo, 774 F.3d at 1321 ( The phrase shall be filed on or before a particular date is a classic example of something that must be done with respect to filing a tax return and therefore, is an applicable filing requirement. ); McCoy, 666 F.3d at 928 (use of term shall is indicative of a filing requirement). 8 Therefore, a late tax return, if prepared in compliance with section 6020(a) and filed within two years of the bankruptcy petition, is still a return (and the tax due thus dischargeable), notwithstanding its failure to meet the otherwise applicable filing requirement of a mandatory deadline. Fahey, 2015 WL 677033, at *4. 9 IRS Chief Counsel Notice 2010-016 (Sept. 2, 2010).
by their very definition, are late-filed support[ing] the conclusion that 523(a)(*) should not be read to exclude all late-filed returns. In re Johnson, 14-CV-80812, slip op. at 19 (S.D. Fla. Feb. 9, 2015). A One Day Late Rule is particularly hard to justify given that the Supreme Court has held that when interpreting the Bankruptcy Code legislative purposes must be considered when effect[ing] a major change of policy. 10 There is no legislative history concerning Congress intent to adopt a One Day Late Rule and certainly nothing to suggest an implicit repeal of the Two Year Rule. Nevertheless, the reality is that three Circuit Courts of Appeals have all held that filing a return, even one day late, means that the associated taxes are nondischargeable. Conclusion To date, all courts analyzing 523(a)(*) have concluded that it is not clearly drafted. Further, as recognized by the dissent in Fahey, 11 and noted by the National Taxpayer Advocate, taxes should not be excepted from the bankruptcy discharge absent an express statement in legislation, or misconduct that would otherwise render a debt nondischargeable. 12 More importantly, the courts must construe amendments removing time honored statutes 10 Dewsnup v. Timm, 502 U.S. 410, 419, 112 S. Ct. 773, 779, 116 L.Ed.2d 903 (1992). 11 Ultimately, this continued confusion may be Congress's problem to fix. In the meantime, debtors who legitimately resort to bankruptcy when they reach wit's end should not be punished for the lack of clarity that persists in the very laws enacted to help them-or for the majority's implicitly articulated viewpoint that a financially strapped person who misses a deadline is trying to work a runaround. Fahey, 2015 WL 677033, at *15 (Thompson, J., dissenting). 12 Forever barring the discharge of tax debts merely because the debtor files a return one date late seems unfair when considering how taxpayers who file late are treated under federal tax law. As noted earlier, while late filers can be subject to penalties, the penalties can be abated. In jurisdictions where tax debts cannot be discharged merely because the return was filed late, the consequences can be more financially severe. In other words, late-filing taxpayers may be punished more severely under bankruptcy law than under tax law. 2014 Annual Report to Congress at p. 421-22, Office of the National Taxpayer Advocate (Jan. 14, 2015), available at http://www.taxpayeradvocate.irs.gov/media/default/documents/2014-annual-report/volume-one.pdf (visited Feb. 23, 2015)
carefully and, when there is doubt, defer changes to a statute until a precise legislative directive is enacted. Congress never expressly removed the Two Year Rule. None of the courts have suggested such an express amendment and, instead, have relied on the ambiguity of 523(a)(*) to infer a change. Thus, Congress need do nothing more than technically amend 523(a)(*) to remove timely filing from applicable filing requirements. Such a technical amendment simply states what the law is, and removes the judicial amendment (without any citation of supporting legislative history) to eviscerate the Two Year Rule. Indeed, the American Bar Association s Tax Section has already 13 proposed language to Congress for such an amendment. 14 13 Proposed Amendment to Section 523(a) of the Bankruptcy Code, Section of Taxation, American Bar Association (Jun 29, 2014), available at: http://www.americanbar.org/content/dam/aba/administrative/taxation/policy/072914 letter.authcheckdam.pdf (visited Feb. 23, 2015). 14 See id. at 8 ( For purposes of this subsection, the term return means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements other than timeliness). )