By Megan Craig, Bayer, Wishman & Leotta (Los Angeles, CA)
Meet the Martins
The Martins missed the deadline to file their tax returns. With good intentions to file, the Martins were delayed by troubles with their accountant. After the IRS sent notices of the deficiency and filed its own substitute assessment, Kevin and Susan obtained a new accountant and filed their missed tax returns. Two years later they filed a Chapter 7 bankruptcy to discharge the taxes. The IRS objects. Are the taxes dischargeable?
Setting The Stage
Prior to the 2005 bankruptcy reform (“BAPCPA”), the Ninth Circuit examined the dischargeability inquiry and held under Section 523(a)(1)(B)(i) that tax debts were excepted from discharge when the debtor taxpayers failed to file a tax return and were required to do so.i Taxes were also nondischargeable when filed untimely and within two years of the debtors’ bankruptcy filing, or when such taxes were fraudulent or evasive.ii
As will be discussed, this is essentially still good law today- with some important case law caveats to explore.
Congress introduced with BAPCPA the nondischargeability statute as part of the Bankruptcy Code amendments. BAPCPA amendments included 11 U.S.C. § 523(a)(*) – another so-called “hanging paragraph” that defines the term “return” to exclude any taxpayer filing that does not wholly and strictly comply with all applicable return filing requirements, even if the taxing authority itself could and would forgive that noncompliance. Stranger yet, the “return” definition expressly includes some types of returns that the taxing authority prepares on behalf of the taxpayer when the taxpayer never gets around to it.
Martin v. United States
Enter United States v. Martin (In re Martin)iii; an extremely informative case, well researched, and critically written. Martin analyzes and relies on §523(a)(1)(B)(ii)- which existed Pre-BAPCPA- as critical to the court’s decision. It rejects a literal interpretation of the “return” definition under § 523(a)(*) & 523(a)(1)(B)(i) that would render these sections superfluous in construction if not meaningless in content when read together with §523(a)(1)(B)(ii) . First, the latter provision already contains a specific and careful treatment of tax debts associated with untimely-filed returns. Second, the Court explains “it would make no sense for a debtor taxpayer who never bothers to file his or her own tax returns to discharge his or her associated tax debt if the IRS fortuitously prepares a substitute assessment on that person’s behalf.” And, finally, the Supreme Court disfavors major changes in practice absent some discussion in the legislative history.iv
For these reasons, Martin rejects the IRS’ contention that the dischargeability of income tax debts associated with a late-filed tax return should hinge on whether the taxpayer filed the return before or after the IRS made any assessment.
The Beard Test
Martin properly relies on the Beard testv. The Ninth Circuit, ahead of the curve, had already followed Beard in In re Hatton IIvi when it cited In re Hindenlangvii to utilize the Beard test. The Beard test – derived from nonbankruptcy law – determines whether tax debts are dischargeable in bankruptcy. The test examines whether the debtor(s) filed something that:
- Purports to be a return;
- Is executed under penalty of perjury;
- Contains sufficient data to allow calculation of a tax; and
- Represents an ‘honest and reasonable attempt’ to satisfy the requirements of the tax law.
Martin opines that Congress intended to codify the Beard test when it enacted BAPCA. And while, for most intensive purposes this is true, such wholehearted reliance would cause the Court’s opinion to depart from its own logic. More likely, Congress simply thought it was creating an easy-to-administer rule. Martin astutely recognizes that Beard is a fact-intensive test (as will be further discussed below), and that Congress typically will not make major changes to the Code without legislative comment.
Nevertheless, Martin shines on the central issue: Prong #4 of the Beard test.
The Honest and Reasonable Attempt
The crux of the ‘honest and reasonable attempt’ inquiry is broad (not narrow) and subjective (not objective) in its scope.viii At its core, the fourth prong of Beard requires an assessment of a totality of the circumstances. That is, a fact-intensive look at each individual case. Factors such as the length of the delay, the reason for the delay, and the number of tax years missed affect the ultimate determination of dischargeability.
The bankruptcy court had failed to consider oral testimony of the Martins attesting to facts which may have been critical to the ‘honest and reasonable attempt’ inquiry. Namely, that the Martins testified to delays caused by sickness and death in family of her former accountant, and to the time it took to reacquire their financial records and obtain a new accountant.
Are the Taxes Dischargeable?
If the B.A.P. opinion prevails, the Martins (and many other debtor taxpayers) will succeed in getting their taxes discharged regardless of whether the IRS filed its own tax assessment against the debtors. In fact, in pushing the issue, the IRS may have caused itself an interminable headache in future case administration. Arguably, the IRS now has a duty to investigate much more deeply into the factual bases for the tax filing delay before asserting nondischargeability. The end result may well be that fewer nondischargeability actions are filed for want of manpower. For now, the dischargeability of tax “returns”.
Megan Craig is an associate attorney at Los Angeles consumer bankruptcy law firm Bayer, Wishman & Leotta. An alumna of Southwestern Law School, Megan has a true passion for bankruptcy law that is reflected in her scholarly achievements as recipient of the Judge Barry Russell Federal Practice Award, American Bankruptcy Institute Medal of Excellence, and her externships with the U.S. Bankruptcy Court Central District Rules Committee and former Chief Judge Vincent P. Zurzolo. In addition to her academic achievements, she has 10 years of experience with reputable consumer bankruptcy law firms across the country. She is a frequent contributor to The Academy’s e-zine ConsiderChapter13.org.