Category Archives: Tax Debt and Bankruptcy

Any Change In Internal Revenue Service Tax Liability Should Be Reported To The California Franchise Tax Board

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By Ryan C. Wood

What is this madness?  No, this is not madness.  It is just the layer upon layer of law that exists.  Let me begin by informing you that filing for bankruptcy protection and owing the Internal Revenue Service or the California Franchise Tax Board unpaid taxes, fees or penalties is treacherous.  Taxes can be discharged when filing for bankruptcy protection under certain circumstances, or better put, the taxes owed fulfill the requirements to be discharged.  There are so many rules and layers upon layers of Tax Code versus Bankruptcy Code versus California State Law that it is treacherous.  One little obscure overlooked, previously not enforced or not known rule could result in the tax obligation not being discharged when filing for bankruptcy protection.  Or some rule not previously defined a certain way could be used to seek a different result not previously known.   That could be what happened to two bankruptcy filers in California and the subject of two recently published opinions by the Ninth Circuit Bankruptcy Appellate Panel.  The opinions were published given this issue had not yet been addressed at the appellate level.  That seems hard to believe so something must have changed.  The various laws below did not change so it must be how they are being enforced or used.  I think that change was the California Franchise Tax Board choosing to define or try and enforce California Revenue Tax Code Section 18622(a)(2) differently.  Unfortunately the lower Bankruptcy Court judges and then the Ninth Circuit Bankruptcy Appellate Panel agreed with the California Franchise Tax Board.  They are going to broadly defined “report” and “change” so that people seeking bankruptcy protection and a discharge pursuant to the Federal Bankruptcy Code cannot discharge unpaid taxes.  Another way to look at it is if you have not fulfilled your obligations to the taxing authorities then taxes owed should not be discharged when filing for bankruptcy protection.   Bankruptcy attorneys everywhere have an entire new set of questions to ask regarding unpaid taxes.         

See: In re: RUDOLF P. SIENEGA, BAP No. EC-19-1334-FLS

The Sienega bankruptcy case was originally filed in the Easter District of California and heard by Judge Christopher D. Jaime.  This case is distinguishable from the Voloshin case listed below.  In this case the bankruptcy filer notified the California Franchise Tax Board of the increased IRS assessments but admittedly he did not actually file “returns” with the California Franchise Tax Board for the same years he was seeking to discharge his tax liability.  See In re Hatton, 220 F.3d 1070 (9th Cir. 2000) regarding what is a “return.”  This case is a good example of arguably the proper application of RTC Section 18622(a) and Section 523(a)(1)(B) of the Bankruptcy Code.  You have to at least file a “return” to have a shot at discharge.   See In re Hatton, 220 F.3d 1070 (9th Cir. 2000).  How to you define what is “an honest and reasonable attempt to satisfy the requirements of the tax law?”

See: In re IDENNIS BERKOVICH and MARINA VOLOSHIN, BAP No. CC-20-1025-FLS

The Berkovich bankruptcy case was originally heard in the Central District of California and heard by Judge Maureen A. Tighe.  Now this case is far different.  The bankruptcy filers in this case had an increase in tax assessment by the IRS of $145,000 for a tax year but did not report to the California Franchise Tax Board of the change.  Eventually the California Franchise Tax Board did learn of the IRS change of assessment and increased the bankruptcy filers’ taxes owed by $45,000 for that tax year.  The taxes owed to the California Franchise Tax Board remained unpaid at the time the bankruptcy case was filed and the taxes met the requirements to be discharged notwithstanding RTC Section 18622(a) and Section 523(a)(1)(B) of the Bankruptcy Code. Unfortunately no [report] of the [change] was made.

When Must This [Report} of the [Change] Take Place?

California RTC Section 18622(a) provides within six months after the date of each final federal determination of the change or correction or renegotiation, or as required by the Franchise Tax Board, and shall concede the accuracy of the determination or state wherein it is erroneous.

Wow, what a mess this temporal or time requirement will hopefully turn into for the sake of bankruptcy filers. When was the federal determination of the [change] final? Can it issue be reopened to as to not be final?

California Revenue and Tax Code Section 18622(a)

This section provides: “requires a taxpayer to make a [report] to the California Franchise Tax Board FTB if the Internal Revenue Service [changes] the taxpayer’s federal income tax liability.

There is actually no language that says increase or decrease. I suppose if there was a decrease in any tax liability that in theory would never create a larger tax liability with the California Franchise Tax Board so who cares. Section 18622(a) is about encompasses increases of tax liability with the IRS and then increasing the California Franchise Tax Board liability accordingly. What if the [change] that is supposed to be [reported] decreased the federal income tax liability of the filer and the bankruptcy filer failed to [report] this decrease to the California Franchise Tax Board? Would this result in some tax not being discharged as well? What if it is only a penny change?  Or a one hundred dollar change?  A tiny change that was not reported?  Would it still be equitable to not allow the discharge of $100,000 in unpaid taxes due to not [reporting] a $0.01 change of assessment by the IRS? It is never so simple and defining terms then applying them to real world circumstances becomes even more difficult.  

Bankruptcy Code Section 523(a)(1)(B)

Section 523(a)(1)(B)1 of the Bankruptcy Code provides that if a taxpayer fails to file a required “return, or equivalent report or notice,” the relevant tax debt is not discharged.  So without knowing more this is about filing a tax return or an equivalent tax return report or notice.  It has nothing to do with informing the California Franchise Tax Board of a “change” in tax liability by the Internal Revenue Service.  Is the “change” an increase or decrease by the way? 

So Is This “Report” Required By California Revenue Tax Code Section 18622(a) What Section 523(a)(1)(B) of the Bankruptcy Code Encompasses?

Sadly the answer was yes in both of the published opinions referenced above. 

The Ninth Circuit Bankruptcy Appellate Panel held that the “report” required under RTC section 18622(a) is an “equivalent report” within the meaning of § 523(a)(1)(B).   So otherwise dischargeable taxes owed to the California Franchise Tax Board are not dischargeable unless a “report” of a change in the taxpayers’ federal income tax liability.

What qualified as fulfilling this obligation to report?  Can you call up the FTB and verbally “report” a change in federal income tax liability?  An email?  A facsimile?  What will fulfill the obligation of RTC Section 18662(a) be?   This is what will come next and how it works.  First a term is broadly defined to encompass something or create a circumstance that was never intended by the legislature then good faith compliance with the new interpretation is deemed not sufficient.  Someone will in fact “report” their change in federal income tax liability and how they chose to “report” will be deemed not a “report.”  This is how it works.  Oh by the way, RTC Section 18622(a) does not make the distinction between an increase in tax liability or decrease in tax liability.  It just says you need to “report” a change in federal income tax liability.  As the plain language of these words provides that is any change.  So you are telling me that a bankruptcy filers federal tax liability could be reduced by hundreds of thousands of dollars but fail to “report” this decrease or change to the California Franchise Tax Board and as it stands right now that failure to “report” would make a tax liability owed to the California Franchise Tax Board not dischargeable when seeking bankruptcy protection?  Is this not absurd?  When the language of a statute is plain, courts must enforce the statute according to its terms unless doing so would produce absurd results.  See Lamie v. U.S. Tr., 540 U.S. 526, 534 (2004).  How is an absurd result defined as not absurd?  The court just says the result is not absurd.  

Section 523(a) Full Text

(a)A discharge under section 727, 1141, 1192 [1] 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—

(1)for a tax or a customs duty—

(A) of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed;

(B)with respect to which a return, or equivalent report or notice, if required—

(i) was not filed or given; or

(ii) 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; or

(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax;

California Revenue and Tax Code RTC § 18622

(a) If any item required to be shown on a federal tax return, including any gross income, deduction, penalty, credit, or tax for any year of any taxpayer is changed or corrected by the Commissioner of Internal Revenue or other officer of the United States or other competent authority, or where a renegotiation of a contract or subcontract with the United States results in a change in gross income or deductions, that taxpayer shall report each change or correction, or the results of the renegotiation, within six months after the date of each final federal determination of the change or correction or renegotiation, or as required by the Franchise Tax Board, and shall concede the accuracy of the determination or state wherein it is erroneous.  For any individual subject to tax under Part 10 (commencing with Section 17001 ), changes or corrections need not be reported unless they increase the amount of tax payable under Part 10 (commencing with Section 17001 ) for any year.

(b) Any taxpayer filing an amended return with the Commissioner of Internal Revenue shall also file within six months thereafter an amended return with the Franchise Tax Board which shall contain any information as it shall require.  For any individual subject to tax under Part 10 (commencing with Section 17001 ), an amended return need not be filed unless the change therein would increase the amount of tax payable under Part 10 (commencing with Section 17001 ) for any year.

(c) Notification of a change or correction by the Commissioner of Internal Revenue or other officer of the United States or other competent authority, or renegotiation of a contract or subcontract with the United States that results in a change in any item or the filing of an amended return must be sufficiently detailed to allow computation of the resulting California tax change and shall be reported in the form and manner as prescribed by the Franchise Tax Board.

(d) For purposes of this part, the date of each final federal determination shall be the date on which each adjustment or resolution resulting from an Internal Revenue Service examination is assessed pursuant to Section 6203 of the Internal Revenue Code . 

The real absurdity or tragedy is that bankruptcy attorneys that know such distinctions and actually properly represent their clients rarely get paid properly for this knowledge and expertise.  The lowest common denominator effect and advertising have ruined the market.  Any attorney can put up a website then use pay-per-click and have fake reviews placed on the internet and sadly it works.  Honest attorneys receive reviews organically over a period of time. Dishonest attorneys have a bunch of reviews with few words in a short period of time on one online platform and it is not organic. A ten out of ten rating on some online website is bought and paid for regardless of experience and knowledge. How can certain entities take money to recommend attorneys with absolutely ZERO knowledge of that attorney? Nothing is being done about this by any organization. Hopefully you read this article and my other articles to know what I am about and how I represent my clients. If you dare try and make things better you will be the nail that sticks out you will get hammered by all those on board with “the system.”

Ninth Circuit Court of Appeals Upholds In re Hatton Test Regarding Definition of Return in Martin Smith Appeal

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The issue in these cases is the effect of the Internal Revenue Service or other taxing authorities filing a Substitute Filed Return (“SFR”) and then the taxpayer voluntarily files their own tax return after that. Does the subsequent honest, accurate and voluntary filed tax return by the tax payer satisfy the definition of a “return” under the Bankruptcy Code and Section 523(a)(1)(B)(i)? A SFR is filed by a taxing authority (Internal Revenue Service or Franchise Tax Board) when a taxpayer fails to timely file their tax return on their own. A SFR is created and filed by the taxing authority. If a taxpayer has a SFR for a tax year and owes taxes for that year, and then files for bankruptcy protection the taxes owed for the SFR year, if normally dischargeable, are exempt from discharge (not discharged) given any debt for a tax with respect to which a return was not filed is nondischargeable pursuant to § 523(a)(1)(B)(i). But this is the bankruptcy world and not the real world. The Bankruptcy Code changes creditors rights to try and treat all parties fairly when the debtor has limited resources or no resources to pay their debts as the come due or at all.

Like many laws Congress passes certain terms that are extremely important are not defined within the law. I wish this was not so common and the undefined terms regularly are extremely important to interpreting the law. The Bankruptcy Code is no different. A “return” was not defined sufficiently and still is not even though Congress in the 2005 BAPCPA reforms amended Section 523(a) to include [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 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.] So the argument is a return filed after the SFR is a tax return that satisfies the requirements of applicable nonbankrutpcy law and the taxes for that year should therefore be dischargable.

As background, and you probably know this, any time a return is filed a form is used like 1040EZ or 1040a. So after a SFR is filed by a taxing authority the person that did not file their return uses the pre-printed form provide by the taxing authority. So for bankruptcy purposes and after the 2005 BAPCPA amended Section 523(a) to include for purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law the use of a preprinted form provided by the taxing authority meets this requirement. It apparently does not.

In the Martin Smith v. United States Internal Revenue Service [https://cdn.ca9.uscourts.gov/datastore/opinions/2016/07/13/14-15857.pdf] case Mr. Smith and his Bankruptcy Attorneys attacked the fourth prong of the Hatton test and tried to argue Mr. Smith’s voluntary filed tax return filed after the SFR is a “return,” therefore the underlying taxes owed are dischargeable and not governed by § 523(a)(1)(B)(i). While the original bankruptcy court agreed, unfortunately the District Court and now the Ninth Circuit Court of Appeals disagreed.

In Hatton in 2000, pre-2005 BACPA, the Ninth Circuit Court of Appeals developed a four prong analysis as to what a “return” is pursuant to § 523(a)(1)(B)(i) and the Bankruptcy Code. See In re Hatton, 220 F.3d 1070 (9th Cir. 2000) The test for a “return” under Hatton is: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law. The 9th Circuit Court of Appeals noted that a number of sister circuits have agreed with the Hatton case. See In re Ciotti, 638 F.3d 276,280 (4th Cir. 2011); In re Justice, 817 F.3d 738, 740–41 (11th Cir.2016) The Ninth Circuit Court of Appeals also noted that the Tax Court has not wavered. See Estate of Sanders v. Comm’r of Internal Revenue, 144 T.C. 63 (2015) Wait, Congress changed Section 523 and added: for purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). So is this non-hanging parentheses language why there was no analysis of the Section 523 language change in 2005? Was Mr. Smith’s late filed return not in compliance with applicable filing requirements?

From my perspective a SFR does not meet the Hatton test. The taxing authority more or less makes up the numbers based upon what they have and not real world numbers. So while requirements 1-3 are met in the Hatton test, again we are left with prong 4. Does a SFR represent an honest and reasonable attempt to satisfy the requirements of the tax law? Subjectively yes. The Internal Revenue Service takes 1099’s or other documents provided by employers and does its best to put together a return on behalf of the tax payer who does not timely file their return. At the same time the tax payer subjectively believes when they do file their return after a SFR is filed they also make an honest and reasonable attempt to satisfy the requirements of the tax law. It would seem both parties are making a an honest and reasonable attempt to satisfy the requirements of the tax law. The courts have analyzed this issue objectively though.

Mr. Martin’s Bankruptcy Attorneys argued that the Smith facts were different then the Hatton facts and therefore distinguishable and I have to agree. I have not read all of the pleadings, but Mr. Martin filed his 2001 tax return seven years after it was due. Mr. Smith reported a higher income than the IRS used in their SFR which increased his tax liability. One issue that is not up for argument is whether the increased tax liability above the amount due on the SFR is dischargeable. The increased tax liability evidenced by Mr. Smith’s actual late filed return is dischargeable. So the late filed return is a partially recognized “return” under the Bankruptcy Code then? Just not the entire return? In Smith, Mr. Smith unfortunately falls prey to the holding in Hatton that belated acceptance of responsibility was not an honest and reasonable attempt to comply with the tax code. I have to disagree with this analysis in Smith. Not only did Mr. Smith file a return, but he honestly listed his income and deductions so that his tax liability increased and subjectively made an honest and reasonable attempt to satisfy the requirements of the tax law. So what if it was seven years after the actual taxes were due. Where is there any temporal requirement in the Hatton test or the new language in Section 523(a) resulting from the 2005 BAPCPA? The Hatton test is not even the law, but another appellate case and a created test prior to the statutory change in Section 523(a) to help define the term “return.” Statutory interpretation/construction requires a court take the plain meaning of the words used within their context. The court must focus on the language of the statute. Must give each word its ordinary meaning unless the statute or the context requires otherwise, and must interpret not only the individual words, but also the provision as a whole along with related provisions. See Lamie v. U.S. Tr., 540 U.S. 526, 534 (2004); Friedman v. P+P, LLC (In re Friedman), 466 B.R. 471, 479 (9th Cir. BAP 2012); Foxgord v. Hischemoeller, 820 F.2d 1030, 1032 (9th Cir. 1987) The court must interpret not only the individual words, but also the provision as a whole along with related provisions. United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 371 (1988) Where is the analysis of how Mr. Smith’s accurate, honest, reasonable, partially relied on and tax liability increasing return does not meet the requirements of applicable nonbankruptcy law (including applicable filing requirements)? The Hatton case was decided in 2000 and before the 2005 BACPA which became effective in 2005.

Unlike Mr. Smith, Hatton merely met with the IRS and capitulated into an installment agreement with the IRS without making any affirmative action to honestly and reasonably comply with the tax code. Mr. Smith clearly did honestly and reasonably not only make the effort, but did comply with the tax code and then filed a return that met the requirements of applicable nonbankruptcy law (including applicable filing requirements) by increasing his tax liability. Mr. Smith should have been rewarded for filing his tax return upon seeking bankruptcy protection under the Bankruptcy Code. An honest debtor deserves a discharge under the Bankruptcy Code. I believe this and believe the holding in the Smith case sends the wrong incentive and message to debtors and their attorneys.

So, somehow the Internal Revenue Service is allowed recognize the validity of a late filed return regarding the increased taxes owed while at the same time arguing the late filed return is not actually a “return” for purposes of §523(a)(1)(B)(i) as the late filed return does not meet the requirements of applicable nonbankruptcy law. I suppose the only reason to file a return after a SFR is to decrease the alleged tax liability in the SFR, but the return is still not a “return” for bankruptcy purposes. The Hatton case and now Smith decision more or less provide a penalty for not voluntarily filing a tax return within a certain amount of time. Well, then what is a reasonable time frame in which the fourth prong of the Hatton Test can be satisfied? One year? Two years or days after the SFR is filed? Some arbitrary time limit after the SFR is filed that if you are a day over you cannot discharge the taxes when filing bankruptcy? I still want to know how a return filed after a SFR does not satisfy the requirements of applicable nonbankruptcy law (including applicable filing requirements). I am going to have to dig deeper into these two cases……….

The Oral Arguments Before the Ninth Circuit Court of Appeals

Wow, what a pressure cooker. After listening to the oral arguments before the three judge panel I still believe the decision here is wrong as the law and Bankruptcy Code are written. It is about interpretation though and past decisions. The Ninth Circuit Court of Appeals just could not get over that the debtor filed the 1040 tax return so late after the IRS had given him so many chances to file his own return. The debtor in this case did not actually file his own return until after the IRS spent the time to file the Substitute Filed Return. I will assume the application of the Hatton test was the correct choice even with the addition to Section 523(a) of a definition of a “return” under the Bankruptcy Code. So we are stuck with the IRS and Ninth Circuit Court of Appeals somehow telling us the tax return filed by a debtor after a Substitute Filed Return is a “return” as to the amount the debtor filed return increases the assessed taxes from what the Substitute File Return assessed, but that same “return” is not a “return” as to the previously assessed taxes owed from the Substitute Filed Return. The Smith case did not nothing to explain how a portion of a “return” can be an honest and reasonable attempt to satisfy the requirements of the tax law and part of a “return” not be at the same time.

The Smith case really just ignores the issue of what the definition of what a “return” is under the Bankruptcy Code or what an honest and reasonable attempt to satisfy the requirements of the tax law (including applicable filing requirements). The Court just took the IRS position that since the IRS filed the SFR then a debtor in this case, Martin Smith, under the circumstances in his case could never subsequently file a return and have the portion of the taxes owed according to the SFR discharged in a bankruptcy case. Mr. Smith just waited far too long to file his “return” that by every measure was complete and accurate. In theory there can still be a set of facts in which a court can determine a return filed by the debtor after a SFR is in fact a “return” and discharge all of the taxes assessed for that year. This case was just not it. What is troubling is the Hatton case represented a debtor that made no good faith effort to file a “return” unlike in the Smith case. Mr. Hatton filed a late return in which he provided true and accurate information resulting in his tax obligation given his tax liability increased from the Substitute Filed Return the taxing authority created. That is by definition a honest and reasonable attempt to satisfy the requirements of the tax law (including applicable filing requirements). What does “including applicable filing requirements” even mean? We still do not know. It would have been nice for the Smith case to have gone this direction and helped to define how to apply the actual words of the Section 523(a) of the Bankruptcy Code.

So, the moral of the story really is to timely and honestly file your tax returns and not let a taxing authority file a return on your behalf. Do not ignore the letters a taxing authority sends in the mail to file your returns and this will never be a problem.

Can I Be Held Liable For Unpaid Sales Tax in California If I Am A Silent Partner?

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In California the State Board of Equalization collects sales tax from businesses and partnerships. But what if you are a silent partner that invested funds to start a business but do not participate in the day to day operation of the business? Why should you be personally liable for unpaid sales tax when you had nothing to do with not paying the sales tax to the BOE if and when the business unfortunately fails? Under California law and the Revised Uniform Partnership Act all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.” Cal. Corp. Code § 16306(a).

This issue was recently discussed and analyzed in a Ninth Circuit Bankruptcy Appellate Panel opinion, In re: Earnest Leal and Maria Leal; BAP No. CC-06-1207-MoDK. The debtors, Earnest and Maria Leal were silent partners in a retail shoe store. The Leal’s did not participate in the actually running of the shoe store and had no responsibility for collecting and paying sales tax. Their business partners, the Stanleys, actual ran the store and were responsible for the day to day operation of the shoe store. The lease for the shoe store was signed by both the Stanleys and Leals. Maria Leal and Ms. Stanley signed a Business License Tax Application that was filed with the City of Rancho Mirage. Retail is a tough business and apparently the Stanleys had to close the shoe store.

So, how does this land in bankruptcy court and the Ninth Circuit Bankruptcy Appellate Panel? Mr. and Mrs. Leal filed for bankruptcy under Chapter 7 of the Bankruptcy Code and did not list any debt owed to the Board of Equalization. Some of the creditors of the failed shoe store did see collection from Mr. and Mrs. Leal. There was at least one default judgment entered against Mrs. Leal and the Leals’ bankruptcy petition included debts resulting from the failed shoe store. Mr. and Mrs. Leal received their discharge and their Chapter 7 case was closed. Sometime after they received their discharge the Board of Equalization began collection activity against Mr. and Mrs. Leal for $20,000 in unpaid sales tax owed from the shoe store. The Leals’ bankruptcy attorney reopened their Chapter 7 case and filed a motion to determine the validity of the alleged sales tax debts and tax liens against the Leals. The bankruptcy court found that the Leals’ were not responsible for the sales taxes given they did not willfully fail to pay them and had no supervision over the business.

The resulting appeal provides the following analysis of the relevant California law regarding partnerships and liability for sales tax payments. Does California Revenue and Tax Code Section 6829 shield debtors from joint and several liability for unpaid sales tax? Section 6829 provides in relevant part: “upon termination, dissolution, or abandonment of a partnership . . . any officer, member, manager, partner, or other person having control or supervision of, or who is charged with the responsibility for the filing of returns or the payment of tax, or who is under a duty to act for the corporation, partnership, limited liability partnership, or limited liability company in complying with any requirement of this part, shall be personally liable for any unpaid taxes and interest and penalties on those taxes, if the officer, member, manager, or other person willfully fails to pay or to cause to be paid any taxes due from the corporation, partnership, limited liability partnership, or limited liability company pursuant to this part.

The Leals’ bankruptcy attorney argues that the Leals cannot be personally liable for any unpaid taxes and interest given they were not charged with the responsibility of filing returns or payment of the taxes. They are just silent partners in the failed shoe store business. The Ninth Circuit Bankruptcy Appellate panel disagreed with the original bankruptcy court and held that Cal. Rev. & Tax Code section 6829 does not protect Debtors from any liability they may have as general partners under Cal. Corp. Code section 16306(a). So silent partners in California beware. Just because you are not part of the day to day operations of a partnership you invested in you can be liable for unpaid sales taxes if they are not paid timely.

Are Substituted Tax Returns Considered a “Filed” Tax Return So That Unpaid Income Tax Can Be Discharged in Bankruptcy?

By Ryan C. Wood

In order for your tax debt to be dischargeable in bankruptcy you need to meet all these criteria: 1) the taxes need to be due more than three years ago, 2) filed at least two years prior to filing bankruptcy, 3) the taxes need to be assessed more than 240 days (8 months) ago, and 4) no filing of fraudulent returns or willful attempts to evade or defeat a tax. If you meet those 4 requirements, your unpaid income taxes can be dischargeable in your bankruptcy case. Today we are going to focus on Internal Revenue Service policies and whether a substituted tax return filed by a taxing authority on behalf of a taxpayer is considered a “filed” tax return to satisfy number two listed above.

What is a substituted tax return? A substitute for return (“SFR”) is a tax return the Internal Revenue Service (“IRS”) files on your behalf if you fail to do so. The IRS gathers all the information submitted to them (W-2s, 1099s, etc.) and the taxing authority prepares your return on your behalf. Keep in mind that the SFR is most likely not going to include all the deductions, exemptions, and credits that you may be entitled to so the tax assessment may be higher than what you actually owe. The IRS will send you a Notice of Deficiency and provide you with a proposed assessment and give you 90 days to file a return or a petition in Tax Court. If you do not respond the IRS will proceed with the assessment and for all intents and purposes the SFR will be considered a valid return for tax assessment and interest and penalties will accrue. Now just because the IRS filed an SFR for you does not mean that you cannot file your own tax return. In fact it is encouraged that you still file your own return because as indicated previously, the IRS does not take into account all the deductions, credits, and exemptions that you may be entitled to. By filing your own return you can reduce your tax liability if not eliminate it altogether. You may even be due a refund. If you do not file your return within 3 years of the date the return is due you risk losing your refund and your right to claim tax credits. Make sure your bankruptcy attorney or you obtain an account transcript from the IRS to verify your tax history and verify that a SFR was filed on your behalf.

Now that you know what a SFR is the next step is to determine if the SFR acts as a filed tax return if the IRS prepares the SFR. The short answer is a resounding NO! Please see IRS Chief Counsel Notice CC-2010-016 and Internal Revenue Code §6020(b). The SFR does not count as a filed return and therefore if you owe taxes pursuant to the SFR it is not dischargeable in bankruptcy. If you prepare and file your own tax return after a SFR was prepared by the IRS, taxes are assessed and file it with the IRS and meet all the criteria of a dischargeable tax debt, then only the portion of the tax that was not previously assessed would be dischargeable. If you end up owing no taxes or a decrease in taxes owed, those taxes would not be dischargeable.

After the IRS prepares a SFR and assesses taxes owed from the SFR you can still prepare and file your own tax return. Once you file your own tax return and if your unpaid income tax meets all the criteria for the taxes to be dischargeable, only the portion that was not previously assessed from the SFR would be dischargeable. If it turns out that you do not owe as much as the IRS claims, whatever amount remaining owed to the IRS from the taxes assessed by the SFR is not dischargeable.

For example:

Let’s look at an example to help you picture this rule. Let’s say you want to file for Chapter 7 bankruptcy in November 2014 and you ask your bankruptcy lawyer if your taxes are dischargeable. You owe taxes for the 2008 tax year but you never filed a tax return for this year and the IRS filed an SFR on your behalf and assessed the taxes in 2010 and the SFR indicated you owed $15,000 for the 2008 tax year. Even though you meet all the other criteria to have your taxes discharged, the $15,000 is not dischargeable because you did not technically file a return since SFRs do not count as a valid return. Now let’s say you immediately go to a CPA to file the 2008 tax return and you were assessed an additional $5,000. That $5,000 would be dischargeable in bankruptcy once it meets the other discharge rules. If the CPA helps you file the tax return and you end up lowering your tax liability from the $15,000 the IRS assessed from the SFR to only $3,000, your tax liability will only be $3,000. This is good news since you only owe $3,000 rather than $15,000, but the bad news is that the entire $3,000 is not dischargeable no matter how long you wait to file for bankruptcy.

The harsh effect of the SFR should encourage you to file your taxes on time in the event you know you are going to owe income taxes. Not filing a return and the Internal Revenue Service filing a substituted return could make any otherwise dischargeable income tax not dischargeable. So no, substituted tax returns are not considered a “filed” tax return so that unpaid income taxes can be discharged when filing bankruptcy.

Amended Tax Returns and Discharging Taxes in Bankruptcy

By Ryan C. Wood

In my previous blog articles I have explained that taxes are dischargeable in bankruptcy if they meet the following requirements: 1) the taxes were due more than 3 years ago, 2) filed more than 2 years ago, 3) assessed more than 240 days ago, 4) filed in good faith, and 5) is not filed fraudulently. What happens if you have to file an amended tax return?

Taxes will become a more common reason for people to file for bankruptcy protection. Bankruptcy lawyers everywhere are seeing more and more people with significant tax debts. Our taxes are not going to decrease anytime soon either.

Everyone makes mistakes sometimes. That is human. Everyone should be allowed to correct those mistakes if possible. If you amend your tax return and you end up owing more money to taxing authorities such as the Internal Revenue Service or the California’s Franchise Tax Board, how does this affect the dischargeability of the taxes owed if you hire a bankruptcy attorney and file for bankruptcy?

If you amend your tax return you may be relieved to know that the amendment of your tax return does not change the filing date of the original return. Your tax return will still be considered to have been filed the first time you filed the tax return. For example: you have filed your 2005 tax returns on April 15, 2006. The IRS contacts you in 2009 to notify you that you have made a mistake on your return and you need to amend your tax returns. You file the amended tax returns on June 15, 2009. You file for bankruptcy on July 1, 2009. The 2005 tax debt should still be dischargeable because you filed the original tax returns more than 2 years prior to the filing of your bankruptcy case.

One thing to note is that if there are additional taxes assessed due to the amended tax return, those additional taxes will be subject to the 240 day assessment rule. For example: you owed $1,000 when you filed your 2005 tax returns on April 15, 2006. When you amended your tax returns on June 15, 2009, an additional $500 was assessed on June 30, 2009. If you filed for bankruptcy on July 1, 2009, the original $1,000 tax debt would still be dischargeable. The additional $500 taxes that were assessed would not be dischargeable yet. If you filed your bankruptcy case on February 26, 2010 or later, the entire $1,500 would be dischargeable. Taxes are complicated. Bankruptcy laws are complicated.