In a startling decision by the Tenth Circuit U. S. Court of Appeals, income tax debts assessed by an IRS Substitute For Return are no longer dischargeable in a bankruptcy filing. Going against both the two-year rule for the filing and the three-year rule for the due date in relation to the dischargeability of tax debts, the ruling places many financially distressed taxpayers now and in the future in a real bind. From the perspective of a tax resolution specialist, such a ruling is sure to be challenged in the near future.
According to Mallo v. IRS, No. 13-1464 (10th Cir. 2014) a taxpayer can no longer discharge an income tax liability in a bankruptcy if the IRS filed a Substitute For Return (SFR) for the taxpayer. If an untimely 1040 Form, filed after the Internal Revenue Service (IRS) has assessed the tax liability, is a tax return for purposes of the exceptions to discharge in section 523(a)(1)(B)(i) of the Bankruptcy Code, it is no longer dischargeable. Such an update means that if a taxpayer needs to maintain the option of discharging an income tax liability in a potential future bankruptcy, they better first file their tax returns before the IRS files a Substitute For Return.
The debtors in the case, Edson and Liana Mallo, did not file timely federal income tax returns for 2000 and 2001. As a result, the IRS issued statutory notices of deficiency. Given the lack of filing, the amount in the Substitute For Return was much higher than the Mallos would have paid if filing themselves. Still, the Mallos did not challenge those determinations, and the IRS began collection efforts in 2006. In 2007, the Mallos filed a joint Form 1040 for tax year 2000 and another joint Form 1040 for tax year 2001.
In 2010, unable to pay their tax liabilities and other debts, the debtors filed a Chapter 13 bankruptcy petition with the United States Bankruptcy Court for the District of Colorado. Their case was converted to a liquidation proceeding under Chapter 7 in early 2011. After the bankruptcy court issued a general order discharging the couple’s debts, the couple filed an adversary proceeding to seek a determination of whether or not their income tax liabilities for 2000 and 2001 had been discharged.
The IRS denied that the debts had been discharged in the bankruptcy. Both parties filed for a summary judgment on the legal question of whether the Mallos' tax debt was excepted from discharge under section 523(a)(1)(B) of the Bankruptcy Code. In the startling decision, the Tenth Circuit Court concluded that both the untimely returns and the Substitute For Returns were not tax returns under the statute. Given this distinction, the Court excluded the Mallo’s tax liability from the general discharge orders of the bankruptcy court.
Given the decision, an IRS Substitute For Return becomes a worst-case scenario for a taxpayer when it comes to discharging income tax debts in bankruptcy. If the IRS files a Substitute For Return, the income tax debts are not dischargeable in any kind of bankruptcy proceeding. Such a ruling becomes a dire warning to taxpayers that if they fail to file a tax return and the IRS submits a Substitute For Return in response, their bankruptcy escape clause is forever closed. From the perspective of an experienced tax resolution specialist, the law is counter-intuitive and will not stand the test of time.
Thank you to article contributor Peter Y. Stephan, Managing Partner, Tax Resolution Institute