Can a Taxpayer Eliminate Tax Debt if He Failed to File a Return Until After the IRS Assessed the Tax?

An old case is instructive for taxpayers who live in Illinois, Indiana, and Wisconsin.  See In re Payne, 431 F.3d 1055 (7th Cir. 2005).  This case is more than 10 years old and applies pre-BAPCPA law, but it is the only case addressing the issue issued by the US Court of Appeals for the Seventh Circuit. Other circuit courts have ruled on the issue. SEE BLOGS. Again, the 7th Circuit has not yet ruled on the issue for taxes due after the 2005 BAPCPA law was enacted.

In Payne, the taxpayer failed to file the 1986 tax return until 1991, which was one year AFTER the IRS had assessed tax liability for income tax due.  Taxpayer offered to compromise his tax debt in 1992, but the IRS rejected the offer.  Five year later taxpayer filed for Chapter 7 bankruptcy relief in 1997.

The court correctly noted that Section 523(a)(1)(B)(i) of the Bankruptcy Code forbids the discharge of federal income tax liability with respect to which a “return” was required to be filed but “was not filed.”  The taxpayer argued that the return filed in 1992 was a “return” as used in the statute, albeit filed six years late and after the IRS had gone to the trouble of figuring out what the taxpayer owed.  The IRS argued that an untimely post-assessment return is not a “return” within the meaning of the statute and that therefore taxpayer never filed a 1986 “return” and so cannot be discharged from liability for the taxes that the taxpayer owes for that year.

The Payne court noted that the Bankruptcy Code had not defined the term “return” pre-BAPCPA.  However, cases held that to be deemed a return, a document filed with the IRS must (1) purport to be a “return,” (2) be signed under penalty of perjury, (3) contain enough information to enable the taxpayer’s tax liability to be calculated, and (4) “evince[] an honest and genuine endeavor to satisfy the law.  Id. at 1057, citing United States v. Moore, 627 F.2d 830, 834-35 (7th Cir. 1980). The Payne court further declared that a purported return that does not satisfy all four conditions does not play the role that a tax return is intended to play in a system of self-assessment.  So while a “return” that satisfies the first three conditions comports with the literal meaning of the word, it does not comport with the functional meaning.

The whole dispute in Payne was whether the taxpayer satisfied the fourth prong of the test and “endeavored to satisfy the law” by filing the 1986 tax return in 1992.  The court rejected a line of reasoning used by other courts that the a late-filed return after the IRS assessed the tax does not serve the purpose of the filing requirement.  The Payne court expressly stated that the legal test is not whether the filing of a purported return has some utility for the tax authorities, but whether it is a reasonable endeavor to satisfy the taxpayer’s obligations.  So the bankruptcy courts should not look through the eyes of the IRS to determine usefulness; rather, the court should look through taxpayer’s eyes to determine if the taxpayer’s efforts constituted a reasonable endeavor to satisfy the taxpayer’s obligations.

The majority of the Payne court reversed the lower court and found that the taxpayer had not reasonable endeavored to satisfy the taxpayer’s obligations.  Hence the tax debt was excepted from discharge.  However, a persuasive counter argument was asserted in a dissent by Circuit Judge Easterbrook, who argued that the return was a “return” for bankruptcy purposes.  The judge believed taxpayer’s failure to timely file the return was distinct from the definition of “return.”  Instead, the judge believed motive may affect the consequences of a late-filed return, but not the definition of “return.”  Motive was an issue relating to Section 523(a)(1)(C) and whether taxpayer “willfully attempted… to evade or defeat” the tax.  Remember, however, this case relates to pre-BAPCPA law established in 2005.  Judge Easterbrook, in dicta, suggested the result would be different if the BAPCPA law was applicable.

Practice Pointer:  This is an old case and several circuit courts have recently ruled that a late-filed return does NOT constitute a “return” for bankruptcy purposes.  So file those returns on time.  The Seventh Circuit has yet to issue a ruling, but a future circuit court panel could agree with Judge Easterbrook’s dissent.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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