Yet Another Hanging Paragraph Creates a Taxing Situation

Yet Another Hanging Paragraph Creates a Taxing Situation

A pair of new opinions suggests that dischargeability of taxes is even more complicated subsequent to BAPCPA. In Matter of McCoy, No. 11-60146 (5th Cir. 1/4/12), which can be found here [an enhanced version of this opinion is available to subscribers], the Fifth Circuit found that, under Missisippi law, late filed returns did not constitute "returns" at all and thus were not subject to being discharged. In In re Hernandez, Adv. No. 11-5126 (Bankr. W.D. Tex. 1/11/12), which can be found here, Judge Leif Clark found that returns filed after the IRS made its own assessment on unfiled returns were not subject to discharge either. While these decisions may be consistent with the prevailing sentiment, they are not necessarily rooted on solid legal reasoning.

The Other Hanging Paragraph

One of BAPCPA's legacies will be the hanging paragraph, a piece of text hanging by itself which is not part of a specific subsection. We are reasonably familiar with the hanging paragraph of Section 1325(a)(*) which has to do with the valuation of vehicles in chapter 13 cases. Now, six years after BAPCPA took effect, a new hanging paragraph has been discovered, Section 523(a)(*), having to do with dischargeability of taxes. While dischargeability of taxes is dealt with in Section 523(a)(1), which would have been a logical place to put the additional language, Congress saw fit to add a codicil to Section 523(a)(1) at the end of Section 523(a). The new language states:

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.

Why do we care about the definition of return? Section 523(a)(1)(B) states that a debt is not dischargeable "with respect to which a return . . . was not filed or given; or" was filed "after two years before the date of the filing of the petition."

Prior to BAPCPA, a return could be filed late but at least two years before bankruptcy and still be dischargeable.

However, under the new jurisprudence, some late returns, even if filed more than two years before the date of the petition, are not returns at all.

Going to Mississippi

Linda McCoy, a resident of Mississippi, filed bankruptcy. Mississippi is one of those states that are not Texas which have a state income tax. (While most states have state income taxes, it is an unwritten law here in Texas that proposing a state income tax is a sacrilege on the same level as urinating on the Alamo). Linda McCoy did not file her state income tax returns for 1998 and 1999 when they were due. She did ultimately file her returns, but she filed them after the date they were due.

The Fifth Circuit held that under Mississippi law, a "return" meant a timely filed return. Therefore, a late return constituted an unfiled return and could not be discharged.

Turning to Texas

A few days later Judge Leif Clark interpreted the hanging paragraph of section 523(a)(*) in the context of federal taxes in Texas. (Have you ever noticed that "taxes" and "Texas" contain most of the same letters. It seems subversive since Texans hate taxes--just ask Rick Perry). The Hernandez decision involved a lot of years of taxes. The Debtor did not file timely returns for 1999 through 2006, although he eventually got them all filed. For the seven years in question, the IRS assessed liability for three years before the Debtor got around to filing returns. For the other four years, the IRS either did not get around to making assessments before the returns were filed or no taxes were due.

The IRS did not contest dischargeability for the years in which the Debtor filed his returns prior to taxes being assessed or where it acknowledged that no taxes were due. However, for the three years in which assessments preceded returns, it contended that the taxes could not be discharged--and the court agreed.

The Rationale

Prior to BAPCPA, the term "return" was not defined. Case law held that "a late filed return that required the government to assess the tax without the tax payer's assistance would not be treated as a return for section 523 purposes." McCoy, at 5. In order to constitute a "return" under prior law, it had to satisfy four requirements:

1. It had to purport to be a return;
2. It had to be executed under penalty of perjury;
3. It must contain sufficient information to allow calculation of the tax; and
4. It must represent an honest and reasonable attempt to satisfy the requirements of the tax law.

The new hanging paragraph replaced the old test with three guidelines:

1. The return must be a "return that satisfies the requirements of applicable nonbankruptcy law (including filing requirements);"
2. It would include 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; and
3. It would not include "a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.

The Mississippi State Tax Commission argued that under the first factor an untimely return was not "a return that satisfies the requirements of applicable bankruptcy law (including filing requirements)." The Debtor argued that MSTC's construction would read the reference to section 6020(a) out of the statute. As acknowledged by the Fifth Circuit, returns under section 6020(a) involve cases in which the Debtor fails to file an actual return but nevertheless provides the IRS with all of the information necessary to calculate the liability.

The Fifth Circuit adopted MSTC's reasoning stating:

We find MSTC''s interpretation of section 523(a)(*) more convincing. We have previously explained that "the plain language of the [Bankruptcy] Code should rarely be trumped. Although the Code at times is 'awkward, and even ungrammatical . . . that does not make it ambiguous." (citation omitted). The plain language interpretation of section 523(a)(*) comports with this admonition.

McCoy at 8-9. The Court went on to find that returns prepared under section 6020(a) constituted a narrow exception to the rule that late filed returns were not returns. It also referred to other courts which have reached the same result.

The Hernandez Court did not significantly expand upon the Fifth Circuit opinion, stating:

Anticipating consistency on the part of the circuit court, this court concludes that late-filed returns cannot be treated as filed, for purposes of section 523(a)(1), save for returns that comport with the requirements of section 6020(b)(sic) of title 26. The exception is a narrow one, and does not apply on the facts of the case sub judice.

Hernandez at 9.

If Every Other Court Jumped Off a Building Would You Join Them?

The Courts following the majority interpretation of section 523(a)(*) show a lemming-like ability to follow the crowd without careful thought. Section 523(a)(1)(B) provides that taxes are not dischargeable in two instances:

1. Where a return was not "filed or given;" or
2. Where the return "was filed or given after the date on which such return, report, or notice was last due, under applicable nonbankruptcy law or under any extension, and after two years before the date of the filing of the petition.

Thus, section 523(a)(1)(B) has two components to it: a substantive one and a temporal one. If no return was filed, then the tax cannot be discharged. However, if the return was filed at least two years before bankruptcy, even if it was not timely filed, it could be discharged (assuming that the other requirements for dischargeability are met).

The McCoy decision does not state when the returns were actually filed. However, In Hernandez, the Court's finding of fact explicitly recite that the returns for 1999, 2003 and 2004 were each filed more than two years before the petition date. Thus, Hernandez raises the Catch-22 situation in which a return filed more than two years before bankruptcy may be subject to discharge but a return filed one day late is not a return at all.

To be blunt, McCoy and Hernandez obliterate section 523(a)(1)(B)(ii) by stating that late-filed returns, much like disgraced party members in the Soviet Union, are non-returns. (In the Soviet Union, party members who had fallen from favor would be erased from photographs and treated as though they had never existed). Why would the statute allow for returns filed more than two years prior to bankruptcy to be considered when all late filed returns would necessarily be considered non-returns? The obvious answer is that the hanging paragraph was meant to address the question of whether the document submitted was sufficient to constitute a return rather than whether it was a timely return. The reference to "filing requirements" in the hanging paragraph is best understood as a reference to whether the document was filed rather than when it was filed.

The language of the hanging paragraph reinforces the interpretation that it was meant to be a substantive rather than a temporal requirement. Under the hanging paragraph, "a written stipulation to a judgment or final order entered by a nonbankruptcy tribunal" would constitute a return. Thus, if the Debtor did nothing and waited for the taxing authority to file suit and agreed to the assessment would have been deemed to have filed a return. On the other hand, if the debtor filed his return one day late and the ever-vigilant taxing authority made its assessment in the intervening hours, the return would cease to exist. This makes no sense.

I may be missing something profound or obvious. However, these decisions appear to be just plain wrong.

Hat tip to Michael Baumer who got the word out on these decisions on the State Bar of Texas Bankruptcy Section listserv. Michael is a smart guy and caught the importance of these opinions before I did.

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