The 10th Circuit Court of Appeals just dismantled bankruptcy law for late-filed returns.
When you don't prepare your own return and the IRS has evidence that you owe taxes they can assess the tax against you without your agreement under 26 USC § 6020(b). This assessment is called a "Substitute for Return" (SFR). But, this is not considered a "return" by you since you didn't swear to the truth of it under penalty of perjury (Attestation Clause).
If you haven't filed but later file before the IRS makes an assessment, this is a "return" because you signed the attestation clause.
In the first case, you can never get a bankruptcy discharge for the taxes because you didn't file a return. But, in the second case, you are allowed a discharge if all the other bankruptcy conditions are met.
Returns after SFR
But, what about the case where the taxpayers file a return after the IRS has assessed the tax by way of an SFR? The taxpayers did sign the Attestation Clause but the IRS has already made an assessment.
The Federal 10th Circuit Court of Appeals says "no discharge" for these late-filed returns. (See Mallo v. USA) The court held that late filed returns did not meet the "applicable filing requirements" under §523(a), thus they were not "returns" and no bankruptcy discharge is allowed.
There is plenty of debate about the wisdom of this ruling and it might become a Supreme Court case. But, the IRS has not delayed in enforcing collection against bankrupt taxpayers. Thousands of hostile letters are now being sent by the IRS to collect.
Taxpayers who have not filed now have a major dilemma. The IRS has 10 years to collect a tax, even if they assessed it by way of SFR. If the taxpayers file returns they give the IRS another 10 years to collect.
So, many taxpayers will likely not file returns and let the 10 years expire, which is contrary to the IRS goal of voluntary compliance.
It appears the 10th Circuit (and the IRS) believe they are enforcing a rule to demand compliance but what really is going to happen is a lot of non-compliance.
The IRS won't accept an Offer in Compromise or enter a payment plan unless all the returns are filed. Taxpayers with late-filed returns can't get a bankruptcy discharge. If the taxpayers file they give the IRS another 10 years to collect.
So, I predict the taxpayers are going to avoid the IRS, not do returns and let the 10 years SFR collection period expire. Let's give a typical example:
Joe works construction. He is called "self-employed" and has received a Form 1099-MISC every year from 2003-2007 at $40,000 a year. He never does his returns and the IRS assesses the tax (SFR) based on the full $40,000 a year income, plus the Self-Employment tax (FICA) on January 13, 2009 for all years. The IRS has until January 13, 2019 to collect that assessment.
Of course, if Joe did the returns he would get to deduct all of his expenses and the amount he owed would be less. But, a debt would still exist. If he can't pay it, it doesn't matter what amount it is.
By 2014, the IRS has pestered Joe to extremity. But, they only have 5 years left to collect. If he does the returns, he lowers the tax but he gives the IRS another 10 years to collect. The IRS penalties and interest for late-filed returns are so great that the debt will still be enormous. If he can't pay it off or Compromise, he'll have to endure another 10 years of IRS collections.
Obviously, many taxpayers will try to avoid the IRS and let the 10 years expire without doing returns. For many, that won't be possible because of changed circumstances, such as marriage, children, a wage-paying job, etc.
It will be even more important now to seek legal advice from a tax lawyer if you have late-filed returns. For those taxpayers who can't avoid the IRS, they are going to have to prepare and file the returns.
From there, they can try to lower the debt with a Penalty Abatement. But, if it still can't be paid, then the only other options are an Offer in Compromise or endure 10 years of payments to the IRS. Both of these options are dangerous.
So, when a taxpayer is faced with another 10 years of IRS hassle for a debt that can’t be paid, dodging the IRS sounds attractive. Thus, I predict that this new ruling from the 10th Circuit will encourage non-compliance with the tax laws.
J. David Hopkins, JD, LLM