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Thursday, March 02, 2006


Income taxes are generally dischargeable in bankrutpcy. However, 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.

If a taxpayer doesn’t file a tax return, the IRS needs to prepare a substitute return for the taxpayer in order to be able to assess tax against the taxpayer (referred to as a substitute-for-return, or SFR, assessment). What happens if the IRS prepares an SFR and assesses tax against a taxpayer, and then the taxpayer wants to discharge the tax in bankruptcy? Since he needs to file a return to get the bankruptcy discharge, can he file a return after the IRS prepared an SFR, so as to make bankruptcy discharge available?

There is no statutory definition of what is a "return" for income tax purposes. Therefore, courts have adopted a four part test that must be met before a filing is considered a "return." To be a return, the filing must:

a. Purport to be a return.
b. Be filed under penalty of perjury.
c. Provide sufficient information to allow for computation of tax.
d. Represent an honest and reasonable attempt to comply with the law.

In regard to whether a return filed by a taxpayer after the IRS has prepared an SFR, courts have struggled with the last requirement - that is, whether such a return is an honest and reasonable attempt to comply with the law. Does filing many years late always mean it is not an honest and reasonable attempt? Does filing a return that is substantially the same as the SFR mean it not an honest and reasonable attempt?

This is presently a facts and circumstances test, and courts will differ in their conclusions based on the circumstances of each particular case. In a recent appellate case, the 7th Circuit Court of Appeals indicated that taxpayers will face an uphill battle in most circumstances in getting SFR taxes to be dischargeable, holding in that particular case the filing by the taxpayer was not a return. In re Payne, 431 F3d 1055 (CA-7, 2005).

This result is more problematic for taxpayers now than it used to be. In the past, special treatment was available in a Chapter 13 bankruptcy for taxes that were otherwise nonpriority/nondischargeable in Chapter 7 - therefore, Chapter 13 was often availed of to get around the SFR problem. However, this course of action was pretty much eliminated under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Therefore, taxpayers who have not filed a return and desire a bankruptcy discharge of taxes better get their tax return filed before the IRS prepares an SFR for them.
For a more detailed discussion of these issues, see Dischargeability of Taxes in Bankruptcy May Be Impossible if IRS Makes Substitute-for-Return Assessment, Journal of Taxation, Mar 2006.

1 comment:

Joe Mastriano, CPA said...

Question: If I want to leave the SFR and not refile, can the liability be discharged in a bankruptcy, or must I actually file a return?
This is a serious client question. Not spam

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