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Discharging Income Taxes and The Two-Year Rule for Late Filed Tax Returns

It is clear that a tax debt is not dischargeable in bankruptcy if a return for the year in question is not filed. See 11 USC § 523 (a)(1)(B)(i). However, The 2 Year Rule provides that taxes due based upon a late filed return (filed after its due date and any extensions) are dischargeable if the delinquent return was actually filed more than 2 years prior to the bankruptcy filing. See 11 USC § 523(a)(1)(B)(ii). Not surprisingly, there has been much Bankruptcy Court litigation, and many conflicting and irreconcilable case decisions, over what constitutes a return, because if whatever the debtor filed is determined not to be a tax return, then the tax debt will not be discharged because a return was not filed. Into this morass of conflicting cases came the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) to the rescue (or so Congress thought), in the form of yet another “hanging paragraph”, this time at the end of 11 USC § 523(a).

Many post-BAPCPA Courts have ruled that this “hanging paragraph” has provided the “death knell” for The 2 Year Rule concerning the dischargeability of late filed taxes. This “hanging paragraph” is largely definitional, stating that for dischargeability purposes “the term ‘return’ means a return that satisfies the requirements of applicable non-bankruptcy law (including applicable filing requirements)”. The problem created for late filing debtors (ie., filed beyond any allowable extensions) is that the “applicable filing requirements” contained in the Internal Revenue Code (§ 6072(a)) and the New York State Tax Law (§ 651(a)) require tax returns to be filed on or before April 15, with the maximum allowable extension being six (6) months, or until October 15th (IRC § 6081 (a) and NY Tax Law § 657(a)). Many Courts have held that since a late filed return is not filed according to “applicable filing requirements” (ie., before April 15th, or October 15th if an extension is granted) it is not a “return” for dischargeability purposes, and a tax debt can never be discharged without a “return” being filed. Accordingly, this harsh reading of the “applicable filing requirements” contained in the “hanging paragraph” leads some Courts to conclude that tax debts are always non-dischargeable whenever a tax return (ie., IRS Form 1040 or NYS Form IT-201) is filed late, which serves to completely eviscerate the 2 Year Rule.

As evidenced by some current case law and IRS executive notices, the IRS currently does not adopt such a harsh position in all cases, providing that you do not make them do a lot of work. See IRS Notice of Office of Chief Counsel # CC 2010-016, dated September 2, 2010. The IRS position seems to be that the dischargeability of a tax debt should be determined by whether or not the IRS had to make an assessment of tax liability based upon a Notice of Deficiency. To get a handle on this it is critical to understand the IRS tax assessment procedure when a taxpayer fails to file a return, which is basically as follows:

  1. When the taxpayer fails to file an individual return, the IRS commences a Taxpayer Delinquency Inquiry and generates several notices to the taxpayer. This usually seems to happen 5-6 months after the due date for the missing return.
  2. If the taxpayer fails to comply with the information requests contained in these notices, the IRS will calculate the taxpayer’s income for the year in question based upon the best available information received from third parties such as banks, employers and financial institutions. This information usually consists of Form W-2s and Form 1099s.
  3. After the IRS has computed the tax obligation, plus interest and penalties, the taxpayer is notified of this by a letter, known as a “30 Day Letter”.
  4. On the date that the 30 Day Letter is sent out to the taxpayer, the IRS posts on taxpayer’s account a “Substitute For Return” (SFR), also known as a “Dummy Return”, but this SFR does not contain a computation of the tax liability or any information from which to compute such tax liability. It is not unusual for 9 months to pass after the commencement of the Taxpayer Delinquency Inquiry before the SFR is posted.
  5. If the taxpayer fails to respond to the 30 Day Letter, the IRS will issue to the taxpayer a statutory Notice of Deficiency, also known as a “90 Day Letter”, which is sent by certified mail.
  6. The Notice of Deficiency advises the taxpayer that unless they respond to the letter within 90 days, the IRS calculated amount of the tax obligation plus interest and penalties (which is also set forth on the Notice) will be assessed against the taxpayer. This Notice also informs the taxpayer that they may challenge the amount of the proposed assessment by filing a petition with the U.S. Tax Court within said 90 day period.
  7. If within this 90 day period the taxpayer fails to either (1) file a tax return with the IRS, or (2) file a petition with the U.S. Tax Court challenging the assessment, the IRS posts on debtor’s account the assessment that was proposed in the Notice of Deficiency and generates a notice of assessment and demand for payment, which is mailed to the taxpayer. This frequently can occur up to two years after the unfilled return was due.

The current position of the IRS seems to be that if the debtor files his tax return (Form 1040) before the IRS is forced to calculate and make its own assessment based upon a Notice of Deficiency, the tax owed to the IRS will be dischargeable even though the return was filed late. To put it in terms of the above 7-Stage assessment procedure, if you get your Form 1040 tax return filed before Stage 7 occurs and thereafter file your Chapter 7 bankruptcy more than 2 years after the filing of said tax return, the federal tax debt will be discharged without any objection from the IRS.

The “hanging paragraph” of § 523(a) does provide a “safe harbor” for delinquent taxpayers in the form of IRC § 6020(a), a little known and rarely used provision which involves the taxpayer disclosing all necessary information to the IRS, with the IRS then preparing the return for the debtor to sign and then file. According to the “hanging paragraph” this will constitute a return for dischargeability purposes even though it is obviously late filed, and the debt due will be dischargeable as long as you wait two years before filing your bankruptcy.

Our advice to delinquent taxpayers who hope to one day have their federal tax debt discharged in bankruptcy is:

  • If you cannot get your Form 1040 federal return filed in a timely manner, at least get it filed before the IRS makes an assessment of your tax liability based upon a Notice of Deficiency (see Stage 7 above). The IRS certainly sends out enough letters and notices before they reach the critical Stage 7. Do not ignore these letters. Get your federal income tax return filed before Stage 7 is reached, and the federal tax due should be dischargeable if you wait two years to file your bankruptcy.
  • If you cannot get your Form 1040 federal return filed before the IRS has made its assessment based upon a Notice of Deficiency, see if you can collaborate with the IRS and get a return filed pursuant to IRC § 6020(a). I do not know that the IRS will cooperate in every case, but it will not hurt to ask. If you do file your return in this fashion the tax due should be dischargeable as long as you wait two years before you file your bankruptcy.

There is little reported case law about New York State’s position on the question of late filed tax returns and the 2 Year Rule In one case that this author is aware of NYS did not oppose the application seeking discharge of NYS income taxes arising from late filed tax returns. From a “one case sample” I do not suggest that it is safe to draw a broad, general conclusion that NYS does not choose to parse the statutory language the way taxing authorities and Courts in other jurisdictions do, but from a debtor’s perspective it certainly is an encouraging sign.

Although not necessarily a bankruptcy issue, it should be noted that if a taxpayer files a legitimate and properly documented Form 1040 after the IRS has made its own assessment based upon a Notice of Deficiency, and the tax owed pursuant to the late filed return is less that the IRS’s assessed amount, the IRS will usually abate the difference between the two figures and seek to collect only the amount set forth on the taxpayer’s late filed Form 1040. You will not get the new, lesser amount discharged in a subsequent bankruptcy, but at least you will get stuck owing only the smaller amount.

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