Substitutes for Return & Non-Dischargeability:
The Ninth Circuit Adds Substitute for Return Assessments to Tax Evasion and Fraudulent Returns as Reasons for Non-dischargeable Tax Obligations.
By Christopher N. Coyle
The Internal Revenue Service’s 2010 policy that substitute for return (“SFR”) assessments can never be dischargeable in bankruptcy has firmly taken hold in the Ninth Circuit with the recent decision In re Smith. With this Ninth Circuit decision, the IRS has succeeded in having most or all SFR assessments join the other “never dischargeable” income taxes: fraudulent return liabilities and willful attempts to evade liabilities. The difference in this new category is that the affected taxpayers merely failed to file their returns, but otherwise committed no wrongs. This article will discuss the Smith decision along with the effects of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005’s (“BAPCPA”) hanging paragraph and concludes in joining Professor Timothy M. Todd in advocating for a legislative or judicial solution to this “draconian and unduly punitive” result.
Delinquent Returns, SFRs & BAPCPA
Taxpayers fail to file tax returns. In most cases, taxpayers with multiple years of non-filing usually have failed to file one return and, behind on their filing obligations and fearing a “gap” between returns, postpone filing subsequent returns until they can “get them all done.” For most taxpayers, only the last six years need to be filed.
When a taxpayer fails to file tax returns, the IRS directs the non-filer to file all delinquent tax returns. Problematically, by the time the IRS takes notice, many of these taxpayers have moved to a new address. Since the IRS is only required to provide notice to the “last known address,” there is a high likelihood that IRS notices are not received by the taxpayer. For the purposes of the IRS, the last known address is “the address that appears on the taxpayer’s most recently filed and properly processed Federal tax return, unless the Internal Revenue Service (IRS) is given clear and concise notification of a different address.” Though the IRS may obtain an updated address from the National Change of Address (“NCOA”) database, it requires that “taxpayer’s name and last known address in IRS records match the taxpayer’s name and old mailing address contained in the NCOA database.” If returns are not filed, a SFR is prepared by the Automated Substitute for Return (“ASFR”) or the IRS’s Examination Division.
The SFRs generated by the IRS may have little relationship with the taxpayer’s actual tax liability: the IRS includes the gross proceeds of a sale as income, only allows a single exemption and the standard deduction, and utilizes either single or married filing separate filing status. Though this SFR forms the basis for the IRS’s assessment, it does not start the three-year statute of limitations for tax assessment nor the ten-year tax collection statute of limitations. Once the taxpayer’s 90-day period to file a petition with the US Tax Court expires, the taxpayer loses the ability to challenge the assessment without paying the tax and filing a refund claim. Through this SFR process, the IRS may create a never-ending tax assessment against a taxpayer.
The BAPCPA amended Section 523(a) of the Bankruptcy Code to add an unnumbered, hanging paragraph to define “return” to require that returns satisfy “the requirements of applicable nonbankruptcy law” and to exclude returns made pursuant to IRC Section 6020(b). Section 523(a)’s hanging paragraph 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.
Despite no legislative history suggesting such a drastic change, numerous courts interpreted the phrase “applicable filing requirements” to include the filing-due-date and imposed a “One-Day-Late Rule”. With this new rule, taxes on late returns, even if only one day late, were never dischargeable in bankruptcy. For example, in McCoy, the taxpayer filed her tax returns late and, since “applicable filing requirements” required filing before the deadline, her returns could never constitute dischargeable returns. That the taxing agency accepted the returns, had not prepared SFRs (or its equivalent), or assessed any liability was irrelevant to the determination: one-day-late is non-dischargeable because it can never be a “return” for purposes of the Bankruptcy Code. To its credit, the IRS has not pursued such a harsh policy, stating its litigation policy that “[r]ead as a whole, [S]ection 523(a) does not provide that every tax for which a return was filed late is nondischargeable.” Likewise, while a number of state taxing agencies have also adopted and enforced the One-Day-Late Rule, to date, the Oregon Department of Revenue has not advocated for this position.
The Smith Decision & Post-Smith Options for Taxpayers with SFR Assessments
The facts of Smith are simple and common. Martin Smith failed to file his 2001 tax return, the IRS prepared an SFR and mailed a notice of deficiency in 2006, and then Smith prepared an accurate tax return (and actually increased his liability) in 2009. The Ninth Circuit decision, the District Court decision, the Bankruptcy Court decision, and the stipulations for summary judgment all recite that the IRS sent various documents to Martin Smith, but are all silent as to whether any of those documents were actually received by Smith. After being unable to pay or resolve his liability, Smith filed a Chapter 7 bankruptcy. While the IRS conceded that the increase in liability due to (what I’ll describe as) his “Superposition Return” was dischargeable (as it was apparently a return for this purpose), the IRS successfully argued that the Superposition Return was not a return with respect to the remainder of the liability. As a “return” filed after an SFR assessment is both (1) a return (for some purposes, including additional assessments) and (2) not a return (for other purposes, including bankruptcy dischargeability), it is, like Schrödinger’s cat, in a state of quantum superposition. It is simultaneously both a return and not a return and, only when the taxing authority needs to take a position does it “collapse” into one of the two possible states.
Previously, in Hatton, the Ninth Circuit adopted the Tax Court’s four-factor Beard test: “(1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law.” Relying on this prior jurisprudence, the Ninth Circuit in Smith concluded that this Superposition Return was not “a reasonable attempt to comply with the tax code.” The Ninth Circuit further determined that Smith’s conduct (filing an accurate return increasing his liability) was sufficiently analogous with the conduct in Hatton even though Hatton never attempted to cure this failure to file a tax return. The Ninth Circuit attempted to soften this harsh result by not deciding the “close question of whether any post-assessment filing could be ‘honest and reasonable,’” but, with the Court’s focus on Smith’s multi-year lack of responsiveness, there will be few, if any, cases where a non-filer will be able to bring themselves back into filing compliance while also addressing outstanding tax obligations through bankruptcy.
In light of Smith’s rejection of filing returns after “the IRS communicated with Smith for years … and Smith waited several more years,” options for “repairing” a delinquent taxpayer’s situation are highly speculative. While the court in Smith did not categorically rule that post-SFR assessment returns are always “not returns,” distinguishing Smith on the “communication” aspect may reach a different result. Since the decision was silent on whether Martin Smith actually received the IRS’s communications, it is possible that a taxpayer may be able to distinguish herself from Martin Smith’s situation if the notices were mailed to a “last known address” and if it can be argued that those notices did not reach the taxpayer. A shorter duration following the SFR assessment may also lead to a different result. However, the Ninth Circuit’s focus on the pre-SFR assessment “communication” (which will be similar for all taxpayers with SFR assessments) may foreclose this option.
Restoring the Fresh Start
Even without application of the One-Day-Late Rule, the permanent non-dischargeable status imposed by an SFR assessment runs contrary to the purposes of the bankruptcy law. As Todd notes, “[c]urrently, tax debts hang like an albatross needlessly prolonging and exacerbating financial instability.” While certain tax claims are non-dischargeable despite the passage of time, these taxes are those to which “the debtor contributed by some wrong-doing or serious fault as, for example, taxes with respect to which the debtor filed a fraudulent return.” Late filed returns, even returns filed after an SFR assessment, lack the requisite “wrong-doing or serious fault” to justify having them treated the same as evasive or fraudulent filings. Tax debt on a tardy return should be dischargeable.
The simplest fix is also the most unlikely: legislative. As the hanging paragraph was added to Section 523 to exclude Section 6020(b) “substitute” returns from the definition of return, it should be a simple matter for Congress to act to revise the hanging paragraph. At the same time, Congress could also clarify its intention with respect to post-SFR assessments. For instance, did Congress truly intend to deviate from the goal inherent in Section 523(a)(1) of encouraging taxpayers to bring themselves into tax compliance by filing missing and late returns?
Potential judicial fixes have also failed. The interpretation and practice that best matches the goals and policies of the Bankruptcy Code was adopted in Colsen, but even this decision has gained little traction. In Colsen, the taxpayer failed to file returns for several years, the IRS prepared SFRs and assessments, and the taxpayer later prepared all his missing tax returns and filed them. The taxpayer then waited four years before filing a Chapter 7 bankruptcy. Relying on Beard, the Eighth Circuit concluded that “the honesty and genuineness of the filer’s attempt to satisfy the tax laws should be determined from the face of the form itself, not from the filer’s delinquency or the reasons for it.” The Eighth Circuit also dismissed the IRS’s suggestion that there was no purpose to a post-SFR return as the “IRS apparently has found post-assessment returns useful, as it has required taxpayers to file them before the agency would consider proposed offers to compromise tax liabilities.” Unfortunately, the Eighth Circuit’s opinion remains the minority opinion with the majority of circuits adopting the draconian view that, post-SFR assessment, taxpayers’ obligations are akin to those who have fraudulently filed returns.
What’s good for the goose is good for the gander. In the cases discussed in this article, the IRS readily accepts a Superposition Return to assess additional tax liability, but disregards the same Superposition Return for purposes of bankruptcy dischargeability. The result of this shifting position is that the taxpayer’s goose is always cooked. With the recent Smith decision, taxpayers have one less option to address their delinquency and one less reason to file missing returns.
 Christopher N. Coyle is an attorney with Vanden Bos & Chapman, LLP, where he practices in the areas of bankruptcy and tax.
 In re Smith, 828 F.3d 1094 (9th Cir. 2016).
 Timothy M. Todd, Discharge of Late Tax Return Debt in Bankruptcy: Fixing BAPCPA’s Draconian Hanging Paragraph,” 24 Am. Bankr. Inst. L. Rev. 433, 456 (2016).
 For factors to shorten or extend this period, including prior history, income from illegal sources, and special circumstances, see IRM 18.104.22.168.18 (Policy Statement 5-133); IRM 22.214.171.124.
 IRM 126.96.36.199; IRM 188.8.131.52. Taxpayers who have indications that their failure to file returns was willful or fraudulent should consult criminal counsel, and appropriate resolution of non-filing is beyond the scope of this Article.
 Treas. Reg. § 301.6212-2(a).
 Treas. Reg. § 301.6212-2(b)(1).
 IRC § 6020(b); IRM 184.108.40.206; IRM 220.127.116.11.
 IRC § 6501(a), (b)(3); Treas. Reg. § 301.6501(b)-1(c).
 There is no legislative history suggesting dramatic changes to the meaning of Section 523(a)(1)(B)(ii), which allows for discharge two years after filing, without regard to late filed status. See Dewsnup v. Timm, 502 U.S. 410, 419 (1992) (“This Court has been reluctant to accept arguments that would interpret the Code, however vague the particular language under consideration might be, to effect a major change in pre-Code practice that is not the subject of at least some discussion in the legislative history.”).
 See, e.g., In re Fahey, 779 F.3d 1 (1st Cir. 2015); In re McCoy, 666 F.3d 924 (5th Cir. 2012); In re Mallo, 774 F.3d 1313 (10th Cir. 2014).
 McCoy v. Miss. St. Tax Comm’n, 2011 U.S. Dist. LEXIS 55463, at *12-14 (S.D. Miss. Feb. 8, 2011) (additional discussion of facts).
 IRS Office of Chief Counsel Notice CC-2010-0016 (Sept. 2, 2010).
 Smith, 828 F.3d at 1095–96.
 Id. at 1096.
 Id. (“Smith and the IRS agreed that the increase in the assessment based on Smith’s late-filed form was dischargeable[.]”); see generally Wikipedia, Schrödinger’s cat, https://en.wikipedia.org/wiki/Schr%C3%B6dinger%27s_cat.
 In re Hatton, 220 F.3d 1057, 1060–61 (9th Cir. 2000) (quoting In re Hindenlang, 164 F.3d 1029, 1033 (6th Cir 1999); Beard v. Comm’r, 82 T.C. 766 (1984)).
 Smith, 828 F.3d at 1097.
 Hatton, 220 F.3d at 1061.
 Smith, 828 F.3d at 1097; see Hatton, 2203 F.3d at 1061.
 Smith, 828 F.3d at 1097.
 Todd, supra note 2 at 456.
 Id. at 467 (quoting S. Rep. No. 95-989 at 14).
 In re Colsen, 446 F.3d 836 (8th Cir. 2006).
 Id. at 838.
 Id. at 840.
 Id. at 841.
 See Todd, supra note 2 at 444–45.