Tax Debt Not Discharged in Bankruptcy When Service Prepares Returns

In Neal Swanson, 121 TC No. 7 (2003), a case of first impression, the Tax Court ruled that substitutes for return (SFRs), which are prepared by the Service when the taxpayer does not file, are not returns under Bankruptcy Code Section 523(a)(1)(B). Thus, the taxpayer is not discharged from the tax debt and cannot avoid paying taxes by not filing. The Tax Court also clarified some related jurisdictional issues.

Background

Neither the Internal Revenue Code nor the Bankruptcy Code defines return. In Beard, 82 TC 766 (1984), affd, 793 F2d 139 (6th Cir. 1986), the Tax Court ruled that to qualify as a return, a document must purport to be a return, be executed under penalty of perjury, contain sufficient data to allow calculation of tax and represent an honest and reasonable attempt to satisfy the tax law.

Sec. 6020(b) permits the Service to prepare returns for taxpayers who fail to do so, using any available information; such returns are prima facie good and sufficient for all legal purposes. However, Sec. 6020(a) requires the delinquent taxpayer to sign the SFR before it can be accepted as the taxpayers filed return. Also, the Service can prepare SFRs that do not meet Sec. 6020(b)s requirements; see Spurlock, 118 TC 155 (2002).

Bankruptcy Code Section 523(a)(1)(B) does not permit an individual debtor to be discharged from a tax debt if a required return either was not filed or was filed late (including extensions) and after two years before the date of bankruptcy filing.

Sec. 6213 allows taxpayers to appeal a Sec. 6211 deficiency notice to the Tax Court. Secs. 6320 and 6330 provide taxpayers with due process rights in lien and levy actions, including the right to a hearing before the IRSs Office of Appeals (Appeals). Under Sec. 6330(c)(2), the hearing is limited to collection issues; the taxpayer cannot raise the underlying tax liability unless the taxpayer has not received a deficiency notice or otherwise had an opportunity to dispute the liability. Sec. 6330(d) allows a taxpayer to appeal the Services determination in the hearing to the Tax Court, but does not specify whether the Tax Courts standard of review is de novo or abuse of discretion.

In Washington, 120 TC 114 (2003), the Tax Court held that, although it does not have jurisdiction to determine whether an unpaid tax debt has been discharged in Bankruptcy Court in a Sec. 6213 deficiency proceeding, it does have jurisdiction to so rule in an appeal from a lien hearing under Sec. 6330(d)(1). (In Washington, the taxpayers had filed returns, but not paid all of the tax due.)

Facts

In Swanson, the taxpayer did not file income tax returns for 19931995. The Service prepared SFRs for these years in February 1997, and issued a deficiency notice in May 1997. The taxpayer did not sign the SFRs; instead, he sought a redetermination in Tax Court, which dismissed for failure to state a claim in February 1998. In June 1998, the Service assessed deficiencies, additions to tax and interest. In August 1998, the taxpayer filed for bankruptcy. The bankruptcy court entered a discharge order, releasing the taxpayer from all dischargeable debts and all debts dischargeable under Bankruptcy Code Sections 523(a)(c).

In January 2000, the Service sent the taxpayer a notice of intent to levy for his unpaid taxes for 19931995; in February 2000, the taxpayer requested a Sec. 6330 hearing. In May 2001, Appeals issued a notice of determination denying relief; the taxpayers tax debt was not discharged in bankruptcy, because he had not filed returns. The notice also stated that SFRs are not deemed voluntarily filed and the liabilities contained therein are not dischargeable under Bankruptcy Code Section 523(a)(1)(B); the taxpayer appealed to the Tax Court.

Tax Courts Decision

The court first addressed two procedural issues. It ruled that it has jurisdiction under Sec. 6330(d)(1) for both levy and lien proceedings. It then held that the standard of review is abuse of discretion, as the validity of the underlying tax liability was not at issue.

The court next ruled that unsigned SFRs are not returns under Bankruptcy Code Section 523(a)(1)(B), whether or not they meet Sec. 6020(b)s requirements; thus, the tax debt was not discharged and the Service could proceed with its collection action. Citing In re Bergstrom, 949 F2d 341 (10th Cir. 1991), the court reasoned that the filing requirement in Bankruptcy Code Section 523(a)(1)(B) prevents a debtor from escaping liability for unpaid taxes by not filing, which would be incompatible with the good faith and candor required to obtain a fresh start under the bankruptcy laws. The SFR is merely an administrative step allowing the assessment and collection process to begin.

The Tax Court also ruled that the taxpayer did not satisfy the Beard tests, because he did not sign the SFRs and failed to make a reasonable and honest attempt to satisfy the tax law. In addition, the court noted that SFRs prepared under Sec. 6020(b) are not returns for certain other purposes, such as the definition of a deficiency and the running of the statute of limitations. Finally, the court observed that, even if the SFRs were returns under Bankruptcy Code Section 523(a)(1)(B), the taxpayers tax debts would not be discharged, because they were filed within two years of his bankruptcy filing.

Conclusion

Swanson closes a potential loophole by preventing nonfilers from having their tax debts discharged in bankruptcy when the Service has prepared SFRs as part of the assessment process. It also continues a line of cases clarifying the Secs. 6320 and 6330 collection-due-process protections.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, and Roy C. Weatherwax, Ph.D., CPA, Professor of Accounting, University of WisconsinWhitewater, Whitewater, WI (Neither Affiliated with Gray, Gray & Gray, LLP)