A large portion of people who get into tax problems do so without filing taxes when they are due. The rationale, although flawed, is that they don’t have the ability to pay the tax debt so will file tax returns later when there is an ability to pay. This procrastination strategy is a bad decision in more ways than one. Namely, the economic reality for most people is that they will never be able to pay those tax debts. They are then surprised to discover that despite the timing rules set forth in the bankruptcy code, courts have held that late filed returns are never eligible for discharge. There is some respite, however, in that the IRS has backed off this rather harsh approach and allowed relief for some late-filed returns.
Income taxes can generally be discharged in bankruptcy if they (1) are more than three years old, measured from the “due date” of the tax return; (2) tax returns were filed more than two years before the filing of the bankruptcy; (3) they were not “assessed” or formally determined to be due within 240 days before filing bankruptcy; (4) were not the result of a false or fraudulent return; and (5) the taxpayer did not willfully attempt to evade of defeat the tax. But this does not address the problem where the debtor filed the return, but late.
The majority of courts that have looked at the issue hold that if you filed your tax returns late, presumably even a day late, then they are never able to be discharged in bankruptcy. These cases interpret the definition of “return” under Section 523(a) to necessarily encompass the filing deadlines contained in the Internal Revenue Code. Accordingly, a late filed return does not meet this statutory definition and cannot be discharged.
However, there is good news for many debtors in that the Ninth Circuit has not adopted such a strict approach and, more importantly, the IRS’ policy is not as extreme. The Ninth Circuit applies the standard of whether a late filed return was an “honest and reasonable attempt to comply with the tax code.” In re Smith, 828 F.3d 1094 (9th Cir. 2016). This is a gray area and depends on just how late the returns were filed and efforts made to timely file or correct deficient returns. There is no bright line but a return filed a few months late could be seen as an honest and reasonable attempt to comply with the tax code whereas a return years late may not.
But the IRS is taking the position that as long as the IRS does not file a tax return for you, also known as a “substitute for return” or “SFR,” and so long as you file your income tax returns more than two years before you file bankruptcy, and the other four requirements of discharge are met, then your income tax debts can be eliminated and cancelled. And even where the IRS files an SFR, only that amount is nondischargeable. If you later file your own return and owe even more taxes, you can wait two years and file bankruptcy to discharge the additional/increased amount. The IRS’ position is set forth in detail in “Litigation Position Regarding the Dischargeability in Bankruptcy of Tax Liabilities Reported on Late-Filed Returns and Returns Filed After Assessment.”
So even though the decisions from the courts have been harsh, the IRS’ position is much more lenient. Of course, this will not protect debtors who owe state tax debts (and many of the reported decisions come from state tax challenges in bankruptcy, not the IRS). Regardless, the best approach is to file your returns before the IRS files one for you. If you are then unable to resolve your tax debt via an offer-in-compromise or otherwise, your federal income tax obligation can be discharged in bankruptcy upon the passing of two years since the filing of the late returns.