Last week, I reviewed a new client’s IRS transcript. The client apparently filed his individual income tax returns late and wanted to file bankruptcy to discharge his 1040 tax obligations. I subsequently learned that the IRS filed substitute individual income tax returns on the client’s behalf and issued an income tax deficiency before the income tax returns were filed.
The question was: if the Internal Revenue Service files a substitute tax return on behalf of the debtor/ taxpayer, before the taxpayer files their own income tax returns would that late tax return be considered eligible for a bankruptcy discharge under Section 523 tax return?
I have to admit that it was my belief at the time that if the late filed tax returns increased the income tax assessment, the late filed tax returns would be dischargeable if the tax returns qualified under the various timing constraints. However, after further research, examining several court cases, I have concluded that if the income tax returns were filed after the IRS had issued a substitute tax return, or issued a deficiency, a bankruptcy discharge is not attainable, even where the debtor subsequently filed an income tax return.
It appears that the bankruptcy courts have not consistently held on issues of discharge where the debtor filed a late tax return prior to the IRS issuing a notice of deficiency. From the Appellate court statements I doubt if the courts would favor the discharge of the late filed income tax returns.
Here are a couple of cases exemplifying the court’s consistency in this matter:
IN RE PAYNE 431 F.3D 1055 (7TH CIR 2005)
The taxpayer failed to file a 1986 tax return, and the IRS subsequently filed a substitute tax return for the debtor. In 1992 the taxpayer filed an offer in compromise that was rejected. The taxpayer filed a Chapter 7 in 1997. The bankruptcy court discharged the 1986 tax debt.
The 7th Circuit Court of Appeals stated that, the substitute tax return and an offer in compromise do not constitute a tax return and therefore the income taxes were not dischargeable.
MALLO V. INTERNAL REVENUE SERVICE
A married couple filing jointly, the Mallos filed their individual income taxes several years after the IRS issued notices of deficiency. Two years after filing the income tax returns the Mallos filed bankruptcy seeking to discharge the income tax obligations.
The Mallo bankruptcy court held that post assessment filings do not constitute tax returns and are therefore excepted from discharge under 523(a)(1).
The Court of Appeals held that tax debt was not dischargeable because, “the filing of a return after an assessment negates an honest and reasonable attempt to comply with tax law”.
The Court of Appeals held that, “if a Form 1040 is filed late, the tax debt is non-dischargeable under 523(a)(1)(b)(i). The court reasoned that a late tax return is not a return as defined by Section 523(a); it does not satisfy applicable filing requirements.
The Court observed that the definition of a filed tax return differs from the IRS’s definition.
The U.S. Supreme Court acknowledged the different interpretations and stated that further review was not warranted, thereby upholding the U.S. Court of Appeals for the Tenth Circuit findings.
My advice after researching this matter? Always file your tax returns in a timely manner.
Questions or comments? E-mail me at if you have any questions about this posting or if I may be of assistance in any way.
Larry Goldsmith is an experienced Financial Forensic expert and CPA who investigates and verifies financial income and assets in matrimonial matters. CJBS, LLC is a Chicago based firm that assists its clients with a wide range of accounting and financial issues, protecting and expanding the value of mid-size companies.