Taxpayers Beware: A Tax Debt May Not Be Dischargeable In Bankruptcy If The Tax Return Is Filed Late

When considering filing bankruptcy, the dischargeability of a taxpayer's outstanding federal tax debt is a significant consideration. In many cases, taxpayers are able to discharge personal income taxes through bankruptcy. However, as recently made clear by the Tenth Circuit Court of Appeals, there are significant traps for the unwary.

Background.

The Bankruptcy Code generally assumes that debts are dischargeable. The Code, however, identifies certain categories of debt that are excepted from this general rule. Personal income tax is dischargeable only if all four of the following conditions are met:

1. Tax return was due more than three years prior to bankruptcy filing ("Three-Year Rule").

2. Tax return was filed more than two years prior to bankruptcy filing ("Two-Year Rule").

3. Taxes were assessed more than 240 days prior to bankruptcy filing ("240-Day Rule").

4. The taxpayer did not file a fraudulent return or willfully attempt to evade paying taxes ("Fraud Rule").

The first three requirements appear to be simple time measurement rules; however, these rules have caused significant angst for unwary taxpayers. In particular, the Two Year Rule requires a taxpayer to have filed a return. Section 523(a) of the Bankruptcy Code specifically states that a tax debt is excluded from discharge if a return was not filed. This seemingly straightforward rule raises the question of what does it mean to file a tax return.

Mallo v. Comm'r (10th Cir. 2014).

In Mallo v. Commissioner, the Tenth Circuit Court of Appeals was faced with the question of whether a late personal income tax return (Form 1040), filed after the IRS assessed a tax liability, is a "return" for purposes of the exclusion from discharge set forth in Section 523 of the Bankruptcy Code.

The case is a consolidated appeal involving two taxpayers that both failed to file timely federal income tax returns. Each of the taxpayers filed a bankruptcy petition. In one case, the bankruptcy court determined that the tax debts were not discharged because the taxpayers had not filed a return. In the other case, the bankruptcy court determined that the late-filed returns were returns, meaning the tax debt was dischargeable in the bankruptcy proceeding.

On appeal, the Tenth Circuit held that late Forms 1040 were not returns under the Bankruptcy Code. The relevant language cited by the court is found in the "hanging paragraph" of Section 523 of the Bankruptcy Code. This paragraph defines a "return" as a...