Taxes on IRS-Prepared Returns Are Not Discharged in Bankruptcy

A recent bankruptcy case gave me pause. The case is Cannon v U.S.

The Cannons did not file tax returns for 1999 through 2001. The IRS audited and made income tax assessments based on the audit. This is known as a substitute return.

The Cannons later filed for bankruptcy. The IRS said that their taxes for 1999 through 2001 were nondischargeable.

What is the issue here? To be dischargeable in bankruptcy, a debtor’s taxes must meet several tests:

* The returns are due more than three years before bankruptcy
* The tax must be assessed more than 240 days before bankruptcy
* A return must have been filed more than 2 years prior to bankruptcy
* The return must not be fraudulent
* The taxpayer must not have attempted to evade tax

The issue is the definition of “return.” In 2005 the Bankruptcy Code was amended to include the following gem of wordsmithing:

...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 § 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 § 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.”

So a return under IRC Section 6020(a) will qualify. What does Sec 6020(a) say?

6020(a) Preparation of Return by Secretary.—

If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.

The Bankruptcy Code will accept the above but will not accept the following under Sec 6020(b):

6020(b)(1)Authority of secretary to execute return.—

If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.

The problem is that a substitute return is a Sec 6020(b) return. If you owe tax with this IRS-prepared substitute return, you are facing the possibility that this tax is nondischargeable, even if the 2-year period has expired.

The question I have is whether amending an IRS-prepared Sec 6020(b) return will constitute filing a tax return and thereby begin the 2-year period. I am looking at Judge Easterbrook’s language in Payne, and Payne’s descendants, such as Creekmore and Links. I must admit, it as clear as mud.

The tax planning for this is pretty straightforward however: file your returns before the IRS catches you.