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.

Tax Break for Exporters

We are taking a look at an Interest Charge – Domestic International Sales Corporation (IC-DISC).

As you can guess, this has to do with a company which exports. I remember the DISC as providing a tax deferral, but it has another tax feature that we like as much or more.

Here is quick breakdown of how the IC-DISC would work:

(1) There is an exporting company (ExCo)

(2) ExCo (or its owners) set up a second company (DISC) and elect to be treated as an IC-DISC.

(3) ExCo pays DISC a commission

(4) DISC pays no tax on the commission (up to a point) as long as 95% of its activities and assets are export-related.

NOTE: Do you see what is happening? DISC pays no tax on the commission. ExCo deducts the commission and reduces its tax.

(5) DISC may pay dividends to its shareholders.

(6) If DISC does not pay dividends, there will a charge to the shareholders. The charge will vary depending on whether the shareholders are individuals or a corporation. Individuals will pay interest (hence “Interest Charge – DISC”). There is a different tax treatment for corporations.

The DISC can be a “paper” company. That is, it does not have to perform any substantial economic functions. It does not have to have employees or office space, for example. Pretty much the only thing it has to do is keep its own books and records, which an accounting department can do. You incorporate, print some new stationary and continue doing what you were doing before. How much easier can this be?

There are of course limits on how to calculate the commission; otherwise you would have a product selling for $50 with a thousand dollar commission tacked onto it. The commission is 4% of the qualified export receipts or 50% of ExCo’s taxable income, whichever is greater.

The DISC can defer $10 million in commissions EVERY year. There is even a way to increase this limit.

The tax deferral is sweet, but Rick and I like the dividend treatment as much or more. We expect the DISC to be an S corporation, and its shareholders to be the same as those for ExCo. We can also see a wealth transfer opportunity here by having the younger generation as the owners of the DISC, while mom and dad (or grandmom and granddad) still own ExCo. We are thinking of having the DISC distribute every year. Under this scenario there is no deferral. We want to move money out of the main company (ExCo), which would otherwise be taxed at the maximum rate, and push it to DISC, whose dividends are taxable at 15 percent. This would be an immediate 20% tax savings.