Many Happy Returns

Many business advisors are unaware that personal income tax obligations may, in certain circumstances, be discharged in an individual's bankruptcy. (As used here, "personal income tax obligations" means those obligations that arise as a result of income to the individual who is in bankruptcy. An individual's obligations for the 100% penalty on responsible persons for willful failure to withhold taxes from employee wages, for instance, is not dischargeable.) Such discharges are hedged by numerous exceptions, however.

One exception is where the individual does not file a return at all, but rather has had his or her income computed by the IRS under its power to calculated the tax due as a substitute for a return pursuant to IRC Section 6020(b). Well, what if the taxpayer, in contemplation of bankruptcy, prepares and files a return after the IRS has prepared a substitute for a return?

There are four requirements necessary for such a return to constitute a valid return such that the "no return" exception to discharge does not apply. Specifically, the document filed must (i) purport to be a return; (ii) be executed under penalty of perjury; (iii) contain sufficient data to allow calculation of tax; and (iv) represent an honest and reasonable attempt to satisfy the requirements of the tax law. The first three requirements would seem to be easy to meet--fill out an accurate Form 1040, sign it on the appropriate line (which already has the penalty of perjury language set forth), and file it. However, taxpayers frequently trip over the last requirement, because their returns serve no legitimate tax purpose. Courts have generally held, for instance, that a return that merely restates the substitute for a return prepared by the IRS does not constitute a return that would allow an escape from the "no return" rule.

Timothy Izzo fared better than average, however. The IRS had calculated that he owed $632,617.83 in taxes for six years. Prior to filing bankruptcy, Izzo prepared returns for the years in question showing tax due of only $155,871.61. These returns were apparently an honest reflection of Izzo's income for the years in question, since the IRS accepted them as amended returns. The bankruptcy court allowed his bankruptcy to discharge the tax due for most of the years in question. (It was not clear why the tax obligations in some of the years at issue were not discharged, but the basis was apparently not the "no return" rule.) The Court distinguished similar cases because in these other cases either the Forms 1040 essentially mirrored the IRS's substitutes for returns or they otherwise did not result in any change in tax liability.

The Izzo opinion can be found by going to the website of the United States Bankruptcy Court for the Eastern District of Michigan and drilling down using the Court's search engine. Alternatively, you can get a copy by sending me an e-mail request.