By: William D. Weber (post script to "Fifth Circuit Judicially Eliminates 2 Year Filing Rule" – dated June 26, 2012)
The McCoy decision is still binding precedent in every federal court located in the Fifth Circuit (all court’s in Texas, Louisiana and Mississippi). Under McCoy, federal income taxes can never be discharged in bankruptcy if the taxpayer files his return late. However, the IRS does not follow the McCoy decision, even for bankruptcy cases filed in the Fifth Circuit. This oddity has provided a backdoor approach that will enable a taxpayer to get the IRS to write off tax debts even if the taxpayer files a tax return late.
Yes, you read that correctly. The McCoy decision, if followed by IRS, would legally permit IRS to refuse to recognize the bankruptcy discharge for any tax debt involving a late filed return. But the IRS official position disregards the McCoy decision entirely and substitutes its own more lenient rule. This official position is spelled out in detail in several official notices issued by the Office of Chief Counsel, as follows:
IRS Substitute Returns
The Internal Revenue Code contains a rule (IRC § 6020(b)) that permits IRS to file a return for a taxpayer, from information it already has available, if the taxpayer fails to file his own tax return in a timely manner. The IRS return is commonly referred to as an "IRS substitute return." Such returns are often filed by IRS when a taxpayer fails to file a return if IRS has W-2, 1099, K-1 or other data that indicates the amount of income earned during a particular tax year.
IRS Internal Administrative Rule
The IRS internal administrative rule works as follows: If the tax debt meets the requirements of the 3 year, 2 year and 240 day rules, IRS will still administratively discharge (write off) the tax debt so long as the taxpayer files his own income tax return before IRS files a substitute return pursuant to IRC § 6020(b). This rule applies regardless of whether the taxpayer files his return late. If the taxpayer files a tax return late and IRS never files a substitute return, IRS will ignore the McCoy decision and write off the tax debt if the tax debt otherwise satisfies the 3 year, 2 year and 240 day rules.
On the other hand, if the taxpayer fails to file his return in a timely manner and IRS then files a substitute return, IRS will not write off any portion of the tax debt assessed as a result of the IRS substitute return. The taxpayer can not completely cure the situation by filing his own tax return after IRS files a substitute return. However, a taxpayer can help the situation by filing a return after the IRS substitute return if he owes more tax than the amount specified in the substitute return. If a taxpayer files a return that does not report any additional tax after IRS assesses a tax based on a substitute return, IRS will refuse to write off any of the tax. If the taxpayer files a return after and an IRS substitute return and the taxpayer’s return discloses additional tax, IRS will write off the additional tax reported in the taxpayer’s return.
The taxpayer will lose if he files a lawsuit attempting to litigate the issue. IRS would then invoke the McCoy case to defeat the taxpayer’s claim that his taxes were discharged in bankruptcy.
Facts. Taxpayer fails to file his 2009 tax return before the due date (April 15, 2010). He also fails to request an extension of time to file the return. On January 2, 2012, IRS files a substitute tax return on behalf of Taxpayer. The substitute return specifies a $100,000 tax liability. IRS assesses the tax on the same day. Taxpayer does not sign or otherwise consent to the filing of the IRS substitute return.
Taxpayer files his own 2009 tax return on June 15, 2012. Taxpayer’s version of the return shows a tax liability of $120,000. Taxpayer’s return discloses the same income used by IRS to assess the $100,000 tax debt specified in the IRS substitute return. Taxpayer’s return also discloses additional information that results in $20,000 of additional tax described in his version of the return. IRS assesses an additional $20,000 of tax on June 30, 2012. Taxpayer files for Chapter 7 bankruptcy on September 15, 2014.
Result. Taxpayer meets all of the requirements of the 3 year, 2 year and 240 day rules. Due to the McCoy decision, IRS is not legally required to write off any portion of the $120,000 tax debt. In addition, IRS will refuse to write off the $100,000 tax debt because the substitute return was filed before Taxpayer filed his version of the return. However, IRS will write off the additional $20,000 of tax because Taxpayer’s return disclosed $20,000 in tax that was not listed in the IRS substitute return.
This is an example of a situation described in the IRS June 12, 2014 notice to the effect that "…a specific tax year may have a portion of the liability that is subject to discharge and a portion that is excepted from discharge under section 523(a)(1)(B)(i)."
Facts. Assume all of the same facts as specified in Example #1, except that IRS never files a substitute return.
Result. Under this scenario, as a result of the McCoy decision, IRS is still not legally obligated to write off any portion of the $120,000 tax debt. This is true because Taxpayer’s return was filed late, and under McCoy, a tax debt related to a late filed tax return can never be discharged in bankruptcy. However, because of IRS internal rules, IRS will voluntarily write off the entire $120,000 tax debt because IRS never filed a substitute return.