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McCoy – Fifth Circuit Judicially Eliminates the 2 Year Filing Rule

Prior to January 2012, the rules relating to the discharge of tax debts in bankruptcy cases were relatively straight forward. Bankruptcy Code §§ 507(a)(8) and 523(a)(1) provide that income tax debts can be discharged in bankruptcy if the tax in question meets the following requirements:

Three Year Age Rule. More than 3 years must elapse between the bankruptcy filing date and the date the income tax return was last due, including all extensions.

Two Year Filing Rule. The taxpayer must file the return for the tax year in question more than 2 years before he files for bankruptcy. Although the 3 year rule considers the age of the tax, the 2 year rule only deals with the actual filing date of the tax return.

240 Day Assessment Rule. A taxpayer can not discharge a tax in bankruptcy unless the taxing authority assesses the tax more than 240 days before the taxpayer files for bankruptcy. If the taxpayer makes any offer in compromise, the 240 day time period is extended by the number of days the offer in compromise is pending, plus an additional 30 days.

In the past, these rules would permit a debtor to discharge a tax debt in bankruptcy if the tax debt was more than 3 years old, the return was filed more than 2 years prior to the bankruptcy filing date, and an additional tax was not assessed as a result of a tax return audit within 240 days before the case was filed. Significantly, a late filed return (a tax return filed after the due date) did not create an impediment to discharging the tax so long the tax in question satisfied the 3 year, 2 year and 240 day rules.

The Fifth Circuit Court of appeals has recently issued a controversial opinion which will eliminate a debtors ability to discharge virtually all federal or state income tax debts in most cases. In McCoy v. Mississippi State Tax Commission, 666 F.3d 924 (5th. Cir. 1/4/12), the debor owed unpaid Mississippi state income taxes for the 1998 and 1999 tax years. She filed for Chapter 7 bankruptcy in 2008. The tax debt in question clearly complied with the 3 year, 2 year and 240 day rules. Approximately 1 year after the bankruptcy discharge order was granted, the debtor filed a lawsuit in the bankruptcy court requesting a declaration that the tax debt was discharged in the prior bankruptcy case. The State of Mississippi argued that: (a) because the state income returns filed by McCoy for the 1998 and 1999 tax years were filed late, they did not qualify as “returns” under the definition provided in 11 U.S.C. § 523(a)(*), a provision added to the Bankruptcy Code as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”); and (b) McCoy’s income tax debts to the State of Mississippi could not be discharged in bankruptcy. In other words, the State of Mississippi argued that filing a return late is the same as never filing it at all. The Fifth Circuit agreed and held that a late filed income tax return filed by the taxpayer can never qualify as a return for bankruptcy discharge purposes.

In Hernandez, 11-5126 (Bankr. W.D. Tex. 1/11/12), a bankruptcy court opinion case issued one week after the McCoy decision, a San Antonio Bankruptcy Court applied the reasoning of McCoy to federal income tax debts and the Internal Revenue Code. The Court stated that “[a]lthough the McCoy holding applied to a state tax regime, its logic applies with equal (if not greater) force to the federal taxing scheme.”

The practical effect of McCoy is to completely eliminate the two year rule contained in § 523(a)(1)(B)(ii). The McCoy decision has been correctly criticized as “just plain wrong” (See, Yet Another Hanging Paragraph Creates a Taxing Situation, Stephen W. Sather, January 20, 2012). McCoy is wrong primarily because it contradicts a basic rule of statutory construction – a court may not construe the text of one statute such that other text in the same statute is rendered completely meaningless. The McCoy decision does just that. If a tax reported in a late filed tax return can never be discharged, the 2 year rule, which permits a discharge relating to a tax return filed more that 2 years before the bankruptcy is filed, can never have any application.

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