The case of IRS, et al v. Starling, No. 7:20-cv-07478 (S.D.N.Y. 2021) reverses the bankruptcy case discussed here. The bankruptcy court followed the authority created in the 8th Circuit almost two decades ago. The 8th Circuit’s position is distinctly in the minority regarding how to treat a taxpayer who fails to timely file a return prior to the time the IRS makes a substitute for return assessment (SFR). By adopting the 8th Circuit’s position regarding late filed returns, the bankruptcy court found that Mr. Starling discharged his taxes and that the IRS violated the discharge injunction by pursuing collection against him after the granting of the discharge. The decision of the district court realigns the outcome with the majority of courts that have looked at the issue. A significant split of authority continues to exist crying out for a legislative or judicial resolution.
Mr. Starling didn’t file his 2002 return. The IRS followed the substitute for return procedures including a preliminary letter and a notice of deficiency. He did nothing in response to these letters allowing the IRS to assess the taxes it determined due through the substitute for return procedures. After the assessment, Mr. Starling submitted a return prepared by him which reflected the same amount of tax as the IRS assessed based on the notice of deficiency. This fact made his case almost identical to the facts in the Hindenlang case that started this issue almost a quarter century ago.
Waiting until after the IRS has gone through the notice of deficiency procedure and made the assessment based on a defaulted notice has caused every taxpayer except Mr. Colsen in the 8th Circuit to lose the discharge argument for one reason or another. The bankruptcy court’s decision surprised me. The government appealed as I predicted in the prior post. The outcome here does not surprise me. Perhaps Mr. Starling will appeal to the 2nd Circuit which does not have circuit decisional law on this issue. If he does appeal, I expect that he will lose but whether he loses or wins he will create a conflict with one circuit or another. Perhaps this could be that case that after a quarter of century resolves the issue of when it becomes too late to file a return and still reap the benefit of a discharge.
The district court decision highlights the continued uncertainty which puts the IRS and state taxing authorities in a tough spot. They must create protocols for discharging taxes. The IRS has created a protocol that it will not discharge a tax if the taxpayer files the return after the IRS has assessed the liability using the substitute for return procedures (except it cannot safely use that protocol in the 8th Circuit.) When the bankruptcy court disagreed with the majority of cases reviewing this issue, it then found that the IRS had violated the discharge injunction and imposed sanctions. The IRS does not want to get sanctioned and it does not want a discharge standard that has too many variables and unknowns. I am sure it will continue to appeal any adverse decisions similar to Starling. Its failure to take the Colsen case to the Supreme Court many years ago has proved to have been a mistake. The IRS believed it could fix the problem created by Colsen with legislation; however, the legislation passed in 2005 has just made the situation more complicated as discussed in the many prior blog posts on this issue.
The additional party in the Starling case was the private debt collection company used by the IRS. That company essentially violated the discharge injunction as an agent of the IRS. With the decision that bankruptcy did not discharge this debt, the private debt collection company gets off the hook the same as the IRS.
The district court does a nice job of consolidating the cases decided on this issue and describing the failed legislative fix. It notes that the bankruptcy court’s decision in Starling goes even further than the 8th Circuit did in Colsen:
But even the Eighth Circuit is unlikely to have regarded Debtor here as having made an honest and reasonable effort. First, there is serious doubt that Colsen‘s reasoning survives the addition of BAPCPA’s hanging paragraph, and at least one bankruptcy court within the Eighth Circuit has instead adopted the one-day-late test. See Kline v. Internal Revenue Serv. (In re Kline), 581 B.R. 597, 604 (Bankr. W.D. Ark. 2018). Second, while Colsen held that “the honesty and genuineness of the filer’s attempt to satisfy the tax laws should be determined from the face of the form itself, not from the filer’s delinquency or the reasons for it,” Colsen, 446 F.3d at 840, the court also noted that the late-filed form in that instance provided the IRS with new information that assisted the agency in determining the taxpayer’s ultimate tax liability, id. at 841. The Eighth Circuit distinguished the facts before it from those in Hindenlang, “where the taxpayer’s forms contained essentially the same information as the substitute forms that the IRS prepared and the calculation of tax did not change substantially.” Id. (citing Hindenlang, 164 F.3d at 1031.) Unlike in Colsen, Starling’s late-filed Form 1040 appears to have simply reiterated the tax assessment the IRS had already performed, and although this effort may have been an “honest” attempt to satisfy his obligations under the tax law, it was hardly “reasonable” to ignore multiple notices and only file years late with the same number the IRS had already come up with on its own. While I do not believe that the Colsen test is the appropriate one to apply here, especially in the wake of BAPCPA, Debtor fails to meet even that most lenient standard for avoiding § 523(a)’s discharge exception.
The statute of limitations on collection has apparently run on Mr. Starling’s debt. So, the discharge aspect of this case no longer matters to him. I don’t know if the contempt fees would sufficiently fuel an effort to go to the 2nd Circuit but maybe someone wants another circuit court decision on this issue and another shot at the Supreme Court. This case breaks no new ground, and puts Colsen back in the 8th Circuit only. The IRS continues to argue that any document filed after the assessment is automatically not a return. To date, the IRS has not gotten one court to buy this argument. In Briggs v. United States (In re Briggs), No. 15-2427-MHC at p.8 (N.D. Ga., June 7, 2017) (government admitted at oral argument that no court of appeals had adopted the per se argument). The IRS has won every case but one when it argues that the document filed after the SFR assessment was not a return. So, it has a de facto, if not a de jure, rule.
The facts in Briggs offer a good argument for the non per se rule but the IRS will continue to push for a per se rule because that’s what it needs in order to comfortably administer a provision, the discharge rule, that has significant adverse consequences when the creditor gets it wrong. Because of their desire for a clear rule, taxing authorities would benefit from a visit to the Supreme Court in order to seek an administrable rule they can follow without fear even if the rule is not as favorable to them as the current situation. Debtors might prefer the current state of affairs unless they live in the 1st, 5th or 10th Circuits where the current rules create a crushing situation for them. We’ll see if Starling is the case that brings the issue to a head.