Bankruptcy Court judges split over state tax dischargeability

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Lawyers say a split in the U.S. Bankruptcy Court over whether tax liability from late-filed state income tax returns are dischargeable in bankruptcy is creating uncertainty and making it difficult to advise debtors on how to proceed.

Under Section 523(a) of the Bankruptcy Code, tax liabilities are nondischargeable if a debtor fails to file a return. A 2005 amendment to the code, an unnumbered “hanging paragraph,” defines the term “return” as one that satisfies the requirements of applicable non-bankruptcy law, including “applicable filing requirements.”

Judge Melvin Hoffman had ruled in March that because a pair of debtors’ late-filed state returns served some tax purpose, they qualified as “returns” under Section 523(a) and thus the debtors’ tax liabilities were dischargeable.

But last month, Judge William Hillman reached the opposite conclusion, holding that because a late-filed return did not satisfy the commonwealth’s “applicable filing requirements,” it did not constitute a “return” within the meaning of Section 523(a) and thus a debtor’s state tax liabilities could not be discharged.

“While I recognize that there’s something unsavory about saying that a ‘late filed return’ is not a ‘return’ under [Section 523(a)] by virtue of its tardiness, I can’t characterize this result as absurd,” Hillman wrote, awarding summary judgment to the Department of Revenue on the debtor’s motion for a determination that his state tax liabilities were dischargeable. “Admittedly, other courts within this district have concluded that this reading does too much violence to the statute. … Unfortunately I must respectfully disagree with my colleagues.”

Marques Lipton of Boston, who represented the debtors in the earlier proceeding before Hoffman, said Hillman’s more recent decision makes it very difficult to counsel clients.

“A lot of people come to us with major tax debts to the [IRS] or the DOR and you really can’t tell them what’s going to happen if they file for bankruptcy,” said Lipton, who practices at the Law Office of Timothy Mauser. “We’ve already had issues with whether or not the DOR will basically ignore a discharge on grounds that they think [such liabilities] are not dischargeable under the ‘willful evasion’ exception to discharge. Now it’s even more difficult to tell them what’s going to happen.”

Roger Stanford of Stanford & Schall in New Bedford, who represented the debtor in the case before Hillman, agreed.

“How do you tell a client that their older taxes to the IRS [which recognizes late-filed returns as ‘returns’] will be discharged, but the same tax years to the DOR may not?” asked Stanford, whose client has filed an appeal. “It could be the luck of what judge you draw.”

‘Fundamental disagreement’

Celine Jackson of the DOR’s Litigation Bureau, who argued both cases on behalf of the commonwealth, said she was encouraged by Hillman’s decision, which she described as “meticulous.”

Jackson noted, however, that an appeal of Hoffman’s ruling is pending before the Bankruptcy Appellate Panel. Meanwhile, the DOR has an appeal pending in U.S. District Court following Judge Henry J. Boroff’s April 2013 decision in In re Perkins, which adopted Hoffman’s reasoning in its entirety. So as a practical matter, Jackson said, the department is waiting to see how the issue will be decided before determining how it ultimately proceeds.

She further stated that the amount of tax revenue at issue is “probably in the millions of dollars in terms of potential collection.”

Lipton said that should Hillman’s view ultimately prevail, it would be a loss for everyone.

“We get a lot of clients in our offices every year who owe tax debts and have late-filed returns,” he said, noting that the amounts can be “astronomical” when penalties and interest are taken into account.

“It’s already extremely difficult to deal with the DOR in just trying to get a payment arrangement or settlement,” Lipton said. “So the DOR will have a major task on its hands to try and collect from all these people who can never discharge their debts. And it’s really unfortunate for people who will never be able to get the fresh start that the Bankruptcy Code is supposed to offer.”

Carl Aframe of Aframe & Barnhill in Worcester agreed that the split makes it difficult to counsel clients.

Those who live in the districts covered by Boroff or Hoffman — western and central Massachusetts, respectively — know what they will get, Aframe said. But those who file in Boston do not know if they will go before Hillman, Frank J. Bailey or Joan N. Feeney.

“We don’t know where Feeney or Bailey sit on this issue because it hasn’t been before them,” Aframe said. “So it’s very difficult to tell a client filing in the Boston area what they’ll get.”

Meanwhile, Aframe encourages attorneys with clients who have been impacted by Hillman’s ruling to seek certification at the 1st U.S. Circuit Court of Appeals so that there is a single resolution circuit-wide.

The case also has national implications, he said, since the 5th Circuit ruled last year in In re McCoy that a late-filed return can never qualify as a “return” for the purposes of dischargeability under Section 523(a).

“If the 1st Circuit and a couple of other circuits come down with a different posture than McCoy, it might get enough traction to take this nationwide,” he said. “If there’s no uniformity of the enforcement of bankruptcy law, that’s the kind of thing that gets the [U.S. Supreme Court’s] attention.”

Jacob T. Simon of Liss Law in Brookline, who represents debtors but was not involved in either the Hillman or Hoffman cases, said sloppy drafting caused the problem in the first place.

“This disagreement is due in large part to the poorly drafted — even by [Bankruptcy Abuse Prevention and Consumer Protection Act] standards — ‘hanging paragraph’ added to the end of Section 523(a),” he said. “Most debtors who owe back taxes have filed their returns late. As someone who does mostly debtor work, I obviously hope the issue is taken up [by the 1st Circuit].”

Roger C. Stanford of Stanford & Schall in New Bedford represented the debtor in Pendergast. He could not be reached for comment prior to deadline.

Untimely filings

In the earlier case decided by Hoffman, debtor John T. Brown filed state income taxes for the years 1998 through 2004, on July 7, 2005. Another debtor, Anthony M. Gonzalez, filed returns for tax years 1999 through 2002 two weeks after Brown.

Both debtors filed for bankruptcy under Chapter 7 of the Bankruptcy Code within two years of filing their late tax returns and received discharges of their debts in 2009 and 2010, respectively.

They each commenced adversary proceedings against the DOR seeking judgments that obligations for their pre-petition state income tax debts had been discharged when they received their Chapter 7 discharges.

The DOR moved for summary judgment in each case.

The case decided by Hillman involved similar facts: a debtor named Timothy Pendergast who, in late 2009, filed state tax returns for the years 2001 to 2006. Pendergast filed for relief under Chapter 7 in May 2012 and received a discharge that August.

Like Brown and Gonzalez, he initiated an adversary proceeding in Bankruptcy Court seeking a declaration that his state tax liability for those years was discharged.

The DOR moved for summary judgment.

Split decisions

In a single consolidated ruling, Hoffman rejected the DOR’s argument that a late-filed return is not a “return” within the meaning of Section 523(a). In doing so, he noted that Section 523(a)(1)(B)(ii) renders nondischargeable any return filed late and within two years of filing for Chapter 7.

Though both debtors filed their late returns more than two years before petitioning for bankruptcy, Hoffman said the provision was still instructive in light of the 2005 amendment to the Bankruptcy Code that added the “hanging paragraph” defining a “return” under the code.

That provision defines a “return” as one that satisfies the requirements of applicable non-bankruptcy law, including “applicable filing requirements.”

Hoffman observed that the DOR argued that, because a late-filed return “by definition” does not comply with Massachusetts filing requirements, taxes relating to periods covered by such returns are never discharged.

“I believe [this interpretation] is ill-conceived and unjustified,” Hoffman said, stating that such an interpretation — that no late-filed Massachusetts tax return can be considered a return — renders Section 523(a)(1)(B)(ii) meaningless.

Such an interpretation rewrites Section 523(a)(1)(B)(ii) so that it no longer covers late-filed returns filed more than two years prior to bankruptcy and would merely cover late-filed returns prepared pursuant to certain Internal Revenue Code provisions, he said.

Since the IRS itself refers to the number of such provisions as “minute,” the DOR’s interpretation turns Section 523(a)(1)(B)(ii) into a “nullity,” Hoffman said.

“There is no legislative history available to shed light on Congressional intent in enacting the [hanging paragraph],” Hoffman continued. “[The DOR’s] interpretation of the amendment to Section 523(a)] simply does too much violence to the statute.”

Additionally, Hoffman said, a late-filed return serves a tax purpose under Massachusetts law. Specifically, it is the formal assessment of the tax in the amount stated in the return.

“The only way a late-filed return does not serve as a tax assessment under Massachusetts law is when the commissioner of revenue assesses the tax first,” he said, concluding that Brown’s and Gonzalez’s late filings did indeed constitute “returns.”

Addressing Pendergast’s motion, Hillman disagreed with Hoffman’s reasoning.

“At the risk of sounding overly simplistic, the filing deadline contained [in Massachusetts law] would seem to be exactly the type of ‘filing requirements’ to which the parenthetical phrase [in the hanging paragraph] applies,” he said. “The ‘filing requirements,’ to the extent that such term was separately emphasized in the parenthetical phrase, is clearly distinct from the issue of whether the attributes of any particular form qualify as a ‘return’ under state or federal law. The vast majority of courts agree.”

Additionally, the fact that Section 523(a)(1)(B)(ii) applies to so few cases “does not render it a nullity,” Hillman said. “So long as there is at least one situation where an untimely return is still considered a ‘return’ for purposes of [the statute], Sec. 523(a)(1)(B)(ii) will apply and have meaning.”

Accordingly, Hillman granted summary judgment for the DOR.