What Is an ‘Honest and Reasonable’ Tax Return?

By Roy Whitehead, Jr.

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JANUARY 2007 - Most accountants and lawyers would scoff if asked the simple question “What is a tax return?” Two recent bankruptcy cases, however, explore the interesting question of what is an “honest and reasonable” tax return for purposes of the discharge of tax liability in bankruptcy. The question is critical for bankruptcy professionals because if the return is not an “honest and reasonable” one, there can be no discharge in bankruptcy of federal income tax owed. The cases are important because two circuit courts of appeals, the Seventh and Eighth Circuits, have reached opposing conclusions. The cases are doubly interesting because they contain a spirited debate about what is an honest and reasonable tax return between two of the nation’s most respected appellate judges and legal scholars, Richard Posner and Frank Easterbrook.

The Payne Facts

In the first case, In Re Payne [431 F.3d 1055 (Dec. 2005)], Payne filed no federal income tax return from 1986 until 1992. Meanwhile, in 1989, the IRS discovered that Payne had substantial income in 1986 from which income tax had not been withheld and for which he had not filed a return. In 1990, the IRS assessed Payne for 1986 income tax due of $20,000. In 1992, a few months after belatedly filing his 1986 return, which contained no payment of taxes due, he offered to compromise his tax liability with the IRS, but the IRS refused. Finally, in 1997, Payne filed for bankruptcy and sought a discharge of his unpaid tax liability for 1986. The bankruptcy judge and the district judge granted a discharge of the tax liability. The government then appealed to the Seventh Circuit.

The Payne Decision

Section 523(a)(1)(B)(i) of the Bankruptcy Code forbids the discharge of federal income tax liability with respect to which a return was required to be filed but was not filed. Payne contended that he complied with the code by filing a return for 1986 in 1992, even if the return was six years late and filed after the IRS had figured out his tax liability. He also contended that his return, even if six years late, met the statutory requirement of a return as contemplated by the Bankruptcy Code. The bankruptcy judge and the district court agreed with Payne and granted the discharge. On appeal, the aggrieved government contended that an untimely post-assessment return is not a return within the meaning of the code and, therefore, Payne had never properly filed a 1986 return and could not be discharged with respect to his 1986 tax liability.

Esteemed jurist and University of Chicago economics professor Judge Richard Posner commenced his majority opinion for the Seventh Circuit Court by stating that neither the Bankruptcy Code nor the IRC defines the word “return.” He wrote that there is a lot of case law interpreting it because what does or does not qualify as a tax return can get a taxpayer in a lot of trouble with the government. Several cases reveal that to be deemed a return, a document filed with the IRS must: 1) purport to be a return; 2) be signed under penalty of perjury; 3) contain enough information to enable a taxpayer’s tax liability to be calculated; and 4) “evidence an honest and reasonable endeavor to satisfy the law.” A purported return that does not meet all four conditions to qualify as a return does not satisfy the role that a tax return is intended to play in the federal tax system of honest self-assessment.

Judge Posner conceded that Payne’s purported return met the first three requirements of a return because it clearly purports to be a return, is signed under penalty of perjury, and contains enough information to allow the IRS to calculate Payne’s tax liability. Recall, however, that the IRS had already calculated and assessed his tax liability before the return was filed, so his return was of little value to the IRS. The critical question for Posner was whether the fourth condition, that the return “evidence an honest and reasonable endeavor to satisfy the law,” was met by the late 1992 filing.

Posner concluded that it was not, for several reasons. First, Payne offered no excuse for the late filing except in his lawyer’s oral statement that 1986 to 1992 was a difficult period for his client. This statement was unsupported by any evidence and was not considered by the court. Second, Judge Posner concluded that the belated filing, unaccompanied by payment of the tax due, was not a reasonable effort to satisfy the basic requirements of tax law, namely, the requirement of filing a timely return and paying the amount of tax calculated on the return. Payne’s tardiness clearly defeated the self-assessment purpose that a tax return is intended to play in the federal tax system. Third, when Payne filed his late return, the IRS had already calculated the tax due. This means that he had already succeeded in defeating the main purpose of tax returns: to spare the IRS the burden of reconstructing a taxpayer’s income and tax liability. A return that is filed after the government has borne the considerable burden of determining the taxpayer’s income and tax liability does not serve the intended purpose of the filing requirement. Finally, Posner wrote that there was no suggestion in the case that Payne was already bankrupt in 1986 or that paying the $20,000 tax when due would have driven him into bankruptcy.

Judge Posner concluded by emphasizing that the legal test is whether the taxpayer’s purported return is a reasonable endeavor to satisfy the taxpayer’s obligations. He concluded, for the several reasons discussed above, that Payne’s efforts were not. One can interpret from the court’s discussion that the court believed the taxpayer had filed the late return to cast about for a discharge in bankruptcy rather than to reasonably fulfill his tax obligations. Posner closed by cautioning that the decision should not be read to indicate that a return filed after an assessment can never be adjudged an honest and reasonable endeavor to comply with the tax law. There might be circumstances beyond a taxpayer’s control that prevent a timely filing, or even asking for an extension, before the tax is assessed. The postal service, for example, might lose or misdeliver the return, or the taxpayer might be physically or mentally incapacitated. But there was no such excuse offered for Payne’s six-year delay.

The Payne Dissent

In his dissent, Judge Easterbrook, the highly regarded judge and senior lecturer at the University of Chicago Law School, found Payne’s return honest and reasonable for three reasons. First, he said that, contrary to Posner’s opinion, belated post-assessment returns are useful to the IRS because they replace IRS estimates with facts about the taxpayer’s tax liability. Second, he said that Posner’s view that an honest and reasonable return is one that leads to the collection of the tax is wrong. The fact that the late return contained no payment does not make it unreasonable, because the intent of the law is to require the revelation of financial information; payment can be handled separately.

Finally, he disagreed with the majority’s focus on the theme that Payne was casting about for a way to discharge his tax debt in bankruptcy. He concluded that whatever the court thought about Payne’s ethics, care, or strategy was not relevant to whether Payne’s return was honest and reasonable, because the question of what is an honest and reasonable tax return is strictly one of law rather than equity. He said there is no equitable override to the Bankruptcy Code. This is intended to keep judges from using equity principles to do favors for taxpayers they feel sorry for [U.S. v. Noland, 517 U.S. 535 (1996)].

The Colsen Facts

In the case of In Re Colsen [No. 05-2476 (8th Cir., May 4, 2006)], when Colsen failed to file tax returns for the years 1992 through 1996, the IRS proceeded to prepare substitute returns and issued notices of deficiency. Toward the end of 1999, Colsen filed 1040 returns for the years 1992 through 1996. Four years later, he filed a petition for relief of the taxes owed, under Chapter 7 of the Bankruptcy Code. He claimed that his income taxes for the years 1992 through 1996 were dischargeable despite the provisions of 11 USC section 523(a)(1)(B)(i), which provide that a tax debt cannot be discharged in which a return “was not filed or given.” The IRS moved for summary judgment, claiming that the returns Colsen filed were not reasonable returns under the statute because they were filed after the IRS assessment had taken place. The bankruptcy judge disagreed and ruled that the tax liability was dischargeable.

The Colsen Decision

On appeal, the Eighth Circuit recognized that Judge Posner had concluded in Payne that the filing of a return after the IRS had calculated the taxes owed was not an “honest and reasonable” return that satisfied the statute. Recall that Posner said that a filing after the IRS had assessed a deficiency plainly defeated the self-assessment role that a tax return is intended to play in the federal tax system and did not serve the intended purpose of the filing requirement, to spare the IRS the burden of determining the taxpayer’s income and tax liability. But the Eighth Circuit dismissed Posner’s reasoning as to what “evidences an honest and reasonable endeavor to satisfy the law.”

Judge Arnold, writing for the court, quickly adopted the reasoning of Judge Easterbrook’s Payne dissent. Recall that Easterbrook pointed out that the “timely filing and satisfaction of one’s financial obligations are requirements different from the requirements for a return.” Easterbrook contended that when the return contained all the information necessary to calculate the tax liability, the statutory requirement, “evidences an honest and reasonable endeavor to satisfy the law,” was met because the proper objective of the return is to obtain accurate financial data. That the return was filed late or that there might be suspicious motives are not relevant to the taxpayer’s endeavor to satisfy the law by filing a return.

Judge Arnold wrote that we hold “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. The filer’s subjective intent is irrelevant.” He pointed out that the IRS clearly found late returns useful, because it requires them to be filed before the agency will consider offers to compromise tax liabilities. The court affirmed the Bankruptcy Court’s discharge of the taxes.

‘Honest and Reasonable’

There is now a sharp split in the circuits regarding what constitutes an honest and reasonable tax return for the purpose of the discharge of tax liabilities in bankruptcy. It is likely that the Supreme Court will have to step in and resolve this issue in the future. To this author, Judge Posner’s arguments are more perceptive and Payne’s and Colsen’s returns were not honest and reasonable ones. To write, as Judge Easterbrook and Judge Arnold did, that the tardy filer’s motives and circumstances are not relevant to what evidences an honest and reasonable endeavor to satisfy the law would seem to lead to an unwarranted and narrow definition of a filer’s obligation in the tax system.

Whatever one’s opinion of the cases, it is certain that the lawyers and accountants who represent and deal with debtors seeking bankruptcy protection must be familiar with what represents an honest and reasonable tax return and the issues raised in these cases. Failure to recognize the several issues involved might result in an individual’s being denied a discharge in bankruptcy. This author is left with the impression that Payne was having some difficulties that might have created some circumstances that could have explained his late filing. But he failed to make the explanation.

Roy Whitehead, Jr., JD, LLM, is a professor of business law at the University of Central Arkansas, Conway, Ark.





















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