Is a Tax "Report" the Same Thing
as a Tax "Return"?
An Emerging Issue in Bankruptcy cases
Morgan D. King, Esq.
Of the California Bar
This article originally appeared in Spidel California Tax Newsletter
California personal income taxes may be discharged in Chapter 7 Bankruptcy, but only if, among other things, the required tax return was filed at least more than two years before the bankruptcy is filed. However, the courts disagree about whether a tax "report" or an "amended return" required by a state taxing entity is the same thing as a "tax return" for discharge purposes in bankruptcy cases.
Some states require that where the taxpayer is assessed additional taxes from an IRS audit or other assess ment, or where the taxpayer files an amended tax return with the IRS showing additional taxes due, the tax payer must either "report" the additional assessment to the state or file an "amended state tax return" to reflect the additional federal assessment.
For example, the California Revenue & Taxation Code provides that where the IRS assesses additional tax the taxpayer must file a report to the Franchise Tax Board (FTB) "... within six months after the final federal determination of the change or correction..." And, where the taxpayer files an amended tax return with the IRS the taxpayer is required to file an amended state tax return with the FTB, also within six months.
In bankruptcy cases an emerging issue has developed over the question, is such a required report or amended return a "tax return" for purposes of dischargeability of the tax in bankruptcy? The answer may be crucial to a taxpayer because the Bankruptcy Code provides that personal income taxes are dischargeable in Chapter 7 bankruptcy if they meet five criteria, one of which is that where a tax return is required, the tax return for the tax year in question must have been filed at least more than two years before the bankruptcy is filed. The problem typically arises where the IRS has conducted an audit, disallowed a tax shelter or otherwise assessed addi tional taxes.
This issue is usually called the "Blutter" issue, after a New York bankruptcy case holding that such a report or amended return is a return for discharge purposes.
In California taxpayers frequently fail to file the required FTB re port or amended re turn. If such report or amended return is a "return," failure to file would cause the additional state piggy-back assessment (derived from the IRS assessment) to be nondischargeable in Chapter 7 bankruptcy. This is because the additional state tax would not be dischargeable until the report or amended return had been filed for at least two years. Even worse, if the report or return is never filed, the two-year period would never expire, and the taxes will never be dischargeable.
In recent years states have begun taking the position that the re port or amended return required by their respec tive tax codes is the same thing as a re turn, thus triggering the two-year waiting pe riod before the tax may be discharged.
The arguments typically raised in favor of the state are; first, the bankruptcy requirement is meant to reward with a full discharge those taxpayers who show good faith by filing all required returns, and not reward those who fail to satisfy tax reporting requirements; second, the requirements assure that the state receives proper and timely notice of assessments so that it can assess additional taxes, as well.
As plausible as those reasons are, the arguments against the State seem to be equally as persuasive.
First, the IRS and the FTB have an arrangement whereby all IRS assessments are reported to the FTB, thus enabling the FTB to do its piggy-back assessment regardless of whether it is reported by the taxpayer.
Second, the Bankruptcy Code requirement is in the singular, that is, requires that "a return, if required," must be filed. The original tax return for the tax year is "a return" that is "required"; accordingly, it would seem that as long as the taxpayer has filed that "return" he or she has satisfied the rule. Had Congress intended otherwise it could have just as easily drafted the statute to read, "all required tax returns ..."
Third, to deem a state tax amended return to be a return for discharge purposes would give the states an advantage in bankruptcy not available to the federal government. For federal taxes the rule is that an amended return is not deemed a "return." Thus for federal tax purposes the only consequence of an additional as sess ment is the trig gering of a new 240-day assessment waiting pe riod as to the additional taxes. This means the taxpayer can discharge the tax after waiting out the 240 days. If, how ever, such report or amended return trig gers a two-year wait ing period before the piggy-back State tax may be dis charged, the re sult would be that the state tax would receive sub stantially more protection from bankruptcy discharge (i.e., a two-year waiting period) than the federal tax (only 240 days). Did Congress intend to give greater protection to state taxes than to federal taxes? Surely, this is not what Congress in tended. Admittedly, however, there is little ex plicit Congressional or legislative literature on this issue.
In California, the matter has been taken up on appeal in half a dozen cases. To date, the cases that have been decided have ruled in favor of the taxpayer.
For example, in California Franchise Tax Board v. Jerauld the bankruptcy court ruled in favor of a taxpayer who had not filed the report, holding that a "report" is not a "return."
Said the Jerauld court,
The plain meaning of the word "return" should be conclusive, as it has a very specific meaning in the world of taxation. Certainly, taxpayers know what it means to have to file a tax re turn; they do it each year.
This opinion did, however, vaguely suggest that had the issue involved a failure to file an "amended return," the opinion may have gone the other way, hinting that an amended return might be a "return" for purposes of the Bankruptcy Code.
The same ruling appeared in In re Rowley.
A third, more recent California case, In re Jackson, also found that a report is not a return. This case, while not settling the question of an amended return, suggests that even an amended return might not be a return for discharge purposes. In Jackson the Ninth Circuit first reiterated the general rule in bankruptcy cases that dischargeability issues "... should be construed narrowly in order to preserve the Bankruptcy Act's purpose of giving debtors a fresh start."
The court then held that the debtor's failure to file a "report" with the state taxing entity following an IRS assessment was not equivalent to failure to file a "return" for discharge pur poses. The opinion stated -
A return is a formal statement on a re quired legal form showing taxable in come, allowable deductions and exemp tions and the computation of the tax due.
The court concluded from this that a mere "report" is not a return as defined by Webster's. This language would at first blush suggest that, unlike a "report" something as formal as an amended return, which is filed on a standard form, fits the definition of a return. However, the opinion goes on, stating that it could not be said the debtor failed to file a required return, because the debtors "did file their original tax returns ..." The court reiterated other case authority to the effect that a state requiring a taxpayer to report an IRS reassessment is not the equivalent of requiring a return, and "Once a re quirement has been satisfied, it does not become unsatisfied because some new re quirement has been superadded." Thus, it would appear that as long as the taxpayer filed his original return, his failure to file an amended return would not bar a discharge of an additional state income tax assessment.
In California at least, the trend in the law appears to be resolving the Blutter issue against the State, and in favor of the fresh start for taxpayers.