Surprising Bankruptcy Case

May 11, 2015

In the case Mallo v. IRS, the Tenth Circuit Court turned the bankruptcy world on its head.

The Bankruptcy Code states that personal taxes are dischargeable if all the following criteria are met:

  1. Due date of the return was more than 3 years prior to bankruptcy filing.
  2. Return was filed more than 2 years prior to bankruptcy filing.
  3. The tax must have been assessed 240 days or more prior to bankruptcy filing.
  4. The taxpayer must not have violated the fraud rule by filing a fraudulent return or willfully attempting to evade paying the tax.

In the Mallo case, the taxpayers failed to file their 2000 and 2001 returns and the IRS eventually prepared returns for them by filing what is called a Substitute for Return (SFR). Subsequently, the Mallos replace the SFRs by filing returns for those non-filed years.

Then in 2010, the Mallos decided to file Chapter 13 in the Bankruptcy Court. The case eventually converted over to a Chapter 7 liquidation case. Upon the discharge of their debt, the taxpayers inquired about their 2000 and 2001 income tax debt. The IRS claimed, not surprisingly, that the taxes were not dischargeable.

The IRS and the Taxpayers ended up before the Tenth Circuit, United States Appeals Court. The Court determined that neither the SFRs nor the late-filed 2000 and 2001 returns were dischargeable in bankruptcy. The Court’s decision hung on language in the bankruptcy code which states that a return means one which meets the “applicable filing requirements.” The Court interpreted applicable filing requirements to mean that the return must be filed timely.

A loud warning should go out to all who are in this type of a situation. Many taxpayers may be surprised to learn that they may be responsible for income tax that they thought would otherwise be discharged in bankruptcy.

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