Discharging Taxes With Late Filed Returns and Substitute Filed Returns

discharge late filed taxes SFR

We discharge income tax debts fairly regularly. While it can be complicated for a variety of reasons, it is formulaic at some level. Assuming no fraud was involved, taxes are dischargeable if these three rules are met:

Three year rule: Your taxes must have been due at three ago.
Two year rule: The taxes were filed at least two years ago.
240 day rule: The taxes being discharged were not assessed in the past 240 days.

This formula works for timely filed tax returns, but what about late filed returns? Or what about when the IRS steps in and files a return for you, known as a substitute filed return or SFR? Let’s cover the distinction between late filed, and late filed with an SFR.

Late Filed Returns

Courts around the country are divided about whether a late filed tax return can be discharged in bankruptcy. Our appellate court that binds our bankruptcy courts leaves that possibility open. While some appellate courts have held a late filed return means it can never be discharged in bankruptcy, our court of appeal did not. It adhered to something called the Beard test (“Beard” is the name of a party to the case). This test looks at multiple factors, but the one most relevant for this discussion is whether the taxpayer made an honest and reasonable attempt to comply with the tax law.

For purposes of a discharge in bankruptcy, the court is looking the length of time what reason there was a delay in filing a tax return. In the recent case about discharging taxes, the person that filed bankruptcy waited eight years from when the taxes were due to file a tax return. She then waited for the three year, two year and 240 days rule to apply. The court found the taxpayer could not justify an eight year delay, and it was therefore not an honest and reasonable attempt to comply with the tax law. The taxes were thus not dischargeable.

This leaves a grey area. What if it was a two day delay, or two months, or two years? And why was there a delay? There could very well be times when late returns are dischargeable, but it is an open question.

Substitute Filed Return or SFR

Sometimes when a person fails to file a tax return timely, the Internal Revenue Service will file an estimated tax return on your behalf. This is called a substitute filed return or SFR. This is also an open question about how it affects your ability to discharge taxes. The upshot is that some courts have held the IRS filing an SFR means your tax debts for years where an SFR was filed means you can never discharge those debts. Other courts have held it has no effect, and you just conduct the same three year, two year and 240 day rule.

Our courts have not yet resolved this, so it remains and open issue. Although partly formulaic, discharging taxes involves many complexities that require experience and knowledge on how to approach the analysis. This is definitely a “do not try at home” experiment.