Putting the Hanging Paragraph Out to Pasture: Reconciling the Mandates of Bankruptcy and Tax Law

Putting the Hanging Paragraph Out to Pasture: Reconciling the Mandates of Bankruptcy and Tax Law Nicholas J. Huffmon  ABSTRACT: This Note explores an area of tension between bankruptcy and tax law. The question of when a tax return is dischargeable through bankruptcy is murky and controversial. The current statutory definition of a tax “return” is widely reviled because it is unnecessarily restrictive. This Note proposes redrafting the statutory definition of tax “return” to resolve the issue in a way favorable to debtors. Specifically, this Note proposes allowing a tax return to be discharged as long as it complies with applicable content requirements on its face. Unlike the current statutory scheme, this proposal would not prohibit the discharge of a tax return because it was submitted after either the passing of a statutory deadline or an independent assessment by a tax authority. This proposal also aligns with the purpose of the Bankruptcy Code—to give the honest debtor a fresh start. I. INTRODUCTION ........................................................................... 1730 II. BACKGROUND ............................................................................. 1733 A. T HE D ISCHARGABILITY OF T AX D EBT T HROUGH B ANKRUPTCY ........................................................................ 1733 B. I NITIAL A PPLICATION OF THE BEARD T EST ............................ 1734 1. Majority View under the Beard Test: The Fourth, Sixth, Seventh, and Ninth Circuits............................. 1735 2. Minority View Under the Beard Test: Judge Easterbrook and the Eighth Circuit ........................... 1737 C. T HE B ANKRUPTCY A BUSE P REVENTION AND C ONSUMER P ROTECTION A CT OF 2005 AND THE I NTRODUCTION OF THE “H ANGING P ARAGRAPH ” ................................................ 1738 D. D EFINING “R ETURN ” A FTER BAPCPA .................................... 1739  J.D. Candidate, The University of Iowa College of Law, 2018; B.A., The Ohio State University, 2015. I wish to thank all the hardworking editors and student writers of Volumes 102 and 103 of the Iowa Law Review —especially Eric M. Hartmann, who piqued my interest in this topic. 1730 IOWA LAW REVIEW [Vol. 103:1729 1. Post-BAPCPA Majority View: The “One-Day-Late” Rule .............................................................................. 1739 2. Post-BAPCPA Minority View: Lower Courts .............. 1741 III. A CHORUS OF CRITICISM FOR THE ONE-DAY-LATE RULE ........... 1742 A. W HEN “P LAIN M EANING ” I S N OT P LAIN ................................. 1742 B. P REVIOUSLY P ROPOSED L EGISLATIVE S OLUTIONS .................... 1745 IV. A NEW APPROACH TO DEFINING “RETURN”: STATUTORILY ELIMINATING ALL TIMELINESS REQUIREMENTS .......................... 1747 A. R EEXAMINING BEARD V. COMMISSIONER .............................. 1747 B. H OW BEARD S HOULD H AVE B EEN A PPLIED IN P OSTASSESSMENT C ASES ........................................................ 1749 C. A N EW P ROPOSAL TO R EDRAFT THE H ANGING P ARAGRAPH .......................................................................... 1750 V. CONCLUSION .............................................................................. 1752 I. INTRODUCTION Federal courts have consistently struggled to resolve a fundamental conflict at the nexus of our country’s systems of bankruptcy and taxation. The Bankruptcy Code exists for the economically and socially beneficial purpose of releasing debtors from otherwise inescapable debt. 1 A person trapped in perpetual insolvency by mounting debt is a burden to society. 2 Absolving debts, while adverse to creditors, is better for society than allowing this cycle of impoverishment to continue. 3 The primary advantage of declaring 1 . See Fahey v. Mass. Dep’t of Revenue ( In re Fahey), 779 F.3d 1, 11 (1st Cir. 2015) (Thompson, J., dissenting) (“Our nation’s bankruptcy system was built on the principle that sometimes, honest people fall on hard times. While the bankruptcy code has naturally gone through revisions and updates since its inception, that foundational philosophy has always laid at its root.”). 2 . See Sligh v. First Nat’l Bank of Holmes Cty., 704 So. 2d 1020, 1025 (Miss. 1997) (“Our statutes upon the subject of exemptions indicate a clear public policy that exemption from personal pauperism is of greater concern than the rights of creditors.” (quoting Leigh v. Harrison, 11 So. 604, 606 (Miss. 1892))). The “very purpose” of the Bankruptcy Code “is to protect debtors from pauperism.” Id. at 1028. 3 . See In re Fahey , 779 F.3d at 17 (Thompson, J., dissenting) (“The primary purpose of the bankruptcy code has always been to ‘relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunes.’ . . . [A] ‘fresh start’ is a ‘fundamental bankruptcy concept.’” (quoting Schwab v. Reilly, 560 U.S. 770, 791 (2010); Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934))). 2018] RECONCILING THE MANDATES 1731 bankruptcy for the debtor is the possibility of ultimately absolving unpayable debts through a discharge. 4 Most debts are dischargeable in this manner. 5 Frequently at odds with the debtor’s hope of discharging debts is the government’s need to raise revenue. Collecting taxes allows the government to continue operating. 6 Income tax collection requires the individual taxpayer to self-report his or her income every year by filing a return. 7 As American taxpayers are well aware, federal income tax returns for a given year are due on April 15th of the following year. 8 Tension between the bankruptcy system and revenue collection becomes evident in the context of a debtor seeking to discharge tax liability through bankruptcy: Whereas the debtor seeks a “fresh start” 9 through the discharge of debts, the government still wants to collect taxes as a means of raising needed revenue. Generally, the ends of the bankruptcy system are given greater weight than the needs of the tax system because enforcing a tax against an individual who lacks the means to pay it will do little to raise revenue. 10 That individual may need to seek assistance—or further assistance—from welfare programs, 4 . See Saluja v. Mantra ( In re Mantra), 314 B.R. 723, 728 (Bankr. N.D. Ill. 2004) (“The discharge provided by the Bankruptcy Code is to effectuate the ‘fresh start’ goal of bankruptcy relief. In exchange for that fresh start, the Bankruptcy Code requires debtors to accurately and truthfully present themselves before the Court. A discharge is only for the honest debtor. Consequently, objections to discharge under 11 U.S.C. § 727 should be liberally construed in favor of debtors and strictly against objectors in order to grant debtors a fresh start.” (citations omitted)). 5 . See 11 U.S.C. § 523 (2012) (listing debts excepted from discharge). 6 . See Jonathan L. Mills, Comment, When a Return Is Not a Return: The Importance of a Timely Filed Income Tax Return for Discharge in a Chapter 7 Bankruptcy , 44 CUMB. L. REV. 461, 491 (2014) (“The underlying purpose of any tax is to raise revenue. While seemingly unending policy reasons exist for the various provisions in our tax laws, the overarching objective is to raise money in support of the governmental functions that our society has deemed appropriate.”). 7. I.R.C. § 6012 (2012) (requiring returns); see In re Payne, 431 F.3d 1055, 1057 (7th Cir. 2005) (“[T]he main purpose of the requirement that taxpayers file income-tax returns . . . [is] to spare the tax authorities the burden of trying to reconstruct a taxpayer’s income and income-tax liability without any help from him.”); see also Mills, supra note 6, at 491 (“Our voluntary system of filing and paying income taxes requires incentives to make the system run smoothly. If an individual does not file a tax return or fails to pay a tax liability, the individual faces consequences. These consequences include penalties, interest, additional taxes, and the threat of criminal sanctions as well. In light of these consequences, most individuals decide to file and pay their income taxes as the IRC or their state or local authorities require.”). 8. I.R.C. § 6072(a); see Ryan G. Saharovich, Comment, To Discharge or Not to Discharge: Tax Is the Question , 33 EMORY BANKR. DEV. J. 219, 220–21 (2016). An exception is made when April 15th falls on a Saturday, Sunday, or legal holiday. I.R.C. § 7503. Individual taxpayers may also be able to obtain an extension on the filing deadline. I.R.C. § 6081. 9 . See Nilsen v. Mass. Dep’t of Revenue, 557 B.R. 1, 3 (D. Mass. 2016) (“The aim of a bankruptcy proceeding is to provide debtors with a ‘fresh start.’” (citation omitted)); see also Grogan v. Garner, 498 U.S. 279, 283 (1991) (“[T]he general ‘fresh start’ policy that undergirds the Bankruptcy Code militated in favor of a broad construction favorable to the debtor.”). 10 . See Sligh v. First Nat’l Bank of Holmes Cty., 704 So. 2d 1020, 1025 (Miss. 1997) (discussing the bankruptcy system’s purpose in avoiding “pauperism”); see also 11 U.S.C. § 523 (generally allowing tax debt to be discharged except under specified circumstances). 1732 IOWA LAW REVIEW [Vol. 103:1729 thereby increasing governmental expenditures. 11 As a result, tax debts are generally dischargeable. 12 However, this principle is not absolute. The debtor’s conduct and the source of the debt often determine when tax liability is excepted from discharge, meaning the debtor remains liable to pay. 13 The Bankruptcy Code and Internal Revenue Code (“IRC”) are both creatures of federal statutory law. Unfortunately, Congress’s attempts to balance the demands of both codes have greatly frustrated both courts and debtors. The Bankruptcy Code requires a debtor to file a return for a given year before income tax liability from that year becomes dischargeable. 14 However, prior to an amendment to the Bankruptcy Code in 2005, Congress did...