Magazine article The CPA Journal

What Is an 'Honest and Reasonable' Tax Return?

Magazine article The CPA Journal

What Is an 'Honest and Reasonable' Tax Return?

Article excerpt

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 1RS, 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 tiled 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. …

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