Does IRS Bear the Responsibility to Affirmatively Obtain a Ruling from the Bankruptcy Court before Pursuing Collection after Discharge?

We welcome back guest blogger Marilyn Ames. Marilyn is retired from Chief Counsel’s office and works with Les, Steve and me on updates to the treatise “IRS Practice and Procedure” which Les edits. Since her last guest post, she has moved from Alaska back to Texas where she lives much nearer to her grandchildren. She writes today about a recent First Circuit opinion that imposes a liability on the IRS for failing to prove that a debt was excepted from discharge. The failure of proof resulted from an unusual situation; however, the important issue in the case focuses on the responsibility of the IRS at the conclusion of a bankruptcy case. I have written about the fraud exception to discharge on several occasions. Here is a sample post on the topic if you want background on the underlying discharge issue. Keith

Both the Internal Revenue Code and the Bankruptcy Code are statutory schemes of almost mind-numbing complexity, and when the two collide, the results are generally ugly. Such was the case in Internal Revenue Service v. Murphy, a case of first impression from the First Circuit issued on June 7, 2018, which can be found here. The majority opinion, as noted by the dissent, has the result of “hiding an elephant in a mouse hole” and could significantly change the ability of the Internal Revenue Service to collect debts that are otherwise not discharged in a bankruptcy case.

The hiding of the elephant began in 2005, when Mr. Murphy filed a Chapter 7 bankruptcy, listing debts of $601,861.61. Of that amount, $546,161.61 was owed to the Internal Revenue Service for unpaid taxes for a number of years, and to the State of Maine for one year. The bankruptcy court entered Mr. Murphy’s discharge in February of 2006, which provided that the “discharge prohibits any attempt to collect from the debtor a debt that has been discharged.” For those without either personal or professional experience with a Chapter 7 discharge order, it does not list the specific debts that are or are not discharged. The Internal Revenue Service was given notice of the entry of the discharge.

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For three years after the entry of the discharge, the Internal Revenue Service informed Mr. Murphy that it believed his tax debts were not discharged under the provisions of Bankruptcy Code § 523(a)(1)(C), as Mr. Murphy had either filed fraudulent returns or had made some other “attempt to evade or defeat [these] taxes in any manner.” In 2009, the Internal Revenue Service levied on property belonging to Mr. Murphy, which caused him to file suit against the Internal Revenue Service in the bankruptcy court, seeking a declaration that the tax liability had been discharged. Although the IRS continued to take the position that the taxes were nondischargeable as they were due to Mr. Murphy’s fraudulent actions, the AUSA did little to present evidence to show this when Mr. Murphy filed a motion for summary judgment, and the bankruptcy court granted the summary judgment motion, holding that the taxes were discharged. The government did not appeal. The AUSA was subsequently diagnosed with a form of dementia, and had probably been experiencing it when he defended the Internal Revenue Service in the dischargeability case.

Mr. Murphy then filed a complaint under Internal Revenue Code § 7433(e), seeking damages for willful violation of the injunction created by the discharge in the bankruptcy case. After some initial procedural skirmishing over the effects of the earlier discharge litigation and the AUSA’s illness, the Internal Revenue Service agreed that the summary judgment ruling determined that the taxes were discharged, and to the amount of the damages Mr. Murphy had suffered. The only issue remaining was the question of whether the Internal Revenue Service had willfully violated the discharge injunction such that Mr. Murphy was entitled to monetary damages under Section 7433(e).

The bankruptcy court held that Mr. Murphy was entitled to damages, as the term “willfully violates” means that “when, with knowledge of the discharge, [a creditor] intends to take an action, and that action is determined to be an attempt to collect a discharged debt.” The bankruptcy court’s decision was affirmed by the district court, and the Court of Appeals also found in favor of Mr. Murphy, agreeing that the Internal Revenue Service only had to intend to take the actions resulting in collection of the discharged taxes. A good faith belief that the taxes were not dischargeable was not a defense. The Court of Appeals also rejected the IRS argument that because Section 7433(e) is a waiver of sovereign immunity, it must be construed narrowly by permitting a good faith defense. The end result of the Court of Appeals’ opinion is that, for all practical purposes, the Internal Revenue Service must litigate dischargeability before it begins collection of taxes it reasonably believes have not been discharged, or risk having monetary damages imposed against it. This requirement of pre-collection litigation, not contained in the Bankruptcy Code, is the elephant the dissent believes the majority is hiding in a mouse hole.

As noted by Judge Lynch in the dissenting opinion, the majority got this one wrong. In reaching its decision, the majority opinion creates a standard of near strict liability by stripping the government of a reasonable good faith defense, rather than reading this waiver of sovereign immunity narrowly and construing ambiguities in favor of the sovereign, as generally required. Judge Lynch notes that the majority picks and chooses among circuit and lower court opinions in reaching its definition of willful violation, ignoring a Supreme Court opinion issued in Kawaauha v. Geiger, 523 US 57 (1998), a case decided just months before Section 7433(e) was passed. (This is an interesting omission by the majority, given that retired Supreme Court Justice David Souter was one of the two judges signing on the majority opinion.) In Kawaauhau, which interpreted the phrase “willful injury” in connection with another provision of Bankruptcy Code § 523, the Supreme Court held that the word “willful” modified “injury” and required a deliberate or intentional injury, rather than merely a deliberate or intentional act that leads to injury. The same rationale would appear to apply to Internal Revenue Code § 7433(e), leading to the dissent’s conclusion that a “willful violation” requires a deliberate or intentional violation, not just a deliberate or intentional act. If the IRS acts reasonably and in good faith, the violation cannot be willful. Judge Lynch notes that this conclusion is consistent with other Supreme Court decisions construing the phrase “willful violation.”

But Judge Lynch’s most convincing argument is that the majority’s opinion changes the tax collection scheme without an express mandate from Congress. Under the majority’s opinion, the Internal Revenue Service must first go to court and prove the taxes are still owed before instituting any collection action after a discharge, even though not expressly required by Bankruptcy Code § 523. The treatment of tax liabilities under Section 523(a)(1)(C) should be compared to the debts listed in Bankruptcy Code § 523(c)(1). For these types of debts, Congress has provided that they are automatically deemed to be included in the discharge injunction unless the creditor obtains a judicial determination that the debt is not discharged. When Congress wanted a creditor to sue first, then collect, it knew how to provide for it. It did not hide the requirement in a statute allowing for damages that is not even in the Bankruptcy Code, but in a provision of the Internal Revenue Code. An elephant in a mouse hole, indeed.

 

 

Mr. Smith Continues to Suffer from His Failure to File and Other Updates on Late Filed Returns

I have not written about the one day late rule in bankruptcy cases for some time. The litigation has cooled off, but the final fate of the issue remains unresolved. See prior posts on the issue here, here, here, here, and here if you need a reminder of the problems taxpayers suffer in bankruptcy when they fail to timely file their returns. While the tide seems to have turned against the one day rule which set up an absolute bar to discharge, taxpayers in circuits other than the 1st, 5th, and 10th still suffer the consequences of filing late as well. Mr. Smith is one.

Mr. Smith brought the case that is currently the leading opinion regarding the discharge of taxes on a late filed return in the 9th Circuit. Though the 9th Circuit declined to adopt the one day rule, it still found that Mr. Smith did not discharge his tax liability in a case in which the IRS had filed a substitute for return before he filed Form 1040 for the year at issue. In a case decided on March 7, 2018, the District Court for the Northern District of California turned back Mr. Smith’s latest effort to rid himself of the liability stemming from failing to timely filing his 2001 return and having the IRS do it for him.

In addition to recounting Mr. Smith’s latest travail, I discuss two recent lower court opinions on the failure to timely file issue.

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Mr. Smith failed to timely file his 2001 return, eventually leading to the IRS preparing a substitute for return. Seven years after his return was due and three years after the IRS assessed a liability based on the SFR, he filed a Form 1040 reporting about $40,000 more than the IRS assessed. After submitting the Form 1040, he waited more than two years before filing his bankruptcy petition. The IRS agreed with Mr. Smith that the $40,000 liability shown on the late filed Form 1040 was discharged but argued that the liability shown on the SFR was not. The 9th Circuit agreed with the IRS.

Having taken his case to the Circuit Court and lost, Mr. Smith now returns to the bankruptcy court with new arguments in an attempt to rid himself of the tax assessment created by the SFR. First, he argues that since the 9th Circuit found his Form 1040 was a nullity he is entitled to “an abatement of taxes since the IRS lacked authority to assess the additional tax amount of $40,095 based on the Form 1040” he filed seven years late. Second, he argues that because he is forever barred from filing a 2001 return, he should receive declaratory judgment relief that he need not comply with I.R.C. 6012. Third, he moves for a class action seeking a declaratory judgment for all taxpayers who failed to timely file a return resulting in an SFR who lacked reasonable cause and another class action for those taxpayers who filed Form 1040 that did not constitute a return.

The bankruptcy court found that Mr. Smith lacked standing to bring this action. It also found there is no actual controversy with respect to the $40,095 assessment. Additionally, the court pointed out that even if he had standing to sue, I.R.C. 6404(b) states that “no claim for abatement shall be filed by the taxpayer in respect of any assessment of any tax imposed under Subsection A.” Further, the court found that the Anti-Injunction Act also bars the relief he sought and no waiver of sovereign immunity exists. The arguments put forth by Mr. Smith basically allowed the bankruptcy court to touch almost all procedural bases for dismissing a case.

The bankruptcy court shows no sympathy for Mr. Smith since he created his own problem, he moves to almost tax protestor like arguments, and he provides the court with no legal basis for granting the relief he sought. The case demonstrates the frustration of owing a non-dischargeable tax especially when it would have been relatively easy for the taxpayer to avoid the problem. The case also shows the limitations of trying alternative arguments to the straightforward discharge argument under B.C. 523(a)(1)(B) as well as the limitations of seeking to bring a class action to stop the IRS by seeking a declaratory judgment.

Smith shows the limitations of continuing to fight about the discharge when taxpayer files a late return. Two cases on this issue were recently decided, Word v. IRS and IRS v. Davis, in which taxpayers filing late returns did not receive a discharge. These cases deserve brief mention in the continuing saga of the two decade old issue.

In Wood, the taxpayers filed a chapter 7 petition on May 29, 2015. The issue turned on whether their 2010 return was filed. Mr. Wood passed away before the trial occurred. Mrs. Wood testified that they routinely prepared and filed their returns over a 20 year period and that Mr. Wood, a CPA, would prepare it, discuss it with her, and then file it. She presented a filed extension and a copy of the return signed by her and her husband on September 19, 2011; however, the IRS denied ever receiving the return. The IRS put on testimony of a bankruptcy specialist who searched the IRS records and found no evidence of a return. The Court found that Mrs. Word’s testimony about what happened could not overcome the IRS records regarding lack of receipt. Mrs. Wood was hampered in presenting her case because her husband had handled the mailing of the return. The Court expressed sympathy but could not get past the absence of evidence to overcome the presumption of regularity in the IRS records.

Based on the fact that the issue arises in the bankruptcy context, I presume that the taxpayers filed the return, or planned to file the return, without remittance or with only partial remittance; however, I would have liked some discussion about that fact. It seems that she should have known about the remittance aspect of the case and that would have made her story more convincing. The couple also owed for 2009 and may have filed the 2009 return without remittance as well since no mention is made in the opinion of audits. Almost no returns have prior credits exactly equal to the liability shown on the return. Taxpayers generally talk about the monetary consequences of filing a return and anticipate results based on those consequences, e.g., anticipating a refund check or anticipating an immediate bill. The discussions surrounding the money may have provided her with more detail about the mailing of the return with which she could have persuaded the bankruptcy court or the absence of those discussions may have been persuasive.

The Wood case does not present the same issue as Smith and the line of cases involving late filed returns. Rather, it presents the straightforward issue of whether the taxpayers filed a return. Although a slightly different issue, the issue of whether the taxpayer filed a return in the first place regularly presents itself in these cases.

In Davis, the IRS brings an appeal of a bankruptcy court decision and the district court reverses based on the Third Circuit’s recent decision regarding late filed returns. Mr. Davis failed to timely file his 2005 and 2006 returns. The IRS prepared SFRs and made assessments based on the SFRs. Subsequently, he filed Forms 1040 for the two years, waited more than two years, and filed his chapter 7 bankruptcy petition on July 12, 2012. After receiving his chapter 7 discharge, he filed a chapter 13 petition on August 11, 2014. The fight over the impact of the chapter 7 discharge arose in the chapter 13 case when the IRS filed a proof of claim asserting a tax due on 2005 and 2006. The bankruptcy court held that filing the Forms 1040 and waiting two years before filing bankruptcy allowed him to discharge the taxes. Subsequent to the bankruptcy court’s decision discharging the tax debt for the late filed returns, the Third Circuit issued its opinion in Giacchi v. United States, 856 F.3d 244 (3d Cir. 2017). In that opinion, blogged here, the Court found that filing a Form 1040 after the IRS made an assessment based on an SFR did not meet the part of the Beard test requiring “an honest and reasonable attempt to comply with tax law.” The Third Circuit did not say that a debtor in these circumstances could never satisfy the fourth prong of the Beard test, but it provided no guidance on how a debtor might do so.

The IRS argued in the Davis appeal that his case did not involve close facts and the district court agreed. The most interesting aspect of the case may not involve the application of Giacchi, but how the IRS was able to take the appeal. I have not gone back to read the motions filed but it appears that the debtor may have kept open the time for the IRS to bring an appeal of the bankruptcy court decision by seeking to directly appeal to the Third Circuit in the original case and then failing to follow through, but in the process keeping the door sufficiently open to allow the IRS to appeal the adverse bankruptcy decision to the district court. The short shrift the district court gives to the arguments of Mr. Davis suggests that in the Third Circuit the fact pattern of an SFR assessment prior to the filing of the Forms 1040 may be fatal to the attempt to discharge the liability.

 

IRS Claims in Bankruptcy

A pair of recently decided cases address the validity and the amount of the claim of the IRS in bankruptcy.  Each case offers a small lesson on such claims.  In In re Yuska, No. 14-01504 (N.D. Iowa April 6, 2018), the debtor attacked the IRS claim because the bankruptcy specialist checked the wrong box on the claim form.  In United States v. Austin, No. 17-6024 (B.A.P. 8th Cir. April 9, 2018), the court determined the value of the IRS secured claim, secured by virtue of a chose in action held by the debtor.  Neither case reaches a surprising result, though the bankruptcy court’s decision in Austin, overturned by the Bankruptcy Appellate Panel in the case discussed here, did produce a surprising result and one which the IRS appealed on a valuation matter because of the legal issue involved.

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In Yuska, the debtor owed the IRS over $1 million, which the court had previously determined in an adversary proceeding.  From the court’s description of Mr. Yuska’s arguments, I believe he qualifies as a tax protestor.  In this follow-up matter, he attacks not the validity of the underlying liability but the validity of the claim of the IRS filed in the proceeding.  He argues that in preparing the claim, the IRS bankruptcy specialist checked the box on the claim indicating that she was the creditor rather than checking the box that she was filing the claim as an agent of the creditor.

The first argument of the IRS in the case sought a decision based on res judicata due to the prior adversary proceeding determining Mr. Yuska’s liability.  The court did not base its decision on its prior determination regarding the amount of the liability but looked instead to the basis for objecting to a claim.  It held that the following bases for objecting to a claim exist:

1) The claim is unenforceable against the debtor and property of the debtor;
2) The claim is for unmatured interest;
3) The claim is for a tax assessed against property of the estate and exceeds the value of the interest of the estate in such property;
4) The claim is for services of an insider or attorney of the debtor and exceeds the reasonable value of such services;
5) The claim is for a debt that is unmatured on the date of the filing of the petition and that is excepted from discharge under section 523(a)(5) of this title;
6) The claim is the claim of a lessor for damages resulting from the termination of a lease of real property and meets other criteria;
7) The claim is the claim of an employee for damages resulting from the termination of an employment contract and meets other criteria;
8) The claim results from a reduction due to late payment in the amount of an otherwise applicable credit available to the debtor in connection with an employment tax on wages, salaries, or commissions earned from the debtor; or
9) The proof of such claim is not timely filed…

The court found that unless the objecting party meets one of these objections, the court shall determine the amount of the claim and shall allow such claim in that amount.  Here, the complaint of the debtor raises a technical issue related to the preparation of the claim form.  The IRS agrees that the employee checked the wrong box but argues that this technical deficiency does not invalidate the claim.  The court pointed out that Bankruptcy Rule 3001(a) requires that a claim conform substantially with the official form published by the rules.  The court finds that the form filed by the IRS substantially complies with the rules, that common sense should not disallow a claim based on a small technical failure, and that the debtor himself recognized in his pleadings that the IRS employee was not the true claimant against the estate.  So, it determines that the IRS has a valid and binding claim.

In Austin, the debtor had a workman’s comp lawsuit pending at the time of filing the bankruptcy petition.  Prior to the filing of the petition, the IRS had filed a notice of federal tax lien.  So, the IRS would have a secured claim in the value of the lawsuit (minus the attorney’s fees for bringing the suit.)  The issue presented is the value of the suit.  The issue can regularly arise in bankruptcy cases; however, cases attacking the value are not commonly reported.

In their schedules, the debtors listed the suits as contingent and unliquidated exempt property and valued the claims at $0.00.  Debtors objected to the secured claim of the IRS assigning value to the lawsuits and argued initially that the value of the IRS lien in these suits was $0.00.  The bankruptcy court determined that the suits had some value and overruled the objection.  While that litigation was pending, the debtor negotiated a settlement netting $15,661.00 after attorney’s fees.  The IRS learned of the settlement and amended its claim to reflect that amount as the value of its secured claim.

The debtors’ objected to the amended secured claim of the IRS, arguing that the value of the claim was not equal to the amount of the settlement.  They attached an affidavit of their attorney who “opined that the worker’s compensation claims had a nuisance value of $3,000 on the petition date.”  The IRS responded that this affidavit was not substantial evidence contradicting their claim and that under B.C. 502 the claim is presumed correct unless an objection to the claim is filed and supported by substantial evidence.

The court found that “substantial evidence means ‘more than a mere scintilla.  It means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.’  Substantial evidence requires financial information and factual arguments.  Here the Smallwood Affidavit does not contain the financial or factual information necessary to support Mr. Smallwood’s opinion of value.”  Debtor’s attorney basically argued that they did not have much of a case and only by his skill did he obtain a settlement of over $20,000.  The court points out that no matter how wonderful Mr. Smallwood was it was the debtors’ claim that formed the basis for the recovery.  It also found that presenting evidence by way of affidavit prevented the IRS from its opportunity to cross examine.  It stated that “allowing a valuation of a tort claim without a reasonable factual basis encourages abuse.”

So, the court found the debtors failed to present substantial evidence sufficient to overcome the presumption of validity in the claim.  The court did not discuss the fact that a secured claim is not static in value.  Even if the value of the tort claim was $3,000 at the outset of the case, the value of the claim could rise if the property to which the lien attach rises in value.  The case provides an interesting glimpse at the amount of proof needed to win an objection regarding the value of property but I wanted it to also discuss the ability of a secured claim to rise or fall in value.  That ability is why creditors seek to lock in value through cash collateral proceedings at the outset of a bankruptcy case.

Priority Status of Individual Mandate Tax Obligation

In In re Chesteen, No. 17-11472 (Bankr. E.D. La. 2-9-2017), the bankruptcy court determined that the liability imposed by the individual mandate is not a tax but a penalty. The consequence of that determination is that the IRS has a general unsecured claim in the debtor’s bankruptcy case and not a priority claim. With the elimination of the individual mandate last year, this decision may not have a significant impact; however, it is another in a series of cases pairing back items in the IRC that are classified as tax for purposes of the bankruptcy code. Guest blogger Bryan Camp teed up this issue and correctly predicted the outcome in a post in 2016.

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The debtor failed to sign up for health insurance. That failure resulted in a liability to the IRS. He filed for chapter 13 bankruptcy on June 8, 2017. Both the debtor and the IRS filed multiple schedules or claims listing varying amounts of priority tax liability; however, in the final claim filed by the IRS it listed, inter alia, the amount of $695.00 due for 2016 as an excise tax entitled to priority status. The debtor objected to the claim, arguing that it was not a tax but a penalty.

Excise taxes that arise within three years of the filing of a bankruptcy petition receive priority status pursuant to BC 507(a)(8)(E)(i). The individual mandate liability is imposed under IRC 5000A and is labeled as an excise tax. The label placed on a liability by the Internal Revenue Code does not control the character of a debt for bankruptcy purposes. As we have discussed previously here, and here, the Supreme Court has determined that a liability labeled as a penalty under IRC 6672 is, for bankruptcy purposes, a tax in Sotelo v. United States, 436 U.S. 268, 275 (1978) and that an excise tax under IRC 4971(b) is, for bankruptcy purposes, a penalty in CF&I Fabricators, 518 U.S. 213, 224 (1996).

The court in Chesteen cites to Sotelo and CF&I Fabricators and numerous other cases that have decided this issue. To decide whether the individual mandate is a tax or a penalty, the court must determine whether the primary purpose of the individual mandate serves to support the government or punish and discourage certain conduct. The court cited CF&I Fabricators for the proposition that the proper analysis turns on whether the liability acts more like a penalty or more like a tax. The IRS argued that the individual mandate excise tax had many characteristics similar to the trust fund recovery penalty imposed by IRC 6672. The court rightly rejected that argument. The individual mandate bears little resemblance to the TFRP in form or substance; however, that does not necessarily mean that it is a penalty.

The court found that it is “designed to deter citizens from living without health insurance.” While true, that also does not necessarily control the determination. Many taxes seek to encourage or deter certain behaviors. If ever tax that influenced behavior or, sticking to the negative side, tried to keep people from doing certain things the number of liabilities imposed in the IRC which achieved the label of tax for bankruptcy purposes could be quite small. Here, the court looked also at the limitation imposed on the collection of the individual mandate. The severe limitation on the IRS collection function with respect to this tax influenced the court in its thinking of the special nature of this liability.

The court also looked at the label Congress placed on the individual mandate. In the statute imposing this liability, Congress referred to the liability 18 times as a penalty and none as a tax. While not controlling, this labeling certainly played an influential role in the thinking of the court.

Conclusion

To my knowledge, this decision represents the first bankruptcy court to render an opinion on the character of the individual mandate. The court follows traditional analysis in reaching the conclusion that the liability falls more on the penalty side of the equation than the tax side. Much about provisions placed into the Internal Revenue Code such as the Affordable Care Act will fail traditional tests of tax. As Congress loads more and more non-traditional liabilities into the IRC, practitioners should push back hard on the label of tax which results in priority status, which results in non-dischargeability. These types of issues will continue to provide a battleground for the IRS.

 

Dischargeability of the First Time Homebuyer Recapture Liability

In Betancourt v. United States, the bankruptcy court for the Western District of Missouri addresses an issue of the character of a debt owed to the IRS as it determines the dischargeability of that debt.

The taxpayer seeks a determination that this type of debt gets discharged in bankruptcy because it does not fall within any of the enumerated exceptions to discharge that apply to taxes. The court finds for the taxpayer. Although the issue here is narrow and has scarcely be litigated, it points to the problem the IRS can have when a debt does not conform to norms for tax debt and the IRS seeks to prevent a discharge.

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Ms. Betancourt purchased a home in Liberty, Missouri in 2008. She claimed the first-time homebuyer credit and received a $7,500 credit on her 2008 return. To obtain the credit, she needed to purchase a home for the “first time”, between April 9, 2008 and May 1, 2010. However, Congress was not just concerned with the initial purchase and added in the law a requirement for repayment of the credit over a 15-year period in certain circumstances. For those unfamiliar with this credit, some links to the IRS descriptions of the credit, here, here, here and here, may help in understanding the issue. Ms. Betancourt argues that the debt for repayment of the credit relates either to 2008 when she received the credit or 2010 when her repayment period began. Based on when she incurred the debt she argues that it is not entitled to priority status and neither is it excepted from discharge.

The IRS argues that the recapture obligation arises each year and that for the years starting with 2017, when she filed bankruptcy, the debt is a future debt contingent upon events that have not yet occurred and, therefore, it did not need to file a claim for this future debt and the future debt was not discharged by the bankruptcy case. It filed a claim for $39.00 as a priority amount because that was the amount of unpaid repayment due at the time of the filing of the bankruptcy petition. The IRS relied on the decision in In re Bryan, 2014 WL 789089 (Bankr. N.D. Cal. 2014), in which the court characterized the obligation to repay the new homebuyer’s credit as a non-dischargeable tax rather than a dischargeable general obligation. Bryan held that the obligation to repay was a tax obligation and that characterization triggers the application of the discharge provisions for taxes rather than for general claims.

At issue here is both the character of the debt as tax and the character of the debt as a fixed future obligation or an obligation so contingent as to fail to meet the broad definition of the word claim. Rather than viewing the repayment obligation as a tax obligation, the court in Betancourt views the transaction as a loan when viewing all of the parts of the transaction. If the credit and its repayment obligation has the character of a loan rather than a tax, then the bankruptcy outcome is completely different. The court cited an IRS Information Release, IR-2008-106, which states “the credit operates much like an interest free loan because it must be repaid over a 15 year period.” Form 5405 is subtitled “Repayment for the First Time Homebuyer Credit” and the instructions for the Form repeat the term “repayment.” There are other bankruptcy cases in which the courts have looked at the substance of the transaction in characterizing the nature of a liability in order to determine its status as a claim in the bankruptcy case. Two of the most famous examples of this are Sotelo v. United States, 436 U.S. 268 (1978), in which the Supreme Court characterized the trust fund recovery penalty of IRC 6672 as a tax rather than a penalty because it is a provision designed to allow the IRS to collect the underlying tax and not one imposing a penalty on the person assessed. In 1996, the Supreme Court in United States v. Reorganized CF&I Fabricators of Utah, Inc., 518 U.S. 213 (1996) determined that the excise tax imposed by IRC 4971 for late payment of funds into a pension plan was not a tax but rather was a penalty, calling into question the character, for purposes of filing a bankruptcy claim, of a whole host of excise taxes imposed for wrongful behavior or to discourage “sin,” such as the excise taxes on cigarettes and alcohol.

In addition to the tax versus loan issue, the court also raises the issue of what constitutes a debt. This is a much litigated issue in bankruptcy because it goes to the core of when a claim must be filed and when the discharge provisions come into play. The court cites to the precedent on this issue in support of its conclusion that the IRS possesses a right to payment which triggers an obligation to file a claim against the estate and not to rely on future repayment as a basis for arguing the debt is not a claim.

The court finds that the right to payment arose before the filing of the bankruptcy petition, which fits within the definition of claim in B.C. 101(5)(A). It determines that this prepetition debt is not a priority tax obligation but a non-tax one. Stripped of its tax veneer, the debt loses its exception to discharge and the court determines that the repayment obligation is dischargeable.

Conclusion

I do not know if the IRS will appeal this decision. The decision could impact a decent number of individuals who benefitted from the first time homebuyer credit and whose obligation to repay has not yet run. Any dischargeability determination like this has consequences for anyone who has gone through bankruptcy with this type of debt since they could still bring a discharge action even if the bankruptcy ended some time ago. If correct, the decision would mean that the IRS probably has a number of discharged debts on its books that it continues to attempt to collect in violation of the discharge injunction. The decision could also implicate other situations in which Congress chooses to use the tax code to front money to taxpayers as it did here in an attempt to spend our way out of the great recession. If Congress is concerned about the loss of priority status here, it may need to structure similar provisions differently in the future to make sure that they do not lose their character as tax debt and to make sure, if they want these types of debt to retain priority claim status throughout the repayment period, that the debt arises anew each year (or something to keep it new enough for priority status). The court seems clearly right on the issue of whether this debt meets the requirements of being a claim. The tax versus non-tax character of the debt is closer since the taxpayer is repaying a tax benefit, but I cannot say that the court was wrong on that aspect of its decision either.

 

Bankruptcy Cases Involving Evasion of Payment and Classification of the Failure to File Penalty

A pair of recent bankruptcy cases deserve some mention. Conard v. IRS and In re Colony Beach & Tennis Club take a look at IRS claims from two perspectives and provide some insight on whether a bankruptcy petition will prove beneficial in certain circumstances. In the Conard case, the husband gets no relief but his wife will get the opportunity to fully litigate the issue of discharge. In Colony Beach, a defunct partnership’s liability gets classified in a way that will help other creditors of the debtor if not the debtor itself; however, in fashioning the equitable remedy that subordinates the IRS claim, the bankruptcy court loses sight of the true party to blame for the problem and creates an inequitable result at odds with earlier precedent and good sense.

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Evasion of Payment

Conard involves the application of facts to BC 523(a)(1)(C). This bankruptcy code section excepts from discharge tax debts incurred through evasion of a tax debt either in the filing or a return or the payment of the tax. The Conrads’ case involves evasion of a tax debt though efforts taken not to pay the tax. The amount of the liability was not in dispute and the IRS did not argue that the Conards did anything to keep the IRS from knowing the correct amount of the liability. Instead, the IRS seeks to deny the Conards a discharge because they have attempted to evade payment of the debt prior to filing their bankruptcy petition. The IRS must prove by a preponderance of the evidence that the Conards did not pay their taxes in an improper effort to avoid doing so. Guest blogger Lavar Taylor discussed this issue previously here and here. I wrote about it here, in a case involving evasion of the creation of the liability and not evasion of payment but the post has links to a couple of earlier discussions of the issue.

Mr. Conard operated a life insurance agency in Northern Virginia. The case caused me to notice that in the district where I practiced bankruptcy law while representing the IRS a new bankruptcy judge had been appointed, Judge Keith Phillips, who I knew and liked as a practitioner. Judge Phillips describes Mr. Conard as someone who “chose to put his federal tax obligations ‘on the back burner’ in favor of paying business expenses ‘to keep the business … afloat’ and expanding his business to generate more income.” Mr. Conard placed his federal taxes so far on the back burner that by the time he arrives in bankruptcy court he owed the IRS almost $700,000 for the years 2004-2009.

Of course, as is common in these types of cases, he made purchases that make it very difficult to have sympathy for him. He bought an $86,000 Mercedes Benz, a $47,000 BMW, a $50,000 Buick Lacrosse, and a $4,000 Harley motorcycle. In addition, he spent $48,000 on his son’s tuition as well as a litany of other goods and services that did not reflect the lifestyle of someone scuffling to get by. Judge Phillips found Mr. Conard’s case so straightforward that he ruled for the IRS on a motion for summary judgment. He finds, citing cases from the 3rd, 5th, 6th and 10th Circuits, that the IRS need to meet the criminal standard of beyond a reasonable doubt for evasion of payment.  The IRS needs to prove that Mr. Conrad attempted to evade the payment of his taxes – essentially the same, if not the same, proof as in a 7201 evasion of payment case; however, the proof does not need to be beyond a reasonable doubt or even clear and convincing in order to have the taxes determined to be excepted from discharge under BC 523(a)(1)(C).  The IRS can have the taxes excepted from discharge if they can prove the attempt to evade payment by a preponderance of the evidence.

However, the Court determined that the IRS had not shown that Mrs. Conard was sufficiently willful in not paying her taxes. It refused to rule on summary judgment with her and will hold a trial to determine her role in the non-payment. I do not know enough about the case against her to have an opinion. With respect to Mr. Conard, he presents the classic case of someone excepted for discharge for seeking to avoid the payment of taxes. If you are not going to pay your taxes, try not to purchase expensive cars and other big ticket items during the period of non-payment.

Reasonable Cause and Equitable Subordination

The Colony Beach case involves a situation in which the IRS seeks to have a penalty claim elevated to administrative claim status. If the claim achieves that status, it will get paid before all other unsecured claims. The debtor, a limited partnership, filed its chapter 11 bankruptcy petition in October, 2009, but by August of 2010 it followed the path of many businesses that start in chapter 11 and converted to a chapter 7 liquidation. It was a fiscal year taxpayer whose year ended on April 30. The return for the year ending in 2011 was initially due July 15 and the extended due date, had it requested an extension, would have been due on January 15, 2012. The trustee filed the return on January 7, 2012 apparently operating under the mistaken impression that his accountant had requested an extension. Because neither the trustee nor his accountants requested an extension, even though they could have done so, and because this penalty applies at the partnership level, the IRS filed a proof of claim for a penalty of $356,695.46.

The trustee, the same person who filed the return late, objected to the claim arguing that reasonable cause existed for late filing. Additionally, the trustee argued that it would be inequitable to allow the IRS to have a priority claim for the penalty and get paid ahead of all other unsecured creditors of the bankruptcy estate. (I do not know exactly how much money was in the estate but it is possible that the penalty claim made the estate “administratively insolvent” which would have meant the trustee would not receive his full fees.)

The first sentence of the reasonable cause portion of the opinion contained a citation to Boyle, which I have noted before is almost always a signal that things will not go well for the party arguing reasonable cause. My use of Boyle as a predictor on this point proved accurate again. The trustee argued that he was involved in “complex litigation which required his full attention.” He also argued that the business was in disarray impeding his ability to reconcile accounts. These all seem like reasons for requesting an extension of time to file which would only have taken a few moments and would have bought the trustee the time he needed to put things together. The court pointed out that the trustee did not file an application to employ accountants to prepare and file the 2011 return until five days before the extended deadline for filing the return. He testified that he thought the debtor’s former accountants would take care of requesting an extension though he never checked on whether they had done so. Consequently, the court had little trouble turning back his reasonable cause claim.

“Nevertheless, it is appropriate in this case to deny the United States’ claim as an administrative expense under 503(b) and to equitably subordinate it.” So, losing the reasonable cause argument in this case does not have any apparent negative impact on the trustee or most of the creditors of the estate. The court notes that penalties can achieve administrative claim status; however, to do so they must relate to a tax incurred by the estate. Here, the taxes related to the late file return are the responsibility of the partners and not the partnership in bankruptcy. So, the claim does not qualify for administrative claim status under section 503((b)(1)(C).

The IRS wants this money so it argued even if the penalty claim does not qualify under (b)(1)(C) it should qualify as a “generic” administrative expense, citing In re 800Ideas.com, Inc., 527 B.R. 701, 702 (Bankr. S.D. Cal. 2015). That case involved a late filed S Corporation return which had the same tax passthroughs as the partnership return and the same late filing penalty application at the corporate level. The bankruptcy court here, acknowledging the appropriateness of the citation, declines to accept the reasoning of that case concluding that “it is appropriate to give meaning to the exclusion of penalties that are unrelated to taxes owed by the bankruptcy estate.” The court also points out the real elephant in the room which is the impact of allowing the penalty claim as an administrative claim on the unsecured creditors who had no hand in the late filing of the return.

Here is where I disagree with the court. It states that in the 800ideas.com case “the impact of the penalty fell on the trustee because the claim, as an administrative expense, reduced the trustee’s compensation.” The court further states that in this case “the trustee will be paid in full, regardless of the United States’ claim receiving administrative status or not….” That makes no sense. The court could have the IRS claim for the late penalty paid in lieu of the trustee’s payment and subordinate the trustee’s payment, to the extent of the penalty claim to general unsecured status. The trustee in this case need not be paid in full while the IRS gets stiffed on its penalty claim that arose because of the trustee’s failure. I totally agree with the court that this penalty should not be borne by the other unsecured claimants but allowing the trustee to take ahead of the IRS cannot be reconciled with equity.

Conclusion

The bankruptcy court in 800ideas.com understood how to fashion an equitable remedy in this situation. I hope the IRS appeals the case to a district judge who has a similar understanding of equity. If the trustee in a situation like this receives his full fee, he learns that filing late has no consequence. That should not be the lesson learned from filing late. This court loses sight of how to fashion an equitable remedy no matter how sorry one feels for a busy trustee.

 

 

Avoiding the Federal Tax Lien Securing Penalties in a Bankruptcy Case

The case of Hutchinson v. United States [No. 17-01076] (E.D. Cal. 2017) involves an effort by taxpayers in bankruptcy to avoid a federal tax lien securing the payment of penalties. The bankruptcy court denies the effort by the taxpayers to avoid the lien while acknowledging that the bankruptcy trustee could have avoided the lien had the trustee sought to do so. As discussed below, the reason that the bankruptcy court allows one party, the trustee, to avoid a federal tax lien securing penalties but not another party, the debtor, results from the benefit Congress sought to confer in allowing avoidance of the federal tax lien securing penalties in a chapter 7 case.

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The taxpayers owed $162,690 in penalties at the time they filed their bankruptcy petition. Prior to the filing of the petition, the IRS had filed a notice of federal tax lien in the city or county in which their residence was located. In their bankruptcy schedules, taxpayers indicated that the value of their home was $185,000 and that it was encumbered by a first deed of trust in the amount of $87,000. They claimed a personal exemption of $100,000. Because they lived in California, which has a generous exemption provision for personal residences, this was possible. Not all states have such a large exemption for personal residences.

Taxpayers’ problem with the exemption was that it removed the property from the bankruptcy estate allowing them to keep the property and the home equity; however, the federal tax lien continued to attach to the property after bankruptcy putting them in the position of going through the bankruptcy only to find that on the other side they had not obtained the relief they needed. Because the federal tax lien still attached to the home, the IRS had/has the ability to sell the home either administratively or through a foreclosure proceeding. The taxpayers presumably sought to avoid the lien in their case in a post bankruptcy discharge action in order to keep the IRS from taking their home and using the equity in excess of their first mortgage to satisfy the tax debt.

Before discussing the Hutchinsons’ case further I stop to note that the IRS is generally very reluctant to take taxpayers’ homes. Before 1998 it did not take taxpayers’ home frequently, but after the Restructuring and Reform Act of 1998 the IRS very rarely takes taxpayers’ homes or other tangible property. The situation gets a little stickier for the IRS in the post bankruptcy situations. Absent bankruptcy, the IRS can simply take no collection action operating under the fiction that the statute of limitations on collection is still open and it might collect from the taxpayers through some mechanism other than seizure and sale of property. No one at the IRS is forced to make a decision concerning collection and the general practice of only seizing tangible assets in rare circumstances usually results in a decision to do nothing which is different than an affirmative decision to walk away from the only property that could satisfy the liability.

When a taxpayer obtains a bankruptcy discharge and before the filing of the bankruptcy petition the IRS  a filed federal tax lien for the discharged taxes discharged, someone at the IRS must make an affirmative determination whether to pursue collection from any assets the taxpayer brought into the bankruptcy estate to which the federal tax lien attached. The equity available in a debtor’s property such as the home equity available in the Hutchinsons’ case is the only thing from which the IRS can collect to satisfy the discharged liability because the bankruptcy discharge turned what was an in personam liability into an in rem liability.  The rem, or the thing securing the debt, in the Hutchinsons’ case, their house, is the only asset the IRS has from which it can satisfy the liability. Someone at the IRS must make an affirmative determination to release the lien.  In this situation the IRS employee assigned to the case cannot rely on the fiction that the IRS might later collect the liability from future earnings or a voluntary payment. The IRS employee knows that if they release the lien they are walking away from $100,000 in equity and that the only way to collect the $100,000 is to enforce the lien on the property. Here, it becomes more likely that the IRS will take action against the property to obtain the equity to which its lien attaches than if the taxpayer had not sought bankruptcy relief.

So, the Hutchinsons would like to eliminate the IRS lien in order to eliminate the possibility that the IRS would take their home. Because the lien at issue here is a lien in which the underlying liability is a penalty and not a tax and because the taxpayers filed a chapter 7 petition, the trustee could have avoided the lien using the powers available in Bankruptcy Code sections 724(a) and 726(a)(4). The Hutchinsons brought this action to avoid the penalty under Bankruptcy Code section 522(h). Section 522 is the section that addresses exempt property. The IRS responded to the action by arguing that 522(c)(2)(B) specifically allows it to assert its lien against exempt property and that only the trustee has standing to assert the lien avoidance provisions of 724(a).

The court acknowledged that the trustee could have avoided the tax lien and then found that if the trustee does not do so debtors can avoid liens under section 522(h) but not tax liens. Citing the earlier Ninth Circuit case of In re DeMarah, 62 F.3d 1248,1250 (9th Cir. 1995) the court holds that “where the lien sought to be avoided secures back taxes, 522(c)(2)(B) eviscerates the debtors’ 522(h) powers.” The court noted that the fact that the debtor could exempt property from the estate does not mean that the debtor can remove the lien “or that portion of it which secures the penalty.” The purpose for allowing the trustee to avoid the tax lien securing penalties in a chapter 7 case is to allow the trustee to obtain a greater recovery for the benefit of the other creditors of the bankruptcy estate. The purpose of the provision allowing avoidance was not to allow the debtor to gain relief.

This case does not break new ground but presents a bankruptcy issue we had not previously discussed on the blog. The penalty avoidance powers in chapter 7 are strong and represent an effort by Congress to clear up some equity for other creditors who should not be penalized themselves by the debtors’ bad tax behavior. The provision allows the removal of the lien on penalties as an impediment to the payment of a creditor with no lien interest or an inferior lien interest and avoids having limited estate funds go to satisfy a debt based on bad behavior towards the IRS.  Those avoidance powers were not intended to allow the debtor to use bankruptcy to escape from their bad tax behavior. In the absence of a filed federal tax lien and if the penalty is not for fraudulent behavior, bankruptcy serves as an excellent mechanism for discharging penalties more than three years old but the existence of the filed federal tax lien changes the game and gives the IRS the opportunity to pursue available equity in a debtor’s property to collect penalty claims if it has the desire to do so.

 

 

Collection from Retirement Accounts Part 3 – IRS Pushes Hard to Collect from F. Lee Bailey

The bankruptcy court in Maine has granted relief from the automatic stay to allow the IRS to collect from Mr. Bailey’s pension accounts and Social Security benefits. While the IRS has the power to go after these accounts, its exercise of this power is governed by the issues discussed in the first two parts of this series. This is another defeat for Mr. Bailey in his efforts to protect his assets from the collection of federal taxes. I wrote previously about Mr. Bailey’s filing of the bankruptcy petition after suffering a massive loss in Tax Court.

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In my earlier post regarding Mr. Bailey’s Tax Court loss, I speculated that Mr. Bailey might achieve relief in bankruptcy because his Tax Court case resulted in the imposition of an accuracy related penalty rather than the fraud penalty. That may still be true; however, the type of penalty does not stop the IRS from pursuing his assets and that is what it is doing with a vengeance. The bankruptcy court starts off the opinion stating “This bankruptcy case is another chapter in the decade long struggle between the Internal Revenue Service and Mr. Bailey over taxes.” We have not previously written much about the ability of the IRS to take a taxpayer’s social security payments and pension accounts. In addition to the first two posts in this series, I briefly touched on it recently in a post about military pensions where I discussed the federal payment levy program. Mr. Bailey’s case provides the opportunity to discuss how and when the IRS will take these assets as the policies apply to a specific individual rather than the group of individuals studied by TIGTA.

Based on the pursuit of these assets in the bankruptcy case, it seems clear that the IRS has determined that Mr. Bailey meets its definition of having committed flagrant conduct regarding the payment of his taxes. I discussed, and linked to, the IRS definition of flagrant conduct in the first post in this series. Cases where the IRS makes the determination that the taxpayer’s conduct is flagrant are the ones in which you see the IRS using its collection tools to their full effect. You should always seek to have your clients behave in a way that keeps them from fitting into the flagrant criteria or, should their conduct fall into the flagrant criteria, have them work quickly to mitigate that behavior because that type of behavior can cause the IRS to use some tools at its disposal that it might otherwise keep holstered.

The IRS will routinely go after 15% of a taxpayer’s social security payments through the federal payment levy program. As discussed in the post referenced above, the IRS has filters that it applies, thanks to the National Taxpayer Advocate, which exclude from the FPLP taxpayers whose income appears to be less than 250% of poverty. Section 6343 requires that the IRS not levy on taxpayers when the levy would put the taxpayer into a hardship situation and the filters the IRS applies in the FPLP program recognize that a high percentage of the individuals with income below 250% of poverty would end up in a hardship situation if the IRS levied on 15% of their Social Security payments. Of course, individuals whose income exceeds 250% of poverty can come into the IRS and show that the levy places them in hardship status if the IRS takes 15% through this program. For a detailed description of FPLP, see part two of this series.

The IRS need not limit itself to 15% of a taxpayer’s Social Security payments and it can levy on the entire amount of the payments if it chooses and if doing so does not place the taxpayer into hardship status. The opinion does not say whether the IRS plans to take only 15% of his Social Security payments or all of them; however, I would be surprised if it is not planning to take them all. When it seeks to take all of a taxpayer’s Social Security payments, the discussion in the last part of part two of this series becomes important. Mr. Bailey’s case is or was prior to bankruptcy in the hands of a revenue officer. Now that he is in bankruptcy, there will also be a bankruptcy specialist working on his case and probably an attorney at the Office of Chief Counsel. These individuals will apply the policy decisions set out in the manual in deciding to take his social security payments. The only legal impediment, aside from the automatic stay, is IRC 6343 setting out the hardship exception to levy.

As discussed previously, taking social security payments does not stop when the statute of limitations on collection ends. The IRS lien attaches to the taxpayer’s right to the stream of payments. Because the taxpayer’s right to this stream is fixed, once the IRS levies on the taxpayer’s interest in the social security payments the levy attaches to the right to receive all of the payments. So, as long as the taxpayer lives and the tax debt remains outstanding, the IRS can continue to receive the social security payments.

From part one of this series you know that the IRS can also levy on interests that taxpayers have in IRAs or pension plans. Even though ordinary creditors cannot reach assets in pension plans because of restrictions put in place by ERISA, these restrictions do not apply to the IRS. The IRS has policies that cause it to pause and obtain approvals and certain levels within the agency in order to levy on pension plans but the law places basically no restrictions that prevent the IRS from levying on these plans. A levy on a pension plan does not accelerate payment from the plan, but just like the levy on the taxpayer’s Social Security payments, the levy on the pension plan does attach to all of the rights the taxpayer has in the plan even if those rights include future and not present payments. I can only assume that prior to seeking to lift the stay in Mr. Bailey’s bankruptcy case, the IRS and its lawyers have already made a determination that neither the policies in the manual or the provisions in IRC 6343 prevent levies upon his pension plan or social security payments.

These IRS rights to pursue Social Security and pension plan payments play out in Mr Bailey’s bankruptcy case in the context of the automatic stay. The automatic stay comes into existence the moment a debtor files a bankruptcy case and works to prevent creditors from taking most assets of the debtor and of the estate. Bankruptcy code section 362(a) lists eight separate matters covered by the automatic stay; however, creditors can apply to the bankruptcy court to lift the automatic stay to permit the creditor to go after an asset otherwise protected by the stay. That is what the IRS has done in Mr. Bailey’s case. The bankruptcy court must then determine whether to lift the automatic stay to permit the IRS to collect from these assets while the bankruptcy case proceeds.

The concern of the IRS is that if Mr. Bailey receives these payments he might spend them. Each time he spends the payments from Social Security and the pension plan, he dissipates an asset on which the IRS has a lien interest and allowing him to receive the payments can only occur if he provides adequate protection to the IRS that its lien interest will not be harmed by his receipt of these payments. The bankruptcy court notes that he has the burden of proof on all issues connected with the motion of the IRS to lift the stay except on the issue of the equity in the Social Security and pension benefits. The IRS must show these assets have equity to which the federal tax lien has attached. Showing that equity exists in social security and pension plan payments is very simple.

By the time the IRS filed the motion to lift the automatic stay, Mr. Bailey had already received his chapter 7 discharge. The discharge lifted the automatic stay with respect to collection against him personally but the stay would continue with respect to assets of the bankruptcy estate until the estate was closed. The claims of the IRS survived the discharge in the chapter 7 case according to the bankruptcy court but the court does not provide specific information as to why they survived. It appears that even if some or all of the IRS claims were not excepted from discharge under bankruptcy code 523, the federal tax lien continued to attach to property belonging to Mr. Bailey which he kept after the chapter 7. After the conclusion of the chapter 7 case, Mr. Bailey filed a chapter 13 bankruptcy case. This maneuver is sometimes called a chapter 20.

The court finds that the IRS lien interest in the Social Security and pension payments is not adequately protected. Mr. Bailey said he needed to use the payments from these sources to fund his chapter 13 case and therefore he should get to keep them; however, that is exactly what the IRS fears since in using them to fund the plan he will spend the money from these plans and as he does so he destroys the lien interest of the IRS. The court points out that though it rules for the IRS in this summary type proceeding, Mr. Bailey can challenge the lien claim of the IRS in another proceeding should he seek to do so.

Mr. Bailey continues in his second bankruptcy case to do what many taxpayers before him have tried to do and use bankruptcy to wriggle free from federal tax debt. While it is possible to do that in certain circumstances, where the IRS has perfected its lien, debtor has assets to which the lien attaches, and the IRS is diligent in protecting its rights, the debtor will basically always lose. That does not mean the IRS will ultimately collect the $5 million dollars owed to it, but it does mean that while some or all of that debt remains due and owing, the IRS will continue to have open season on his assets including his Social Security and pension assets.