Bankruptcy and the Voluntary Payment Rule

The IRS has a rule that if a taxpayer makes a payment voluntarily the taxpayer can direct the tax debt to which the IRS must apply the payment. In the absence of a valid designation, the IRS takes the position that it can apply payments in the manner most beneficial to the government. It frequently occurs that a taxpayer will owe for multiple periods and perhaps multiple types of tax debt. Having a payment go to pay down certain tax debts before others can greatly enhance a taxpayer’s position in certain circumstances. Persons assessed the trust fund recovery penalty (TFRP) find designation particularly important.

The policy regarding designation leaves open then the question of the voluntariness of a payment. If the IRS obtains the payment via levy, that generally presents an easy case of a non-voluntary payment. On the other hand, if the taxpayer mails in a check to partially satisfy a debt, that generally presents an easy case of a voluntary payment. Payments made in situations not as clear as these provide opportunity for discussion and debate which occurred in the case of In re Donaldson, No. 16-14126 (Bankr. N.D. Miss. July 2, 2018) a chapter 13 case.

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Mr. Donaldson served as President and CEO of a charitable organization that failed to pay its payroll taxes for several quarters. A few quarters passed prior to Mr. Donaldson learning of the failure to pay the payroll taxes. Upon learning of the problem, he did not insure payment of the taxes, past or current, but determined that the assets of the entity could cover the arrearages should the entity fail to rectify its cash flow.

The entity had two parcels of real estate and a claim against BP for the Deepwater Horizon Settlement. The entity passed a resolution that it would use the proceeds of the claim to make a voluntary payment to the IRS of the past due taxes; however, this resolution was an internal document to which the IRS was not a party. Eventually, the IRS levied on the BP Claim. The levy resulted in the IRS receiving funds with a designation on the settlement check that the funds be applied to the trust fund taxes. The IRS ignored the designation since it received the funds pursuant to a levy and arguably applied in its best interest by applying the funds to both trust fund and non-trust fund taxes. The opinion does not state exactly what the IRS did but I suspect that it applied the money to the oldest periods and just paid them off in chronological order until the money ran out. Doing so provided a significant benefit to Mr. Donaldson since the IRS could have applied the money first to all of the outstanding non-trust fund liabilities which, in my opinion, would have been its best interest.

The two parcels proved worthless for paying the past due taxes. Since the BP settlement funds did not fully satisfy all of the outstanding taxes, the IRS used the other tool at its disposal to collect the unpaid portion of the taxes that represented monies held in trust for it, viz., the TFRP. Found in IRC 6672, TFRP allows the IRS to assess against all persons responsible for the failure of the taxpayer to pay over money collected for the IRS and held by the taxpayer in trust. The IRS determined that Mr. Donaldson, and others at the charitable entity bore responsibility for the failure to pay. It made assessments against several individuals. In doing so the IRS seeks to collect the unpaid taxes only once. So, if one of the other persons responsible pays off the debt, Mr. Donaldson no longer owes the IRS on this debt but may owe the individual who paid if that individual seeks contribution from him. In this case it does not appear that one of the other responsible officers made any payment and certainly none of the other responsible officers made a payment sufficient to eliminate the liability.

Once the IRS turned its collection attention to him, Mr. Donaldson filed a chapter 13 petition, and the IRS filed a claim for $87,564 based on his obligation as a responsible officer of the entity. Because the claim resulted from unpaid trust fund liabilities, it acquired priority claim status pursuant to BC 507(a)(8)(C). Because it had priority status, Mr. Donaldson had to provide for full payment of the claim in order to confirm his chapter 13 plan. (Though not at issue here, Mr. Donaldson will also find out to his sorrow that when the chapter 13 ends he will owe interest on the liability for the full life of the chapter 13 plan even if he has fully paid the amount of the IRS claim. The IRS cannot claim postpetition interest from the chapter 13 debtor but can seek this interest from the individual after the lifting of the stay.) TFRP represents the worst type of debt to carry into bankruptcy because it always has priority status no matter how old and it will haunt the taxpayer coming out of bankruptcy even if the full amount of the prepetition debt gets paid through the bankruptcy.

Mr. Donaldson argues that the IRS must honor the designation on the payment written on the BP claim payment designating that the IRS apply the funds to trust fund taxes. The IRS argues that the bankruptcy court does not have jurisdiction to reallocate the payments (and that the payment here fails to meet the voluntary payment test.) The court agrees that it lacks authority to order the IRS to reallocate the payment to satisfy the trust fund portion of the entity’s liability. It notes that the entity is not before it. Because the entity is not before the bankruptcy court, the court lacks the ability to dictate the manner of the application of the funds recovered by the IRS as a result of a levy. What the IRS does with a payment of the entity’s liability is simply outside the scope of an individual officer’s bankruptcy case.

It distinguished U.S. v. Energy Resources Co., Inc., 495 U.S. 545 (1991) which held that an entity in bankruptcy could designate payments in its chapter 11 plan to trust fund liabilities. In Energy Resources the Supreme Court determined that a bankruptcy court has the power to determine that designation of payments is necessary for a successful reorganization. I have always had trouble understanding how designation, as a factual matter, benefited the entity and not the individual but the Supreme Court decided the issue on the basis of the power of the court and not the logic of the decision. The bankruptcy court in Donaldson, which does not have the entity before, lacks the power that the court had in Energy Resources where the entity that failed to pay the tax was the entity seeking to confirm the plan.

Next the court addressed Mr. Donaldson’s TFRP liability. He argued that while he met the statutory definition of responsible person he should not be liable because “(1) other, perhaps more culpable, responsible persons also failed to pay the trust fund taxes,” and (2) his nonpayment was not willful. His first argument totally falls flat. The court cites a couple of cases but could have cited many more. This argument has no legs. The TFRP statute allows assessment against many people and makes no provision for allocating the amount of the liability based on the amount of culpability.

His willfulness argument also fails. He knew of the liability and thought that the entity could cover it with available assets. The fact that his mistaken calculation of the value of the entity’s assets occurred in good faith does not provide any cover for him in avoiding the liability. He knew other creditors received payment instead of the IRS. That’s all it takes.

So, he will need to commit to full payment in order to confirm his chapter 13 plan and he will have to make those payments in order to obtain his discharge. Assuming he succeeds in his chapter 13 plan, he can also look forward to a bill from the IRS for the interest on the TFRP liability it could not charge the bankruptcy estate. A nice parting gift from chapter 13.

 

Detrimental Reliance on the IRS

The Tax Clinic at Harvard has, so far, unsuccessfully litigated on behalf of individuals misled by the IRS regarding the last date to file a Tax Court petition as discussed here. Getting bad advice on when to file a Tax Court petition represents only one way in which bad advice from the IRS can mislead a taxpayer. In Kerger v. United States, No. 3:17-cv-00994 (N.D. Ohio 2018) another situation in which incorrect advice can harm a taxpayer surfaces. In all of these cases the individual at the IRS does not seek to mislead but a wrong answer from someone who would seem to hold a position of knowledge and authority can send taxpayers down the wrong path.

In this case the Kergers seek a declaration that certain taxes were discharged in a prior bankruptcy case. The IRS argues that the Declaratory Judgment Act prohibits such an action against the United States. Of course, as discussed in a recent post, the debtors could obtain a determination of wrongful collection if the taxes were discharged and the IRS kept pursuing them. Here, the IRS not only defended against the suit but used the suit as an opportunity to reduce the taxes to judgment which will have the effect of keeping them around forever (or at least until the taxpayers can successfully discharge them in their next bankruptcy.)

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The Kergers asked the court to equitably estop the IRS from collecting taxes they contend a previous bankruptcy discharged. In 2008 the Kergers filed a chapter 11 bankruptcy case in 2008 but eventually converted to a chapter 7 in 2010. Individual chapter 11 cases do not happen with great frequency. I did not study their bankruptcy case to determine why they needed to convert. The tax debt may have caused the conversion because they would have to commit to full payment of all priority taxes in order to confirm their chapter 11 plan. Following the conversion, they obtained a discharge after which the IRS pursued collection of the liabilities at issue in this case. The Kergers disagreed that the tax debt survived bankruptcy but could not obtain a response from the IRS.

In 2014 they had to abandon their home due to the presence of mold. The cost to fix the mold problem was estimated at $100,000. They decided to sell the house; however, the IRS had filed a notice of federal tax lien which created a problem in selling the property since the sale would result in payment of the tax liability prior to their ability to receive any proceeds. Their attorney contacted the IRS to obtain a payoff amount since the amount they would need to pay could influence their decision to sell. The IRS representative told the attorney that the Kergers did not owe any taxes. The IRS sent transcripts showing no liability and a conversation with an Appeals Officer confirmed that the lien would release due to the absence of a liability.

Relying on the representations of the IRS, the Kergers spent the money to clean the house, prepared for an auction and purchased a new home. The home sold on August 15, 2015, “with the understanding that the IRS liens would fall off before the thirty day closing period concluded.” Before the running of the 30 days, the Kergers received several pieces of certified mail notifying them of the taxes owed. The Kergers learned that the IRS had moved their liabilities from master file accounts to non-master file accounts due to the bankruptcy. Of course, the IRS individuals with whom the Kergers and their attorney spoke looked only at the master file accounts and did not access the non-master file accounts where the data about their liabilities resided.

The Kergers brought the case seeking a declaratory judgment that the bankruptcy discharged the liabilities or, in the alternative, that the actions of its employees equitably estopped the IRS from collecting on these liabilities. The opinion does not state why the Kergers brought suit seeking a declaratory judgment rather than an action for a determination that the action of the IRS violated the discharge injunction. The court does mention that their complaint expressly states “there is no issue as to the discharge raised in this Complaint.” The district court had little trouble determining that it could not grant a declaratory judgment because the language of the statute clearly bars the court from doing so because it lacks subject matter jurisdiction.

In an effort to save the Kergers, the court found that the claim of equitable estoppel could survive bankruptcy because an issue regarding the discharge of the liability exists. The court does not decide this aspect of the case but allows the case to continue so that the debtor can present information about the tax liability and show that the discharge provisions apply. The case does not contain enough information to allow me to speculate whether they have a chance to show the taxes were disqualified in the prior bankruptcy. The court does not say that it intends to hold for them as a result of the bad advice they received from the IRS. As of the writing of this post, the court had not issued a ruling on the discharge of the liabilities.

The court also discusses the pleadings and finds Twombly and Iqbal concerns. We have discussed this issue previously. Here, it finds the pleadings adequate.

We have discussed it before but switching accounts from master file to non-master file can cause confusion at the IRS as well as with the taxpayer. If the taxpayer whom you represent has a liability that you think exists and you see an IRS transcript that says nothing is owed, you need to talk to the IRS about the possible existence of a non-master file account. Do not get joyous prematurely. Taxpayers who have filed a joint return and who go into bankruptcy, request innocent spouse relief, or otherwise have some action on their account that causes it to need to be split must exercise caution when reading master file transcripts. Usually, the master file transcript has a transaction code removing the liability that hints of the creation of another account. If you are concerned, get someone at the IRS to pull the non-master file transcript before celebrating the end of the liability. Maybe the Kergers will still find relief in this case but generally, relying on bad advice from the IRS in this setting does not eliminate the liability. The IRS may apologize as it takes the next collection action.

 

 

 

Filing the Notice of Federal Tax Lien during the Automatic Stay

Once the IRS makes an assessment, it sends the taxpayer a notice and demand letter as required by IRC 6303. If the taxpayer fails to pay the full amount in the notice and demand letter within time period set out in the letter, usually 10 days, then a federal tax lien arises and relates back to the moment of assessment. This lien sometimes goes by the name of assessment lien or secret lien but whatever name it may receive, this lien is the federal tax lien and it exists in essentially every case in which the taxpayer has an outstanding liability even if few taxpayers appreciate that a lien exists and has attached to all of their property and rights to property. The existence of the federal tax lien allows the IRS to file a notice of that lien alerting the world to the person’s tax debt. Filing the notice of lien serves as a disclosure of a person’s tax situation which IRC 6103 normally prevents but Congress permits the disclosure in this circumstance in order to allow the IRS to perfect its lien vis à vis the four parties listed in IRC 6323(a).

The IRS normally has total control over the decision to file the notice and the timing of the filing of the notice; however, the filing of a bankruptcy petition by the taxpayer limits that unfettered ability to decide when to file the notice. The automatic stay found in BC 362(a) prohibits creditors from, inter alia, filing liens and taking other actions to collect. I cannot recall seeing a case in which the IRS filed a motion to lift the stay to allow it to file a notice of federal tax lien after the filing of a bankruptcy petition; however, in In re Gorokhovsky, No. 17-28901 (Bankr. E.D. Wis. 2018) the IRS did exactly that and the court granted the IRS request. For that reason the case deserves some attention.

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The debtor owned three separate pieces of property at the time of filing the bankruptcy petition, none titled in his name:

  • A house in Ozaukee County, Wisconsin titled in the name of his ex-wife but awarded to him in a 2011 divorce;
  • A condo in Cook County, Illinois titled in the name of his ex-wife but awarded to him in the divorce; and
  • A condo in Milwaukee County, Wisconsin titled in the name of a defunct LLC owned by the debtor.

At the time of the filing of his bankruptcy chapter 7 proceeding he owed the IRS over $450,000. The IRS filed a notice of federal tax lien in Ozaukee County, Wisconsin but not in Cook County, Illinois or Milwaukee County, Wisconsin. In his bankruptcy schedules, Mr. Gorokhovsky acknowledged ownership of all the properties and acknowledged the tax debt. The chapter 7 trustee abandoned the three properties after determining that they had inconsequential value to the bankruptcy estate. Chapter 7 trustees routinely abandon property after researching the value of the property and outstanding liens attached to it since the job of the chapter 7 trustee involves recovering value for the unsecured creditors of the bankruptcy estate. Property that the trustee cannot turn into value for unsecured creditors has no benefit to the estate since all of the value will go to the secured creditors.

The IRS wanted to pursue collection against the properties. It asked the court to lift the stay so it could do so. The abandonment of the property removed it from the estate; however, the opinion did not say whether the stay was lifted against the debtor by the granting of the discharge or some other means of lifting the stay. The debtor opposed the lifting of the stay. The IRS first showed that the debtor had no equity in the property. The IRS could show that the debtor did not need the property in order to reorganize since the debtor filed a liquidating bankruptcy case. The IRS argued that its interests were not adequately protected and it could be harmed by maintaining the stay. The court concluded that lifting the stay would not interfere with the bankruptcy case and that the harm the IRS might suffer outweighs any harm to the debtor.

Because the bankruptcy case is a no asset chapter 7 case and because the trustee had already determined that the property had no value for the bankruptcy estate, the result here naturally flows from the facts. In most no asset chapter 7 cases, the debtor will already have received a discharge as an individual by the time the trustee abandons the property. The stay applies to actions regarding individuals and actions regarding property of the estate. Here, it appears the IRS needs the stay lifted because the stay on the individual remained in effect. The granting of the stay relief requests now clears the deck for the IRS to file the notice of federal tax lien it should have filed previously in order to perfect its interest in two of the properties and to bring suit. If it brings suit quickly enough, it can avoid the need to file the notice. While the case seemed odd to me at first glance, the timing of the request to lift the stay makes sense if the stay regarding the individual remained in effect.

 

 

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.