The Federal Tax Lien and the Homestead Exemption

The case of In re Selander, No. 16-43505 (Bankr. W.D. Wash. Oct. 19, 2018) pits the bankruptcy trustee against the IRS. The trustee attempts to use a provision in Chapter 7 to take from property secured by the federal tax lien in order to pay his fees and other administrative costs. The IRS argues that when its lien attaches to property claimed by the debtor as a homestead, the provision allowing the trustee to use an asset secured by the federal tax lien does not apply. The case allows for an explanation of B.C. 724(b), in which Congress allows the use of money that would otherwise come to the government because of its secured position to pay unsecured priority creditors, and the interplay between the federal tax lien and the homestead exemption. The bankruptcy court here gets the law right and does a good job of explaining it.

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Mr. Selander filed a Chapter 7 petition on August 22, 2016. The Umpqua Bank filed a claim for over $5 million and the IRS filed one for over $700,000. The bank had liens against the debtor that predated the IRS’s federal tax lien. The debtor owned a ½ interest as a tenant in common of a home in the Seattle area. Other assets may have existed, but the house occupied the attention of the court.

The trustee of the bankruptcy estate found a buyer for the house for a gross sales price of $825,000. After paying off the mortgage, closing costs and the other owner, about $200,000 came to the bankruptcy estate. Washington is one of the states that allows debtors to choose between the federal bankruptcy exemptions in B.C. 522, or its own state-level exemptions, including a pretty generous homestead exemption of $125,000. The debtor elected to receive that amount as his homestead exemption.

The homestead exemption seeks to allow debtors something to get going after bankruptcy as part of their fresh start. While some states provide generous homestead exemptions and other states provide very little, the exemption in all states comes to the debtor subject to the federal tax lien. So, debtors owing federal taxes do not get the benefit of the homestead exemption that the state might intend since the state homestead law lacks the ability to pass property to the debtor in a way that overrides federal law. The operation of the federal tax lien vis-à-vis the homestead exemption has frustrated many debtors and provides one of many reasons to pay down federal tax debt prior to bankruptcy rather than to pay ordinary creditors.

The trustee ordinarily cannot use the homestead amount to pay his fees or to pay the claims of creditors of the estate. B.C. 522 carves the homestead amount out of the estate and gives it to the debtor as property exempt from the estate.

B.C. 724(b) allows the trustee to take an amount that would ordinarily go to the IRS because of the federal tax lien and use that amount to pay unsecured creditors of the bankruptcy estate entitled to priority status. The trustee is one of the creditors entitled to priority status. In the B.C. 724 analysis of Mr. Selander’s bankruptcy estate, nothing would go to the IRS because of the higher priority lien of Umpqua. That higher priority lien and the value of the assets in the estate prevents the IRS from having a secured claim against the estate. Without a secured claim held by the IRS, the trustee could not use B.C. 724(b) to carve out money to pay priority claimants.

Even though the IRS could not take from the estate, it stood to receive the homestead amount. The trustee argued that the payment of the homestead amount should allow the B.C. 724(b) carve out to occur even though the basis for the payment occurred from money not a part of the bankruptcy estate.

The court rejects the trustee’s argument, citing to relevant case law and finding:

There is no conflict between § 724(b) and § 522(k) because those two sections speak to different kinds of property. Section 724(b) involves property of the estate where the IRS holds a valid lien. In this scenario, Congress has made the decision that the bankruptcy trustee may subordinate the secured tax claim to pay administrative expenses. What § 724(b) does not address is the property a debtor removes from the estate by exemption, but still subject to a continuing lien of the IRS. This property is not covered by the plain language of § 724(b), which provides that it only applies to property ‘in which the estate has an interest….’ Exemptions remove property, or a certain value of that property, from the estate. Alsberg v. Robertson (In re Alsberg), 68 F.3d 312, 315 (9th Cir. 1995). Debtor’s Homestead Exemption removed the value of $125,000 from the estate but such exemption was powerless to eliminate the interest of the IRS in those funds claimed with the exemption.

The court noted that in the absence of the federal tax lien, the trustee’s attempt here would be a naked effort to take exempt funds to pay his fees, and that B.C. 522(k) prohibits that action. The bankruptcy court found that by claiming the homestead exemption, the debtor removed the property from both the estate and the application of B.C. 724(b).   It further found that the IRS need not bring a separate action to seize the money in the debtor’s bank account, but that the trustee should remit the $125,000 to the IRS. This victory by the IRS may benefit the debtor if the taxes were excepted from discharge. If the taxes would have been discharged by the bankruptcy, the debtor loses as well as the trustee since the debtor’s homestead exemption turns out to provide him with no benefit. Prior to filing bankruptcy, debtors should check the impact of a federal tax lien if they hope that bankruptcy will allow them to take certain assets with them. Mr. Selander’s case leaves him with a bankruptcy discharge but no major asset to take with him as he leaves bankruptcy.

 

Bankruptcy Court Declines to Exclude Retirement Plan from Estate

Congratulations to Keith Fogg on his new grandchild, Samuel! And now, back to tax procedure. Christine  

The case of In re Xiao, No. 13-51186 (Bankr. D. Conn 2018) presents the unusual situation of a bankruptcy court analyzing whether the pension plan of debtor’s corporation met the qualifications required by the Internal Revenue Code for such a plan. Here, it was not the IRS attacking the validity of the pension plan, though it might have if it had noticed. Rather, the bankruptcy trustee brought the action seeking a determination that the plan did not qualify in order to bring the money in the pension plan into the bankruptcy estate. Because the plan held over $400,000 in assets, it provided a rich target for creditors of the estate. Of course, the trustee also has a financial incentive to bring assets into the estate since the more assets the estate contains the larger the fee received by the trustee. Regardless of the financial incentive, bringing the asset into the estate for use to pay the unsecured creditors also fulfills the trustee’s obligation to the estate.

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As a general rule B.C. 541(c)(2) excludes a debtor’s pension plan from the bankruptcy estate. The Supreme Court confirmed this reading of the statute a quarter of a century ago in Patterson v. Shumate, 504 U.S. 753 (1992). The exclusion from the bankruptcy estate does not cover everything labeled as a pension plan. Excluded plans must meet certain criteria. Even if not excluded by BC 541(c)(2), funds could be exempted from the estate under B.C. 522. Few cases exist in which trustees have successfully attacked a plan to bring its assets into the bankruptcy estate. The trustee’s success in this case demonstrates the possibilities of such an action and also the perils to someone who fails to follow all of the necessary formalities for maintaining a proper plan. Even if you believe that the IRS has so few people looking at these plans that the chances of an IRS audit remain slim, the Xiao case shows another way in which failure to properly maintain a pension plan can create problems.

The court here spends several pages recounting the inappropriate manner in which the pension plan of debtor’s corporation was established and administered. The details of the administration of this plan suggested many lapses in following the necessary formalities to properly maintain a plan. The trustee hired an expert to examine plan activity and to testify concerning plan failures. In effect, the expert hired by the trustee acted like a revenue agent performing an audit of the plan. He explained in great detail the plan’s failures. The trustee charges the estate for the cost of the expert and the cost of the litigation attacking the plan. In essence, the plan assets will pay for the cost of the attack. The debtor’s creditors do not mind because even though these costs reduce the funds available from the plan, the trustee still brings into the estate money not otherwise available. The loser here is the debtor who sees his entire pension plan used to fund the attack on the plan and to pay creditors who would not otherwise have had the opportunity to get paid from this asset.

Debtor also hired an expert who testified about the plan in order to prove it was appropriately administered. Debtor himself testified on this point as well. The court did not find the debtor credible and did not find his expert persuasive.

After a detailed examination of the plan, the court found that it did not operate in a manner that allowed the debtor to exclude or exempt this asset. The concluding paragraph of the opinion provides the best overview of the court’s reasoning:

…the Plan failures at issue in this case do not merely constitute technical defaults, but instead are operational failures that ‘are substantial violations of the core qualification requirements for a retirement’ plan as set forth in the IRC Section 401(a)(2). … it appears that LXEng [debtor’s corporation] operated the Plan in order to solely benefit Mr. Xiao and his then spouse, Ms. Chen. According to the Treasury Regulations, a plan cannot act as a subterfuge for the distribution of profits to the owners of the employer. 26 C.F.R 1.401-1(b)(3). It appears to have been so here.

The opinion does not explain how the trustee came to the conclusion that the debtor’s plan did not meet muster. Because I have seen few of these cases over the years, I do not think that many trustees key in on this issue and perhaps the taxpayer’s failure to follow plan formalities represents a rare aberration. I suspect that there may be a number of plans of small businesses with problems that could be attacked by a trustee if the business owner seeks bankruptcy relief and tries to shelter assets in a pension plan. The former employees of the business that this plan did not properly cover could have had claims against the bankruptcy estate. Such employees may have provided the trustee a roadmap to unlocking the assets in the plan. While I am just speculating that one of the employees the plan sought to stiff provided critical information about the inadequacies of the plan, this serves as yet another reminder why employers should keep employees happy and not overtly antagonize them.

The court stresses that it tests qualification of the plan as of the date of the filing of the bankruptcy petition. For any small business where the owner is headed for bankruptcy, the Xiao case should serve as a significant wake-up call regarding the proper administration of a pension plan. The debtor here loses an asset that the creditors could not have reached had the plan been properly administered. Conversely, the case also serves as a reminder to attorneys for creditors that they should pay attention to pension plans in the case of small businesses to look for improper administration of the plan as a way to pull the asset into the bankruptcy estate that might otherwise have few assets for the unsecured creditors. Hiring an expert to do the analysis of the plan and pursuing the litigation to get information about the plan serve as barriers where the plan assets are not significant and information about plan administration does not suggest problems worth pursuing.

 

Suspending the Priority Claim Period and an Update on Clothier v. IRS

On August 17, 2018, I wrote about the bankruptcy case of Clothier v. IRS which held that a debtor’s prior bankruptcy did not suspend the time period for the IRS to retain priority status. I will come back to that case in a postscript to this post. Clothier involved the issue of whether a taxpayer’s prior bankruptcy case tolled the time for the IRS to claim priority status. The case of Tenholder v. United States, No. 3-17-cv-01310 (S.D. Ill. 2018) looks at the same issue but examines a different basis for tolling – a Collection Due Process (CDP) request. The district court, affirming the decision of the bankruptcy court, concludes that taxpayers’ CDP request did toll the time period for claiming priority status.

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Debtors filed a chapter 7 petition on December 30, 2015. At issue in this discharge litigation is tax year 2011. Debtors requested an extension of time to file their 2011 return making the return due date October 15, 2012. That extended due date falls more than three years before the date of their bankruptcy petition. As such, the priority claim provision of BC 507(a)(8)(A)(i) did not apply nor did the other two rules that allow the IRS to file a priority claim for assessments within 240 days of the bankruptcy petition and for taxes not yet assessed but still assessable. So, the IRS sought to hold open the three years from the extended due date for filing by resorting to the flush language added to the end of 507(a)(8) in the 2005 legislative changes.

That language provides:

An otherwise applicable time period specified in this paragraph shall be suspended for any period during which a governmental unit is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior case under this title or during which collection was precluded by the existence of 1 or more confirmed plans under this title, plus 90 days.

Applying this language suspends the three year period for 207 days in the debtors’ case because that was the time between their CDP request on July 22, 2013, and the end of the CDP hearing on February 14, 2014. In addition to the 207 days, the flush language also tacks on an additional 90 days. Adding 297 days to the end of the period three years from the extended due date of October 15, 2015, yields a date of August 7, 2016. Since debtors filed their bankruptcy petition prior to August 7, 2016 the IRS filed its claim for 2011 as a priority claim. Based on its claim of priority status for 2011, the IRS argued that the debt was excepted from discharge by BC 523(a)(1)(A).

Debtors disagreed with the application of the flush language because the language of the paragraph says taxes for “which a governmental unit is prohibited under applicable non-bankruptcy law from collecting a tax.” Debtors acknowledge that the IRS could not levy while their CDP case was pending but argued that the IRS could offset or could bring a collection suit while the CDP case was pending and, since it was not totally prohibited from collecting, the flush language does not apply to suspend the priority period.

Debtors were not the first to make this argument. At least three prior cases addressed the same issue but the district court did its own analysis of the provision. It found IRC 6330, the CDP provision, was a non-bankruptcy law prohibiting collection. The court disagreed with debtors’ argument that the language provided a clear statement requiring broad prohibition of any type of collection and agreed with the argument of the IRS that the statute does not say all collection and it clearly covers the collection prevented by a CDP hearing. In holding for the IRS the court found the language of the statute ambiguous but the legislative history clear in its intent to cover the CDP situation. As a result it found that debtors filed within the period during which the IRS could claim priority status. This decision aligns with the prior decisions interpreting the language of this paragraph.

The harsh result here points to the care that a debtor must take in choosing the timing of a bankruptcy petition where discharge of a tax for a specific year serves as the goal of the filing of the bankruptcy petition. Had the debtor realized the impact of the filing of the CDP request, and assuming no other factors drove the timing of the filing of the petition, the debtor could have realized the discharge of this tax debt by simply waiting a little longer to file.

This brings us back to the Clothier case which raised a similar issue of timing but did not discuss the flush language of 507(a)(8) added in 2005. As I mentioned in the earlier post about Clothier, the Court’s decision essentially overturned the Supreme Court’s decision in Young v. United States, 519 U.S. 347 (1997).

Following the post, I received an email from Ken Weil in Seattle who specializes in bankruptcy and tax matters citing me to the hanging paragraph at the end of 507(a)(8). Ken’s cite to this part of 507 is perfect because in this hanging paragraph Congress codified the decision in the Young case. I am getting too rusty on bankruptcy and should have questioned in my post why the government did not vigorously argue this language.

Coincidentally, I had a conversation with someone familiar with the case who informed me that the case was argued by an assistant United States Attorney rather than a Department of Justice Tax Division attorney. The AUSA would not be as familiar with tax issues in bankruptcy and did not cite the court to the hanging paragraph. So, the judge missed it as well.

We have not yet confirmed that the IRS appealed the Clothier decision. I expect that it will and that the outcome of the decision will change. We will see.

 

 

Proper Treatment of Earned Income tax Credit in Calculating Disposable Income

In Marshall v. Blake, 885 F.3d 1065 (7th Cir. 2018) the Seventh Circuit accepted a certified appeal from the bankruptcy court and ruled that taxpayer’s earned income credit refund (EIC) could be prorated over the year. Both the procedure for certification of bankruptcy appeals and the method for calculating disposable income provide useful procedural information.

Before discussing the issues raised in the opinion, I would like to point out a related issue that bothers me in offer in compromise (OIC) submissions. The IRS pre-printed OIC contract permits the IRS to retain the debtor’s refund for the year in which the IRS accepts the OIC. This includes the EIC refund. In many cases, even if the IRS allowed taxpayers to keep their refunds and added the prorated amount to a taxpayer’s monthly income, monthly expenses will still exceed projected income.  The EIC refund seeks to lift the taxpayer out of poverty. It is not a refund of funds withheld. Taking the refund hurts the children of the taxpayer as much as or more than the taxpayer. Many families rely on the EIC to purchase everyday items, as indicated by a recent Federal Reserve analysis. The analysis tracked retail sales following the 2017 congressionally mandated delay in tax refunds for EIC claimants. It noted that retail sales were much lower than previous years during the period in which refunds are typically issued, but peaked once the EIC was finally released. For a more detailed analysis, see Elaine Maag’s recent blog post. I think the IRS should not require offset of the taxpayer’s refund generated by EIC where the debtor’s schedules show allowable expenses in excess of income but should allow a refund recoupment bypass as cryptically described in IRM 5.19.7.2.21.  Allowing the taxpayer to retain future refunds under these circumstances, makes economic sense because of the purpose of the credit. Taking the EIC portion of a taxpayer’s refund where the schedules demonstrate its need to meet basic living expenses just seems wrong. The Seventh Circuit shows a better way.

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The trustee in the chapter 13 bankruptcy case seeks to have debtor turn over her entire refund each year to fund the plan. The debtor, a low-income wage earner, single mom living in subsidized housing with three dependent children, argues that the court should allow her to retain the portion of her refund attributable to the earned income tax credit allocating a portion of the credit each month to offset her reasonably necessary expenses. Her annual income of $30,000 falls well below the median income for a family of four in Illinois. In her schedules she included a pro rata share of her anticipated EIC. Doing this and subtracting payroll deductions and allowable expenses created for her the ability to pay $120 a month toward her chapter 13 plan.

The chapter 13 plan explicitly laid out her proposed use of the refund each year attributable to the EIC. The trustee filed a motion to dismiss the case for failing to correctly list her income and expenses. The trustee argued that the court should not confirm the plan because it failed to commit all of the debtor’s projected disposable income since it called for her to retain a portion of her annual refund. The debtor argued that the EIC should not count as income under the bankruptcy code. The bankruptcy court allowed the debtor to confirm a plan with a prorated version of annual income that would have her offset expenses throughout the year in a manner that would have her keep most or all of the EIC portion of the refund.

The court noted in its confirmation order that the debtor sought to purchase beds and furniture for her two 19 year old sons who had previously slept on air mattresses. The plan also proposed purchasing dressers for their bedroom which they previously did not have. These types of purchases created “a pretty skinny budget overall.”

The trustee moved for a direct appeal to the circuit court. The debtor objected. The normal path to the circuit court would involve a stop at the district court or a bankruptcy appellate panel; however, a direct appeal can occur in certain circumstances and the majority of the panel at the 7th Circuit citing 28 USC 158(d)(2)(A)(i) agreed that certification to the circuit “was appropriate because there is no controlling decision from the Supreme Court or the Seventh Circuit as to whether tax credits are disposable income under the Bankruptcy Code.”

Although the parties had argued in the bankruptcy court about whether to characterize the EIC credits as income, the circuit court recast the issue by focusing on the language of the bankruptcy statute. It looked at BC 1325(b)(1) which defines disposable income and BC 101 which defines “current monthly income.” It found that current monthly income includes the monthly income from all sources that the debtor receives “without regard to whether such income is taxable income.” The Seventh Circuit also looked at case law in reaching the conclusion that “Congress intended for the [EIC] to be included in the calculation of income.”

More importantly, however, the court found that just because current monthly income includes the EIC refund received by the debtor, that does not mean that the debtor must pay the entire refund to the trustee because the real issue in this case involves how the EIC works when calculating projected disposable income. The court noted that several bankruptcy courts in its circuit used the same calculus used by the bankruptcy court and allowed debtors to prorate future expense on which the debtor would spend the refund as long as such expenses met the reasonably necessary test.

The Seventh Circuit found that the holding here fits with the Supreme Court’s interpretation of projected disposable income. In Hamilton v. Lanning, 560 U.S. 50 (2010) the Court adopted a forward-looking approach to the question. It provided several reasons for approaching this issue with flexibility. It looked to the ordinary meaning of projected. The Supreme Court found that the mechanical approach adopted by the trustee in that case clashed with the provisions of BC 1325 and would produce senseless results in cases in which the debtor’s income during the six month lookback period was “substantially lower or higher than the debtor’s disposable income during the plan period.” Here, the bankruptcy court’s flexible approach aligned with the approach used by the Supreme Court.

The trustee argued that prorating the annual refund to a monthly amount artificially inflated the debtor’s income; however, the Seventh Circuit found that nothing in the bankruptcy code requires that current monthly income “is limited to income that is received on a monthly basis.” Rather, the bankruptcy code defines current monthly income as “the average monthly income from all sources that the debtor receives’ during the six-month lookback period.” The court describes the trustee’s objection to the plan as one driven by the fact that it allows the debtor to deduct reasonable expenses which reduces the amount that the debtor could use to fund plan payments.

The Seventh Circuit also found that allowing confirmation of this plan meets the good faith requirement of BC 1325(a)(3), that it meets the feasibility requirement in 1325(a)(6), and that it promotes the purposes of chapter 13. The dissenting opinion on the circuit court did not object to the holding on the merits but expressed concern that the case did not meet the criteria for direct appeal from the bankruptcy court.

The opinion avoids rigid treatment of the EIC just because it comes once a year. Though the court did not mention this, the EIC was available throughout the year prior to 2010 when Congress discontinued that option apparently because of the low uptake on the monthly option and the higher cost to employers. The impact allows debtors to project the true cost of their expense on an annual basis rather than treating the once a year payment as some sort of special payment that does not relate to the annual expenses. I would like to see the IRS adopt this approach in the treatment of OICs which have very similar considerations.

 

Another Clawback of Money Paid to the IRS

Last year, I wrote about a Ponzi scheme case, Zazzali v. United States in which the 9th Circuit allowed a bankruptcy trustee to recover money paid to the IRS by the perpetrator of the scheme prior to the filing of the bankruptcy petition. The payments could not be recovered for the estate using the preference provisions because of the timing and the nature of the payments; however, the court allowed the trustee to pull the money away from the IRS and into the bankruptcy estate using a combination of state remedy and waiver of sovereign immunity.

The 9th Circuit decision represented a split with the 7th Circuit, which had held in In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014) that a clawback under similar circumstances was not permitted under the applicable provision of the bankruptcy code. The last entry shown for the Supreme Court docket in Zazzali is Justice Kennedy granting the motion to extend the time to file a petition for a writ of cert. The motion was granted on April 9, and extended the deadline until May 18. The IRS regularly obtains extensions of time when considering whether to appeal. Here, it appears it decided not to appeal. Many reasons could exist for the decision not to appeal. In the meantime, the IRS lost another case with this issue, McClarty v. Hatchett, Case No. 17-451163-MBM (E.D. Mich. 2018) and has filed an appeal to the 6th Circuit in that case. So, the decision not to seek cert in Zazzali does not represent a concession of the issue by the IRS.

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At issue in these cases is the interpretation of B.C. 544(b)(1) and 548 and the interplay of one or both of these sections with B.C. 109 and the waiver of sovereign immunity. Where the Zazzali case involved a Ponzi scheme, the Hatchett case involves the use of funds belonging to the debtor, Laurestine Hatchett, to pay the federal tax liabilities of her husband. In 2014 the debtor’s children were appointed co-conservators of for her because of her disability which prevented her from managing her affairs. Mrs. Hatchett’s husband and her daughter were appointed her co-guardians. In 2015 real property was sold for over $300,000 which debtor owned 50/50 with her son. She received net proceeds of $122,827. The son turned the proceeds over to the father who deposited them into an account in the name of his law firm. A major portion of the proceeds were then used to pay federal taxes owed by Mr. Hatchett (the father) or his law firm.

On April 6, 2017, an involuntary chapter 7 petition was filed against debtor. While persons going into bankruptcy file almost all bankruptcy cases voluntarily, under the right circumstances creditors can “take” a person into bankruptcy involuntarily and that happened here. I did not go to the bankruptcy case to try to determine why; however, the involuntary bankruptcy was accepted by the bankruptcy court shortly after it was filed and a trustee was appointed to administer the bankruptcy estate. The trustee has a duty, and a financial interest because of the ways fees are paid, to find and bring back into the estate all money possible. The trustee looked at the transaction described above and determined that it fit the provisions of fraudulent transfer. The IRS in these situations has not participated in the fraudulent transfer other than to accept and apply funds as directed by the person making the payment. Based on the facts here, Mr. Hatchett’s transfer of his disabled wife’s funds to pay his personal or business tax liability certainly appears to be an improper conversion of her funds.

The IRS defended the action by arguing that sovereign immunity protected it from this action. Essentially, the IRS made the same arguments it previously made in Zazzali and Equipment Acquisition Resources.

The bankruptcy court started with an explanation of the applicable fraudulent transfer law and the two provisions in the bankruptcy code at issue here:

Fraudulent transfers can be avoided under two different sections of the Bankruptcy Code:

11 U.S.C. § 548, which creates a body of federal fraudulent transfer law, and 11 U.S.C. § 544(b), which gives the trustee power to avoid a fraudulent transfer by the debtor if the transfer would be voidable by one of the debtor’s creditors under state law. Specifically, § 544(b)(1) permits a trustee to step into the shoes of an actual creditor who has a fraudulent transfer remedy under other “applicable law” (i.e. a state fraudulent transfer statute) and exercise that creditor’s remedies on behalf of the bankruptcy estate. 11 U.S.C.§ 544(b)(1) provides, in relevant part, that a “trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim. . .

The key difference between an action under § 548 and an action under § 544(b)(1) is the reach-back period. Section 548, captures only transfers made in the two years preceding the filing of the bankruptcy. Section § 544(b)(1) looks to the specific state statute’s reach-back period, which is generally longer than two years. Thus, a bankruptcy trustee seeking to recover transfers made more than two years prior to the filing of the bankruptcy must file an action under 544(b)(1).

The court then discussed the interplay of sovereign immunity with the fraudulent transfer provisions since the IRS argument in the case was that sovereign immunity prevented the relief requested. BC 106 sets out the waiver of sovereign immunity and that section lists all of the bankruptcy code sections that waive immunity. Included in that list are 544 and 548. The court notes that the plain language of the statute includes the statutes at issue within the waiver of sovereign immunity citing favorably to the Ninth Circuit’s decision in Zazaali. The IRS argues that while 544 waives sovereign immunity it does not waive it for suits that could not be brought outside of bankruptcy. Since no waiver exists outside of bankruptcy for a creditor to sue the IRS under a state based fraudulent transfer statute, Congress could not have intended to allow such a suit by the trustee in a bankruptcy case.

The bankruptcy court rejected the IRS interpretation and followed the reasoning In Zazzali stating:

The Ninth Circuit’s broad reading of section 106 was bolstered by the fact that section 106(a)(1) was enacted after section 544(b)(1). As a consequence, when Congress passed 106(a)(1), it was, presumably, well aware of the fact that section 544(b) allowed a trustee to bring claims derived from applicable state law, a power that had been included in the Bankruptcy Code at the time the Code was enacted in 1978, and had existed under the Bankruptcy Act of 1898.

The court also cited the reason for the fraudulent conveyance statute in support of its decision:

It is undisputed that Debtor does not have a tax liability to the IRS. In its fraudulent transfer action under § 544(b)(1), the Trustee is simply seeking to recover money that Debtor should have used to pay her own creditors. In abrogating governmental immunity for suits brought under § 544, Congress’s clear intention was that the fraudulently transferred property must be recovered for the benefit of Debtor’s creditors, regardless of the status of the recipient of the fraudulent transfer.

The court then addressed additional defenses raised by the IRS. The IRS based the first of these defenses on BC 106(a)(5) which provides:

Nothing in this section shall create any substantive claim for relief or cause of action not otherwise existing under this title, the Federal Rules of Bankruptcy Procedure, or nonbankruptcy law.

In rejecting this argument the court finds that the substantive claim is permitted under otherwise existing law, specifically BC 544(b)(1).

It then moves to the IRS argument that the federal law in title 26 preempts the state law fraudulent conveyance action. The IRS arguments is that “state law is preempted where state law attempts to regulate conduct in a field that ‘Congress intended the Federal Government to occupy exclusively.'” In rejecting this argument the bankruptcy court finds that the argument of the IRS does not apply since the suit here has nothing to do with the payment or collection of taxes from Laurestine Hatchett. The fraudulent conveyance suit seeks to bring money into the bankruptcy estate wrongfully taken from her. The court focuses on her and not on the payment of taxes by her husband.

Finally, the court rejects the IRS argument that IRC 7422 prohibits the repayment of this money. IRC 7422 provides:

No suit prior to filing claim for refund.–No suit or proceeding shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof. The bankruptcy court says that 7422 has no applicability to this situation.

The IRS will continue its arguments on this issue into the circuit court. If it loses again, I expect it will either seek to take this case to the Supreme Court or it will give up on this argument. In the meantime trustees will look for payments to the IRS by debtors in bankruptcy that satisfy the tax debt of someone other than the debtor.

 

Bankruptcy Court Limits Prior Supreme Court Decision on Equitable Tolling

Regular readers of the blog know that the tax clinic at Harvard has been pushing to break down jurisdictional barriers and have equitable tolling applied to allow taxpayers to get into court in situations in which the government has caused, or partially caused, them to miss the filing deadline. The IRS vigorously opposes our requests just as it vigorously opposed the equitable tolling request in the cases leading to the Supreme Court’s decision in Brockamp v. United States, 519 U.S. 347 (1997).

Sometimes the IRS wants to use equitable tolling. In 2002, it won a major victory in the Supreme Court in the case of Young v. United States, 535 U.S. 43 in which the court found that the time period for an income tax liability to have priority status could be tolled by a prior bankruptcy case. The decision significantly expanded the possible life of priority status for claims of the IRS. Priority status not only assists the IRS in recovering from the bankruptcy estate but makes the tax non-dischargeable because of the interplay of the priority and discharge provisions. In Clothier v. IRS, No. 18-00104 (Bankr. W.D. Tenn. 2018) the bankruptcy court held that Young no longer applies because of changes to the law in 2005.

I feel confident that the IRS will appeal this decision; however, the decision has nationwide implications and will no doubt cause enterprising bankruptcy lawyers, who previously did not think that the changes to the bankruptcy law in 2005 changed the outcome in the Young case, to litigate this issue around the country. When coupled with Internal Revenue Service v. Murphy, a case of first impression from the First Circuit issued on June 7, 2018, this might keep the IRS and the U.S. Attorneys representing the IRS busy at the end of a high number of bankruptcy cases obtaining rulings from the bankruptcy court regarding discharge. Our post on Murphy can be found here.

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Bankruptcy code section 507(a)(8)(A) has three subparts describing the income taxes that achieve priority status in a bankruptcy case. Subpart (i) describes income taxes for which the tax return is due within three years, including extensions, of the bankruptcy petition. This subpart would make a debtor’s taxes for the years 2017, 2016 and 2015 entitled to priority status if the debtor filed bankruptcy today because the returns for those years were due on April 15, 2018; April 15, 2017 and April 15, 2016, and each due date is within three years of today’s date. If the debtor obtained an extension to file the 2014 tax return, the due date for that return would have been October 15, 2015 and that due date is also with three years of today’s date. If the debtor did not obtain an extension to file the 2014 return, the due date of April 15, 2015 is more than three years from today’s date and any liability for that year would not meet the priority test imposed by subpart (i).

Because the ability to assess income taxes, and therefore to collect income taxes, involve the deficiency procedure which allows the taxpayer to delay the timing of the assessment by failing to file a return or declining to accept a proposed increase, Congress added two additional subparts to BC 507(a)(8)(A) to cover the eventuality that an assessment would not occur at or near the original due date for filing the return. The thinking behind the provisions for priority status for taxes was that the IRS should have a reasonable time to collect before a tax loses its priority status. It picked three years as the generally reasonable time but knew that the three year rule could be frustrated by certain taxpayer actions which is why it created subparts (ii) and (iii).

Subpart (ii) provides priority for taxes assessed within 240 days of the bankruptcy petition. I will come back to talk about the exceptions to subpart (ii) which form the basis for this decision but first want to explain how it works. A typical case in which subpart (ii) would apply involves a liability assessed after a Tax Court case or an extended examination. If the IRS audited the debtor’s 2013 return, it might be April 1, 2018 before the Tax Court rendered a decision regarding additional taxes for that year and the IRS made an assessment based on the decision. If the taxpayer filed bankruptcy today, the income tax liability for 2013 would not receive priority status based on subpart (i) because more than three years have passed since the due date of the return; however, today’s date is less than 240 days after the making of the additional assessment for 2013 causing subpart (ii) to bring this liability into priority status. Note that if the debtor had an outstanding liability stemming from the filing of his return because he did not include sufficient remittance, the liability related to the return would not have priority status because it would fail the tests of both (i) and (ii). It would be a general unsecured claim while the liability for the same tax period assessed as a result of the Tax Court decision would have priority status.

Subpart (iii) applies to those taxes which the IRS can still assess. Building on the prior example, assume that the debtor filed a Tax Court petition for 2013 but the Tax Court has not yet rendered a decision. The IRS cannot yet assess the taxes in the notice of deficiency. It has a priority claim for those taxes based on subpart (iii). It would not have priority status based on subpart (i) since more than three years has passed since the due date of the return nor would it have priority status based on subpart (ii) since there has been no assessment within 240 days of the filing of the bankruptcy petition. While subpart (iii) would appear to grant priority status for unfiled or fraudulent returns since the assessment period would remain open in those instances, an exception prevents the IRS from gaining priority status if the reason the statute of limitations on assessment remains open is due to an unfiled or fraudulent return. The discharge provisions will allow the IRS to continue collecting from the debtor after bankruptcy on this type of debt but the priority provisions prevent the IRS from gaining an advantage over other creditors from the property of the estate when the debtor’s bad actions with respect to taxes created the problem.

Circling back to subpart (ii) and the issue in Clothier it is necessary to look at the exceptions that exist in that subpart. Prior to 2005, it contained an exception in the case of a pending offer in compromise which extended the 240 day period if an offer was pending during that time period for the period the offer was pending plus 30 days. In the 2005 bankruptcy legislation, Congress added a second exception which provides “any time during which a stay of proceedings against collections was in effect in a prior case under this title during that 240 day period, plus 90 days…”

The bankruptcy court here finds that the passage of this subsection, passed after the decision in Young, shows Congressional intent to overrule Young and to limit the application of the tolling of the priority period to the circumstance prescribed in the new subsection in subpart (ii). If correct, this means that the tolling permitted by Young would not apply to extend the time in subpart (i) which is the time period on which the IRS was relying in Clothier.

Here, the debtors filed the bankruptcy case at issue in the opinion on September 4, 2013. The tax years at issue in the discharge proceeding are 2008 and 2009 for which the debtors had extensions to file until October 15 of year of the respective years. Debtors filed a prior bankruptcy petition on January 19, 2012 which was dismissed on June 5, 2013.

The bankruptcy court quickly and correctly found that the 2009 liability was entitled to priority status under BC 507(a)(8)(A)(i) because the filing of the current bankruptcy fell within three years of the extended due date for the 2009 return, viz., the return was due on October 15, 2010 which was less than three years prior to September 4, 2013. (The bankruptcy filing was ill timed if motivated by eliminating this tax debt absent consideration of the effect of Young.)

A very different result, however, applies with respect to 2008. The due date for the 2008 return, as extended, clearly falls outside of the three year period in BC 507(a)(8)(A)(i). Here, the IRS filed a priority claim relying on Young which tolled the time period due to the prior bankruptcy filing. The prior bankruptcy existed long enough to cause the new bankruptcy to fall within the three year period. Because of the apparent codification of the Young decision in BC 507(a)(8)(A)(ii), the bankruptcy court finds that Young no longer helps the IRS when it relies on subpart (i). Since the IRS does not receive the additional tolling, the 2008 tax debt does not achieve priority status and since it was not classified as a priority debt it was discharged in the bankruptcy case.

I have not looked at the brief filed by the IRS in this case to discover what arguments it makes that equitable tolling should continue in the face of the statue change. The statute change was driven by the bankruptcy commission created in the 1994 bankruptcy legislation. That commission created a tax advisory panel which recommended several changes to the bankruptcy code to make it better align with the tax code. The recommendations of the tax advisory panel and the bankruptcy commission were wrapped up a few years before the decision in the Young case but, after the IRS victory in Young no one went back to the proposed legislation to remove the change to subpart (ii). Now we will find out if the bankruptcy court’s seemingly logical interpretation of the statutory change effectively overrules Young and limits the IRS to the new statutory provision.

The reason for tolling the time period still exists when the IRS relies on subpart (i) to achieve priority status. The tax clinic at Harvard has some experience with arguing equitable tolling. We will be thinking about filing an amicus brief on behalf of the IRS. Given our track record on this issue, it would be the kiss of death.

 

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.