False Return Conviction Provides Basis for Collateral Estoppel to Prevent Discharge

For a brief period the Tax Court treated a conviction for filing a false return, IRC 7206(1) as the basis for sustaining the civil fraud penalty using collateral estoppel.  The period ran from the decision in Considine v. Commissioner, 68 T.C. 52 (1977) to its reversal in Wright v. Commissioner, 84 T.C. 636 (1985) (reviewed).  In the recent unpublished bankruptcy appellate panel (BAP) case of Terrell v. IRS, BAP No. WO-16-007 (Bankr. 10th Feb 17,2017), the 10th Circuit BAP sustained the decision of the bankruptcy court and held that a guilty plea for filing a false return provides the basis for collaterally estopping the debtor from challenging the discharge of his taxes for the year of the plea.  Though unpublished, the opinion, without much analysis, pushes the scope of collateral estoppel on the issue of criminal conviction and civil fraud toward a more favorable position for the IRS.  Reasons exist for drawing a distinction between collateral estoppel in the bankruptcy discharge context and civil fraud penalty.  Had the court articulated those reasons, I would have come away from the opinion with a more comfortable feeling.

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The Tax Court opinions, cited above, determining first that collateral estoppel applies to civil fraud and then subsequently determining it does not provide lengthy analysis concerning the scope of a false return plea.  From the perspective of punishment both tax evasion, IRC 7201, and filing a false return will get the taxpayer to the same prison sentence almost every time.  Because the elements of the two crimes differ slightly and because proving the filing of a false return is slightly easier, prosecutors lean towards a false return conviction at times. Chief Counsel attorneys used to complain bitterly when Assistant United States Attorneys would accept a plea to a false return count rather than evasion because it meant a lot more work in the subsequent civil case; however, the change to 6201(a)(4) to allow assessment of the restitution amount may have taken some of the sting off of the situation.

The difference in the elements of the two crimes plays a role in deciding whether collateral estoppel applies.  The Tax Court examined this difference closely in its opinions applying the elements of the crimes to the civil fraud penalty while the BAP does not do spend as much time applying the elements of the crime to the elements of the applicable discharge statute.

In Considine the Tax Court reasoned:

(a) that it had previously held that a conviction for willfully attempting to avoid tax (I.R.C. § 7201) established fraudulent intent justifying a civil fraud penalty, see Amos v. Commissioner, 43 T.C. 50, aff’d, 360 F.2d 358 (4th Cir. 1965); (b) that the Supreme Court had held that “willfully” has the same meaning in section 7206(1) (false return) as in section 7201 (attempt to evade tax), see United States v. Bishop, 412 U.S. 346, 93 S.Ct. 2008, 36 L.Ed.2d 941 (1973); and (c) therefore that a conviction for filing a false return, without more, establishes fraud justifying the civil penalty.

Considine v. United States, 683 F.2d 1285, 1286 (9th Cir. 1982)(the 9th Circuit criticizes the Tax Court’s decision in citing to Considine v. Commissioner, 68 T.C. at 59-61)

In reconsidering and reversing Considine, the Tax Court in Wright stated:

“In a criminal action under section 7206(1), the issue actually litigated and necessarily determined is whether the taxpayer voluntarily and intentionally violated his or her known legal duty not to make a false statement as to any material matter on a return. The purpose of section 7206(1) is to facilitate the carrying out of respondent’s proper functions by punishing those who intentionally falsify their Federal income tax, and the penalty for such perjury is imposed irrespective of the tax consequences of the falsification. As noted above, the intent to evade taxes is not an element of the crime charged under section 7206(1). Thus, the crime is complete with the knowing, material falsification, and a conviction under section 7206(1) does not establish as a matter of law that the taxpayer violated the legal duty with an intent, or in an attempt, to evade taxes.” (internal citations omitted)

The IRS Chief Counsel’s office at page 63 of its Tax Crimes Handbook states that “there is no collateral estoppel as to civil fraud penalties under this section. The section 7206 (1) charge is keyed into a false item, not a tax deficiency. Collateral estoppel arises only with a conviction or guilty plea to tax evasion.”  Similarly, IRM 25.1.6.4.3 provides that “A conviction under IRC 7206(1), filing a false return, does not collaterally estop the taxpayer from asserting a defense to the civil fraud penalty since conviction under IRC 7206(1) does not require proof of fraudulent intent to evade federal income taxes. In these cases, additional development is required to establish the taxpayer’s intent to evade assessment of a tax to be due and owing.”

At issue in Terrell is whether the his guilty plea for a false return places him squarely within the elements of 523(a)(1)(C).  Section 523 of the bankruptcy code sets out the actions with respect to individual debtors that prevent, or except, the discharge of a debt.  Congress has added to the list over the years since the adoption of the bankruptcy code in 1978.  The list of excepted debts in 523 numbers 19 and several of those 19 subparagraphs of section 523(a) have more than one basis for excepting the debt from discharge.

The provision relating to tax debts, 523(a)(1), has three separate bases for excepting a debt from discharge.  Subparagraph (A) excepts debts that achieve priority status under section 507(a)(8).  This subparagraph, in general terms, prevents debtors from discharging relatively new tax debts.  Subparagraph (B), which has been the subject of many posts, prevents debtors from discharging tax debts for which the debtor has never filed a return or filed a late return within two years of the filing of the bankruptcy petition.  Subparagraph (C) at issue in this case prevents debtors from discharging tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The question before the BAP concerns the language of the discharge exception for making a fraudulent return and the language of IRC 7206(1) for filing a false return.  Section 7206(1) holds a taxpayer liable for a felony tax offense if he “willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter.”  Does this statute, which does not require any understatement of tax but merely a false statement, match the elements of bankruptcy code section 523(a)(1)(C) such that the conviction under IRC 7206(1) requires a finding of collateral estoppel regarding the discharge of the underlying taxes.

The BAP, after acknowledging that Mr. Terrell presented “no arguments as to why the bankruptcy court’s application of collateral estoppel was in error” says yes because (1) “the issue in the Criminal Case is identical to the issue presented in the Adversary Proceeding” because the same factual issues existed in both statutes; (2) his “guilty plea in the Criminal Case constitutes a full adjudication on the merits”; (3) both the debtor and the IRS were parties to the criminal case; and (4) the debtor “had a full and fair opportunity to litigate the Criminal Case.”

The language in 523(a)(1)(C) “made a fraudulent return” may sufficiently line up with the language of IRC 7206(1) to allow collateral estoppel to work here but I would like the court to work a little harder to make that connection for me.  The Tax Court eased into a similar conclusion with respect to the fraud penalty and an IRC 7206(1) conviction and then had to walk it back after the 9th Circuit brought its attention to the elements of that crime.  The standard of proof for the IRS in a 523(a)(1)(C) case is preponderance of evidence unlike the clear and convincing standard needed for sustaining the civil fraud penalty.  There are certainly differences between the Considine situation and the Terrell case but enough similarities to deserve more analysis.  I am not yet convinced.

Does Failure to List a Refund Claim in a Debtor’s Bankruptcy Schedules Provide the IRS a Defense Barring the Refund

The case of Martin v. United States (C.D. Ill 1-5-2017) examines the jurisdictional objection raised by the Department of Justice Tax Division to a claim for refund filed by taxpayers who went through a chapter 7 bankruptcy proceeding prior to filing the claim for refund.  The bankruptcy proceeding matters because the refund claims here relate to pre-bankruptcy petition years.  Because the refund claim existed at the time of the bankruptcy, the claim became property of the bankruptcy estate under B.C. 541.  The taxpayers had a duty to list all of their property and rights to property when they entered bankruptcy.  The taxpayers did not list the refund claims on their bankruptcy schedules and did not file the refund claims until just prior to closure of their bankruptcy case in 2005.

In this case, the IRS seeks to knock out their claim because of the failure to list it in the bankruptcy proceeding regardless of the merits of the claim.  The position of the IRS has a sound basis.  The district court does not dismiss the refund claim but discusses several theories raised by the IRS.  The court signals that it may dismiss the claim once it acquires more facts.

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I first saw this issue almost 30 years ago in a Third Circuit case Oneida Motor Freight, Inc. v. United Jersey Bank, 848 F.2d 414 (3rd Cir. 1988). Citing to In Re Hannan, 127 F.2d 894 (7th Cir.1942), the Court stated

“a long-standing tenet of bankruptcy law requires one seeking benefits under its terms to satisfy a companion duty to schedule, for the benefit of creditors, all his interests and property rights.”

The Court also pointed to the debtor’s statutory duty stating

“Section 521 of the current Bankruptcy Code outlines a non-exhaustive list of the debtor’s duties in a bankruptcy case. Foremost for our purposes, the debtor is required to ‘file a … schedule of assets and liabilities … and a statement of the debtor’s financial affairs….’”

Oneida argued that at no point in the bankruptcy case prior to the time it filed its action against the bank did the right moment exist to bring such an action.  The Court gave little weight to this argument stating

“Although Oneida may be technically correct in its argument that it was never procedurally compelled to raise its claim, we are satisfied that its failure to mention this potential claim either within the confines of its disclosure statement or at any stage of the bankruptcy court’s resolution precludes this later independent action. Even absent a specific mandate to file a counterclaim, complete disclosure is imperative to assist interested parties in making decisions relevant to the bankrupt estate.”

In Oneida, the debtor brought a suit against a bank for breach of duty but failed to list the chose in action in its schedules and failed to mention it in its plan of reorganization.  Because Oneida was a chapter 11 case, it presents a slightly different setting than Martin but most of the principles remain the same.  I should also note that there was a vigorous dissent in Oneida pointing out the negative impact to the estate of barring the suit against the bank.

The issue presents the question of fair play.  The law has some doctrines that apply when a party fails to treat others properly while seeking benefits for themselves.  By failing to list the claim for refund, which exceeds $100,000, the taxpayers here misled their creditors regarding the amount of assets available from the bankruptcy estate.  The creditors received distributions from a bankruptcy estate that did not include all of the assets owned by the debtors.  Based on those facts, it seems unfair to allow the debtors to benefit, in this case to substantially benefit, from their own failure to properly file their schedules which they signed under penalties of perjury.  I acknowledge that it is possible that at the time of filing the schedules they may not have been aware of the existence of the refund claim but that still raises a question of whether the timing of their becoming aware of an asset is the controlling event for a determination of who should benefit.

A logical way to prevent the debtors from benefiting would be to deny their claim, but there is more to the story.  I want to paint a fuller picture of fairness before I go back to the doctrines examined by the Court.  Here, the debtors in Martin did go back to the trustee and notify him of the possible refund many years after the closing of the bankruptcy case.  The trustee did seek to find and notify the creditors of the estate but none stepped forward to renew their claims.  I did not go and pull the schedules in this case to see what kind of payout occurred from the bankruptcy estate, how many creditors existed, what type of creditors existed, etc.  Depending on the type of creditors and the distance in time between the close of the case and the correspondence from the trustee, it is almost certain that the creditors had written the taxpayers’ accounts off several years prior to the inquiry from the trustee about a possible additional distribution.  If they looked back on their computerized accounts they may have seen that no liability was due from the debtors and may not have had a good way to recreate the account.  The creditors had a duty to write off all dischargable debt in order to avoid violating the discharge injunction imposed by the bankruptcy code and would have taken steps to do so many years before the trustee wrote to them.  If the creditors had not taken immediate steps to write off the debt following discharge, they would have incurred the significant penalties that arise when it is violated.  While it is easy to question why the creditors of the taxpayers’ bankruptcy estate did not raise their hands and request the money when given the opportunity to do so, it may not have been easy or possible for them to identify the debt so long after writing it off.  Because no creditor came forward to ask that their long forgotten debt be paid, the trustee told the bankruptcy court that no creditor of the estate had an interest in the taxpayers’ pre-bankruptcy refund even though it was potentially a six figure refund and even though the creditors probably got paid only a fraction of what they were owed.

First, the taxpayers allege that they did not know of the refund claims until 2005.  If they did not allege this, or at least allege that they did not know of the claims at the time they filed their bankruptcy petition and the attendant schedules under penalty of perjury, they would risk prosecution.  By bringing the refund action and exposing their failure, the debtors would know that this issue would arise.  Without knowing more, I believe them that they were unaware of the refunds at the time of filing their bankruptcy petition because of the defense such belief provides to the possible prosecution for bankruptcy fraud.  So, their failure to list the refund claims may well have resulted not from an effort to deceive their creditors but rather from a desire to claim a benefit once discovered.

Second, the IRS, assuming the taxpayers’ refund claim deserves acceptance, would itself become the beneficiary of a windfall at the expense of the debtors pre-bankruptcy creditors should the court deny the debtors the refund under a theory that no pre-bankruptcy refund could ever be paid if not listed in the schedules.  Unlike the Oneida case, in which the unlisted asset the debtor sought to later recover was against a creditor of the estate, nothing in the facts suggests that the IRS had an unpaid claim in the bankruptcy case.  Should the remedy for a situation such as this provide a windfall to the IRS as it argues?  While the IRS might receive a windfall, it did nothing wrong.  The denial of the refund would result from the debtors’ failure and not due to any actions by the IRS.

Third, maybe an appropriate remedy in a case like this should not allow debtors or the IRS to reap a benefit that, had debtors submitted a timely claim, would have gone to the creditors.  Perhaps a doctrine such as Cy Pres should apply to send the funds to a deserving charity.   The equities at issue here do not favor the debtor even though the debtor did eventually go back to the trustee and bring up the existence of the claim.  It will be interesting to see what remedy the bankruptcy court fashions out of the mess created by the failure to list an asset.  Because the debtors may not have had a good way to identify the refund at the time of filing their bankruptcy petition, the debtors here do not have the same level of culpability that the debtor in the Oneida case had because the cause of action against the bank in the Oneida case would have something that debtor knew or should have known existed at the time of filing the schedules and at the time of presenting a plan of reorganization.  With tax refunds, the existence of the refund sometimes does not become clear for some period after the refund potentially arises, what is a fair method of dealing with parties when such an even occurs.  Maybe Martin will shed some light on the best answer.

Update on Splitting Refunds in Bankruptcy Cases

In May of 2014, I wrote a post describing the way that bankruptcy courts approach splitting refunds in the circumstance in which one spouse goes into bankruptcy the other does not and then the couple files a joint return which generates a refund.  That post has, in a surprise to me, been one of the most popular posts in terms of the number of people who have accessed it.  Last month, another bankruptcy court opined on the issue while coming at the issue from a slightly different position than in the case from the prior post.  The recent case gives me a chance to update the post and describe bankruptcy procedure regarding the automatic stay, but also to bring up the filing season issue of injured spouse.

I recently wrote on the filing season issue of superseding returns.  I hope to write soon on another filing season issue updating another popular prior post regarding offset bypass refunds.

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As a prelude to the discussion of the problem of splitting refunds in bankruptcy cases, a quick reminder of injured spouse rules will assist those facing the situation as filing season approaches.  I wrote about the injured spouse provisions in September of 2016 in the context of discussing the statute of limitations for making an injured spouse request.  In that post I noted that if a taxpayer knows at the time of filing a joint return that their spouse owes the IRS but the taxpayer does not owe the IRS, the IRS has created a form to file with the return to alert the IRS to the desire of the spouse with no liability to have their portion of the refund actually refunded rather than offset:

When someone believes they qualify for injured spouse status, they should attach a Form 8379 to their tax return. Of course, a spouse may not know that their partner has a debt which will cause an offset of refund on the joint return and may not know that they should proactively file the Form 8379 to avoid the problem.

Unlike the innocent spouse provisions which apply when the IRS determines an additional liability on a joint return, the injured spouse provisions apply when one of the spouses already owes the IRS a liability.  When a couple knows that one partner owes the IRS a liability (or any other liability subject to the 6402 offset provisions such as student loans, child custody, state tax, etc) and the couple desires to file a joint return nonetheless, usually because of the tax benefit of joint return status, then the couple should attach the Form 8379 to the return.  If the spouse who does not owe the IRS (or the other offset entities) had no knowledge of their spouse’s debt to the IRS (or the other offset entities) at the time of filing the joint return, then he or she can file the Form 8379 when they learn of the problem which will generally occur not too long after the filing of the return because of the failure to receive the anticipated refund.  The outside time period for making the request, is discussed in the prior post.

While the IRS has issued rulings and a form making the path to injured spouse relief from the IRS relatively straightforward, the path takes on a different form if the fight over the refund occurs outside of the IRS.  Outside of the IRS, the fight over the refund usually takes place in a bankruptcy court or a domestic relations court.  The IRS rules regarding the splitting of the refund do not bind these courts but do provide context for deciding how to do so.

In the recent case of In re Nevins No. 15-10003 (Bankr. N.H. December 23, 2016), the application of the rules came up in a fight between the debtor and the IRS, rather than the debtor and the debtor’s spouse or the debtor and the bankruptcy trustee, in the context of a potential violation of the automatic stay.  Mr. Nevins filed a voluntary chapter 13 petition on January 4, 2015.  The court confirmed his plan on March 18, 2015, a normal time period between filing and confirmation of the plan.  The plan provided for payment of the IRS claim under terms that varied depending on the different types of claims held by the IRS.  In a twist on the injured spouse situation, Mrs. Nevins, who did not join her husband in filing bankruptcy, did also owe the taxes.  So, the Nevins case does not involve an injured spouse claim although the analysis applied here could also apply in an injured spouse context.

Married couples can make an election when filing bankruptcy to file a joint bankruptcy or to have just one spouse file bankruptcy.  Like the tax code, the bankruptcy code does not dictate the filing of a joint bankruptcy petition just because of marriage.  If one spouse files bankruptcy, the automatic stay of bankruptcy code section 362 applies to that spouse but not necessarily to the other spouse.  Bankruptcy code section 1301 does create a stay that can cover the non-filing spouse in chapter 13 cases; however, this stay only applies to consumer debts and the definition of consumer debt does not include taxes.

So, when Mr. Nevins filed bankruptcy and Mrs. Nevins did not, she remained exposed to the full panoply of collection weapons available to the IRS while he fell under the shield of the bankruptcy code.  In this case, the issue of offset involves not only the shield of the bankruptcy code but also the ultimate impact of discharge.  Most of the liabilities owed by Mr. Nevins fell into the general unsecured claim category.  He owed slightly over $40,000 but the IRS claim and the chapter 13 plan classified about $32,000 of that debt as general unsecured debt.  General unsecured debt is the worst type of debt a creditor can hold.  In Mr. Nevins’ plan he proposed to pay about 2% this debt.  This means that over the five year life of his plan he would pay the IRS about $640.00 and the balance of the debt would go away upon completion of the plan together with all of the interest and penalties on the debt.  For Mrs. Nevins, however, the full amount of the debt continued to exist and continued to accrue interest and, possibly, penalties.

This situation provides the IRS with an incentive to take the joint refund and apply it to Mrs. Nevins’ debt.  The automatic stay prevented the IRS from applying it to his debt since it must take payment through the plan on his debt.  The IRS calculated how much of the $1,293.00 refund each party should receive.  It determined that using its formula for allocation of refunds Mrs. Nevins should receive the entire refund and so it offset the entire refund in partial settlement of her debt.  By doing so, it collected in one action more than his five year plan would pay on this debt.  Mr. Nevins objected, arguing that the offset of the refund violated the automatic stay because it acted as a taking of property of the estate during the period of the stay.  The IRS countered that its actions did not violate the stay since none of the refund belonged to Mr. Nevins and nothing prevented the IRS from collecting on Mrs. Nevins’ liability.

The bankruptcy court faced a situation in which it needed to decide how it should calculate the refund in order to know if the taking of the refund violated the stay.  After noting the absence of controlling precedent in its jurisdiction, the court went through the same type of analysis the Lee court had done in the case previously blogged.  It also came to the same conclusion.  It rejected the 50/50 rule as too simplistic.  It rejected the income rule because it divides the refund based on “a factor which may have very little to do with actual contributions to the total tax obligations between spouses.”  It similarly rejected the withholding rule for similar reasons, noting that it may apply anyway in cases with no credits.

This led the court to the so-called separate filings rule adopted by the IRS in the revenue procedures.  The court notes that the majority of the courts are falling in line with the separate filings rule as it does.  The court described the rule as follows:

[The Separate Return Rule] allocates the refund based on each spouse’s hypothetical individual tax liability (hypothetical liability) had the spouses filed their tax returns as married parties filing separately. First, each spouse’s contribution to total payments is determined. Second, each spouse’s share of the joint tax liability is calculated based on the ratio of that spouse’s hypothetical liability to the sum of both spouses’ hypothetical liabilities. Each spouse owns that portion of the joint refund equal to the amount by which his or her contribution exceeds his or her share of the joint tax liability.

Because it lacked all of the facts necessary to rule on the precise disposition of the refund, it reserved the ruling on the outcome for another day.  The case caused the bankruptcy court to spend lots of energy over a $1,293 refund but a decision that sets precedent should the issue arise again.  If the IRS correctly calculated the refund based on the separate filings rule, the offset will stand.  If it did not, in whole or in part, some of the refund will come into the estate to satisfy the liability of Mr. Nevins under the plan and the IRS will potentially face damages for violation of the automatic stay.  I suspect any damages here would be small but it is a risk for the IRS anytime it takes money that arguably belongs to a bankruptcy estate.

New Developments in the Cases Involving Discharge of Late Filed Returns

We have reported on numerous occasions regarding the issue of whether a taxpayer who files a return late may discharge the taxes owed on the late-filed returns in bankruptcy.  See prior posts here, here, here, and here.  The recent case of Biggers v. Internal Revenue Service decided by the District Court in the Middle District of Tennessee on September 9, 2016, demonstrates yet again the difficult administrative position that IRS put itself in by embarking on this argument almost 20 years ago.  In Biggers, the District Court reversed the bankruptcy court and determined that the application of the Beard test requires a subjective determination of the taxpayer’s intent in filing the late return.  The case has other interesting facets which I will discuss below.

Additionally, some new developments in the 3rd and 9th Circuits on this issue deserve mention for those following this line of cases.  In the 3rd Circuit, an attempted appeal to the Circuit Court bypassing the district court or Bankruptcy Appellate Panel has been turned back.  In the 9th Circuit, a case on which we reported previously has requested cert.

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I will start with the Biggers case.  Mr. and Mrs. Biggers did not timely file tax returns for the years 2001 through 2004 for reasons that the court does not explain.  The IRS prepared substitute returns for Mr. Biggers for each of these years, sent him notices of deficiency on which he defaulted, and then assessed the taxes.  After the IRS had assessed taxes through this process for all of the years, Mr. and Mrs. Biggers filed joint Forms 1040 for each of these years on February 15, 2007.  On three of those returns, the reported liability decreased from the amount previously assessed; however, on the return for 2002, the joint return reported an increased liability of about $15,000.  The Biggers then waited slightly more than two years and filed a joint chapter 7 petition in December of 2009 after which they received a discharge three months later.

The IRS conceded that the discharge relieved Mrs. Biggers of liability for the four years.  It also conceded that the discharge relieved Mr. Biggers of the $15,000 increase in tax reported on the Form 1040 for 2002 but not for the amount assessed through the substitute for return process.  For the other three years the IRS abated the taxes down to the amount shown on the late filed Forms 1040 but argued that the bankruptcy petition did not relieve Mr. Biggers of the liability because it had prepared the substitute returns first and made assessments before he filed the Forms 1040.  The bankruptcy court agreed with the IRS citing to the seminal case in this area, United States v. Hindenlang, 164 F.3d 1029 (6th Cir. 1999) as controlling circuit precedent.  On appeal, the district court took a different tack.

Before I get to what the district court decided, I need to pause to point out what the district court said that the IRS argued.  The principal argument of the IRS focused on the prior assessment through the substitute for return process.  The argument of the IRS did not exactly mirror the holding in Hindenlang, the controlling circuit authority.  Hindenlang adopted a subjective test based on the Tax Court’s Beard case and found that Mr. Hindenlang, whose return filed subsequent to the preparation of the substitute return, matched the substitute return exactly.  That, said the 6th Circuit, was not a good faith attempt to file a return, and good faith is one of the Beard elements.  The IRS primary argument morphed the Hindenlang argument into an essentially per se rule that once the IRS has assessed based on a substitute for return any Form 1040 filed thereafter can never meet the Beard test and lead to discharge.  This is standard stuff in these cases; however, the district court reports that the IRS went further.  Alternatively, it argued that if the court did not want to adopt its primary argument, the court should adopt the position of the three circuits holding that for bankruptcy cases filed after the 2005 amendments the language in the handing paragraph of B.C. 523(a) means that a late return can never satisfy the discharge requirements because it does not meet the additional statutory requirements in the hanging paragraph.

The district court noted that this argument by the IRS represented a change in its position from other cases.  It does.  This argument goes directly against the Chief Counsel Notice giving guidance on this issue.  It is unclear if the alternative argument the IRS appears to have made in Biggers represents an unannounced shift in the IRS position, a disagreement between Chief Counsel’s office and the Tax Division on this issue or merely a rogue argument by the Tax Division attorney arguing this case.  Unless making this argument represents a mistake by the trial attorney in the heat of battle, the ground seems to have shifted in these cases from a situation in which only certain states argue for the per se rule that filing a return one day late forever  prevents it from receiving a discharge to one where the IRS will also make this argument.  If it will make this argument, it will change the way it administratively processes these cases upon discharge.  This change comes as quite a surprise.

The district court did not adopt the per se rule argued by the IRS as its lead argument or its alternate argument of the one day late rule.  It concluded “that ‘applicable bankruptcy law’ as used in section 523(a)(*) includes pre-BAPCA [the 2005 legislative amendments to the bankruptcy code] case law, which encompasses the Beard test, as well as any other non-bankruptcy law as to requirements for a return.”  So, the district court finds that in deciding whether a document filed as a tax return satisfies the test for being a tax return requires a look at Beard and other case law deciding what constitutes a return.  The court cited a Tax Court case, Swanson v. Commissioner, 121 T.C. 111 (2003) which carefully examined the debtor’s intent before deciding that the taxpayer in that case did not have an intent to file a return.  Imagine IRS bankruptcy examiners doing that in every case.  Impossible.  The IRS cannot administer the subjective test which explains why it has morphed to its own form of per se rule when it has made an assessment pursuant to a substitute for return.

The district court also went back to a long standing anomaly in the IRS argument concerning how it treats taxpayers in bankruptcy cases versus offer in compromise cases.  In bankruptcy cases, it says that Forms 1040 filed after the IRS has made an assessment based on a substitute for return exist only as claims for abatement; however, in offer cases, it requires taxpayers to file Form 1040 even where it has already made an assessment based on a substitute for return.  The district court found the IRS treatment of taxpayers in the offer context suggestive of the continued possibility that Forms 1040 filed in this context could meet the Beard test or otherwise meet the statutory requirement necessary for consideration as returns.  As a result, the district court remanded the case to the bankruptcy court for it to look into the subjective intent of Mr. Biggers in filing the late Forms 1040 in order to determine if they might, in fact, be returns.  If the district court’s analysis of the applicable test holds up, the IRS must carefully investigate the taxpayer’s intent in each of these late file return cases and have courts second-guess its conclusions in hearings involving the violation of the discharge injunction.  Because the IRS cannot handle such a test, I suspect it will seek to appeal this decision.

Meanwhile, a petition for cert has been filed in the Smith case out of the 9th Circuit which we blogged here.  The petition, partially written by Professor John Pottow at University of Michigan, does an excellent job of explaining the state of the law and the various splinters into which it has broken over this issue.  The Supreme Court has denied cert on this issue before, but I do not think that it has previously received a request of this quality.  Whether the Smith case provides the best vehicle for cert is something about which parties will disagree.  Those in the 9th Circuit which averted the per se rule in Smith may prefer to live with Smith rather than face the possibility of the McCoy per se rule, but Mr. Smith can choose to seek cert if he wishes.  Will the IRS, which declined to seek cert before when it had the chance after the creation of the first circuit split based on the decision of the 8th Circuit not to follow Hindenlang, join in this request or will it continue to find that the current state of the law provides it the best avenue for administering the discharge of late-filed returns?  The brief cites to the importance to individual debtors to have consistency in the law across the country.  Will the IRS also find administrative importance in the need for consistency?  Does the alternative argument it made in Biggers signal a new litigating strategy that will play out in its response to the cert request?

Another, meanwhile, concerns the Third Circuit.  We posted previously on a case headed to that circuit; however, it appears that the Third Circuit has turned down the direct appeals, meaning that it will be longer before that circuit joins the parade of circuits weighing in on this issue.

District Court Reverses Bankruptcy Court and Finds that Emotional Distress Alone Insufficient to Justify Awarding of Damages When IRS Violates Stay on Collection

Earlier this year in Migraine Caused by Improper IRS Collection Action During Bankruptcy Stay Triggers Damages for Emotional Distress I discussed Hunsaker v US, where a bankruptcy court held that IRS was on the hook for damages arising for violations of the stay on collection even when the only damages were from the emotional distress and were not actual economic damages. Last week a district court in Oregon reversed the bankruptcy court, finding that there was no clear waiver of the government’s sovereign immunity  in the absence of direct economic damages.

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In my post earlier this year, I described what led to the Hunsakers suing the government. It started with financial problems when they realized that their “homestead was discovered to be subject to disputed claims by secured creditors, in turn complicated by claims of Marion County, Oregon, that the purchase of the homestead created an unlawful partition.” In September 2012 the Hunsakers filed a Chapter 13 bankruptcy reorganization. IRS received notice of the filing, and it filed a proof of claim for $ 9,301. As I previously discussed, “at the moment of the Chapter 13 filing, the automatic stay under the Bankruptcy Code came into place. In a Chapter 13 case it continues throughout the life of the case, which usually means it lasts for three to five years until completion of the plan or dismissal of the case.”

So IRS had notice of the plan, and should have backed off on collection. IRS however failed to back off and on numerous occasions sought payment and in fact served levies on Social Security payments even though the Hunsakers’ attorney contacted IRS and reminded IRS of the stay and the illegality of the IRS collection actions.

At the Bankruptcy Court, the judge found a specific connection between the IRS misconduct and an increase and aggravation of the Hunsakers’ anxiety and stress and awarded them $4,000 on account of that stress and anxiety, which in the judge’s opinion contributed to the onset and severity of Mrs. Hunsaker’s migraines. In reaching that conclusion, the bankruptcy court relied on and discussed a 9th Circuit case, In re Dawson that, on reconsideration, concluded that emotional distress stemming from violations of the bankruptcy stay can give rise to actual damages even if the debtor suffers no pecuniary losses.

On appeal, the district court noted that Dawson did not address the government’s violations of the stay; that case involved a private creditor. That was a key difference.

I will avoid the temptation to provide the NSFW link to Mel Brooks’ History of the World Part 1 where he reminds us that it is indeed good to be the king. While we no longer have royalty, sovereign immunity remains and limits the opportunities for private parties to sue the government. It stems from the adage that the king can do no wrong. While IRS most certainly can and does do wrong, the principal protects IRS from damages unless there is a specific and clear Congressional expression allowing the government to be sued.

The district court provided the framework:

Section 106(a) of the Bankruptcy Code clearly waives sovereign immunity for some claims under § 362(k). See 11 U.S.C. § 106(a) (“[S]overeign immunity is abrogated as to a governmental unit to the extent set forth in this section with respect to . . . [§] 362[.]”). Section 362(k) allows individual debtors injured by a creditor’s willful violation of the automatic stay to recover “actual damages.”

The opinion then goes on to discuss how in Dawson the 9th circuit provided that “allowing emotional distress damages best fulfills legislative intent to protect debtors from excessive psychological and emotional harm.” But that was not enough for the Hunsakers, as the creditor in Dawson was a private party and not Uncle Sam:

That emotional distress damages are available against private parties does not automatically authorize them against the federal government. After all, “when it comes to an award of money damages, sovereign immunity places the Federal Government on an entirely different footing than private parties.” Lane v. Pena, 518 U.S. 187, 196 (1996).

The opinion discusses how that different footing requires a clear expression that Congress meant for the government to be sued, and the district court said that was not present in these circumstances:

The Dawson court concluded the phrase “actual damages” was ambiguous even given the text and context of § 362(k) as a whole. 390 F.3d at 1146. The legislative history discussed in Dawson cannot waive sovereign immunity where the text of § 362(k) otherwise remains ambiguous. See Cooper, 132 S. Ct. at 1448 (“Legislative history cannot supply a waiver that is not clearly evident from the language of the statute.”). Because the phrase “actual damages” is ambiguous, this Court must construe § 362(k) in favor of immunity. See id. (any ambiguities in the statutory language must be strictly construed in favor of immunity, including ambiguities regarding the scope of the waiver). Reinforcing this conclusion is the fact that, before concluding “actual damages” includes emotional distress damages, the Dawson panel came to the opposite conclusion in an opinion it later withdrew. Dawson v. Washington Mutual Bank, F.A., 367 F.3d 1174 (9th Cir.), withdrawn, 385 F.3d 1194 (9th Cir. 2004). The two Dawson opinions provide compelling proof that any waiver of sovereign immunity as to emotional distress damages in § 362(k) is, at best, implicit.

(emphasis added).

The cite in the above block quote is to a 2012 Supreme Court case, F.A.A. v. Cooper, 132 S. Ct. 1441, 1448 (2012). The district court notes that Cooper supports its holding as well, as in that case the Supreme Court in examining a possible cause of action under the Privacy Act looked to “essentially the same question: if a statute waives sovereign immunity for “actual damages,” does that waiver include emotional distress damages? Id. at 1447–48. The Supreme Court answered no.”

Parting Thoughts

For good measure, the Hunsaker opinion discusses how even if there were no sovereign immunity issue it was skeptical that in fact there was an injury that was sufficient to warrant damages anyway, pointing to “alleged only brief losses of appetite, stress, and mounting frustration after receiving the IRS notices.” When I wrote my original post on the bankruptcy court case I said I was somewhat surprised at the outcome and I am not surprised that the district court reversed. On the other hand, the IRS conduct in this case is nothing to write home about.

I understand the government wanting to limit the possibility that other debtors similarly suffering from IRS mistakes in this process would sue and connect their stress from the IRS mistakes to an award, even a smallish one. It does seem that there should be some ramification for IRS mistakes, especially when the mistakes are repeated and the taxpayer/debtor has made a good faith effort to ensure that the government is aware of the stay. I note that Congress last systematically looked at these issues was in 1998 when it added Section 7433(e), allowing for an alternate statutory hook for taxpayers to petition the bankruptcy court for actual, direct economic damages and costs of the action if the IRS willfully violated the automatic stay injunction (7433(e) is also now the exclusive means for IRS violations of the discharge). I am not aware how often IRS whiffs on respecting these provisions so perhaps the issue is one rarely encountered in practice.

Collecting Partnership Debt from General Partners

The 9th Circuit recently sustained the district court which sustained the bankruptcy court in the case of Pitts v. United States.  The taxpayer sought a determination that the taxes claimed against her in the bankruptcy proceeding were discharged.  The courts determined that the taxes were not discharged, rejecting various arguments that she presented.  The case breaks no new legal ground but serves to highlight how the IRS collects from general partners.  If you have this issue, you might look at IRM Part 5, specifically 5.1.21, 5.17.7, and 5.19.14.

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Ms. Pitts was the general partner of DIR Waterproofing. DIR failed to pay its employment taxes including both trust fund and non-trust fund portions. The IRS would typically make some effort to collect from the partnership and then seek to collect from the partners. The opinion does not describe the efforts made here, but the IRS did issue a notice of federal tax (NFTL) against Ms. Pitts. In these situations the IRS does not go through a separate assessment process for Ms. Pitts but uses the assessment made against the partnership in order to pursue collection against her. The NFTL would reference the partnership debt although it would make clear that the lien is against her. Because the debt arose through the partnership, she argued that it was a state law debt and the IRS was limited to collect as a state law creditor. The 9th Circuit made three separate explanations of why her arguments failed.

First, the court pointed out that under IRC 6321 Ms. Pitts was a person liable to pay any tax and, as such a person, a lien arises under federal law which attaches to all of her property and rights to property once the IRS makes demand for payment and payment is not made. This is federal law and not state law creating the lien. The court cited several cases in support of its position.

Next, the court found that the IRS can use all of its administrative enforcement tools because she is secondarily liable on this debt. The court cited to a Supreme Court decision, United States v. Galletti, 541 U.S. 114 (2004) that may have caused Ms. Pitts to make the arguments she made here but which should also have suggested to her that these arguments would likely fail. In Galletti, similarly situated taxpayers to Ms. Pitts went into bankruptcy where the IRS filed a proof of claim based on the assessment against the partnership in which they were general partners. The Gallettis argued that no debt existed against them because the IRS had not made an assessment against them (and the statute of limitations on assessment of the partnership debt had run by the time of the bankruptcy.) In that case, the bankruptcy court, the district court, and the 9th Circuit agreed with the Gallettis. These opinions relied upon the definition of ‘taxpayer’ in IRC 7701 and looked to the separate nature of the partners as taxpayers from the partnership. The IRS pushed the case to the Supreme Court, which held that the IRS did not need to make a separate assessment because the Gallettis were liable under state law as general partners of the partnership.

Writing for a unanimous Court, Justice Thomas said:

“Under a proper understanding of the function and nature of an assessment, it is clear that it is the tax that is assessed, not the taxpayer. See §6501(a) (“the amount of any tax … shall be assessed”); §6502(a) (“[w]here the assessment of any tax”). And in United States v. Updike, 281 U. S. 489 (1930), the Court, interpreting a predecessor to §6502, held that the limitations period resulting from a proper assessment governs “the extent of time for the enforcement of the tax liability,” id., at 495. In other words, the Court held that the statute of limitations attached to the debt as a whole. The basis of the liability in Updike was a tax imposed on the corporation, and the Court held that the same limitations period applied in a suit to collect the tax from the corporation as in a suit to collect the tax from the derivatively liable transferee. Id., at 494-496. See also United States v. Wright, 57 F. 3d 561, 563 (CA7 1995) (holding that, based on Updike‘s principle of “all-for-one, one-for-all,” the statute of limitations governs the debt as a whole).

Once a tax has been properly assessed, nothing in the Code requires the IRS to duplicate its efforts by separately assessing the same tax against individuals or entities who are not the actual taxpayers but are, by reason of state law, liable for payment of the taxpayer’s debt. The consequences of the assessment–in this case the extension of the statute of limitations for collection of the debt–attach to the tax debt without reference to the special circumstances of the secondarily liable parties.”

Ms. Pitts wants the courts to recognize that the assessment only applies to her because of the operation of state law and since it is the operation of state law causing her to become liable she wants the debt treated as state law debt and not tax debt with the exceptions to discharge applicable to tax debts. The 9th Circuit, perhaps still remembering the Galletti outcome, does not allow her to split hairs in this manner. State law plays an important role in creating the liability but her liability is for a federal tax debt.

The 9th Circuit rejects her argument that state law creates the statute of limitations. It also rejects her argument that the continuation by the IRS of its efforts to collect this debt violates the discharge injunction. I did not go back and read the earlier opinions to see the age of the debt. The trust fund portion of the partnership’s unpaid employment taxes will always be excepted from discharge because B.C. 507(a)(1)(C) will always make this a priority debt in bankruptcy and that will always make it excepted from discharge under B.C. 523(a)(1)(A). The non-trust fund portion of the partnership employment tax debt should become dischargeable for bankruptcy petitions filed more than three years after the employment tax return due date, assuming it timely filed the returns. The court engages in no analysis of this issue making me think that she is not entitled to a discharge of the non-trust fund portion; however, depending on the timing of the debt and the bankruptcy petition, this portion of her debt could potentially be discharged in her bankruptcy just as in the bankruptcy of the partnership itself.

This case demonstrates how the IRS will proceed to collect from a general partner. It simply uses the assessment against the partnership to open the full range of administrative collection tools given to it under the Code. The effort by Ms. Pitts to use the Galletti opinion to argue that the operation of state law which lets the IRS go after the general partners without a separate assessment should also limit the IRS in its ability to collect. The 9th Circuit rejects that limitation on the power of the IRS in this situation and, I think, its decision is correct. The issue brings up in another context the interplay between state law which creates certain rights and obligations and the federal tax collection law which builds upon the state created rights and obligations.

Is the Liability a Taxpayer Incurs under the Affordable Care Act for Failing to Obtain Health Insurance a Tax or a Penalty for Bankruptcy Purposes

Today we welcome back guest blogger Professor Bryan Camp of Texas Tech. Professor Camp writes today on the issue of the proper classification of the liability imposed for failure to obtain health insurance. The issue can apply to many excise taxes and has importance in the bankruptcy context.    

Before getting to Bryan’s post, I want to comment a misleading statement I made in the post last week entitled Bankruptcy Court Jurisdiction Over a Tax Claim. In that post I questioned the timing of the filing of their bankruptcy petition because I said they should have waited until three years had passed from the due date of the returns for all years. The issue has applicability to Bryan’s post and he gets it right. Thanks to Ken Weil for pointing out to me that if they filed a Chapter 13 plan and if they completed their plan there is no need to wait three years from the due date of the return to file bankruptcy if you seek to discharge a penalty. For debtors who complete a Chapter 13 plan, the discharge is covered by B.C. 1328(a). Prior to 2005, this provision gave what was called a superdischarge to debtors completing their Chapter 13 plans and made that chapter especially attractive to debtors with late filed returns, fraudulent returns and lots of other penalties. The changes in 2005 watered down the broad scope of the B.C. 1328(a) discharge but did not change the superdischarge of penalties. So, the timing of the bankruptcy vis a vis penalty discharge very much depends on the chapter of bankruptcy debtors choose and their ability to complete their Chapter 13 plan. Keith

Whether a debt is a tax or a penalty is not always easy to determine. The Supreme Court has weighed in on this topic twice, first in Sotelo v. United States, 436 U.S. 268 (1978)(in a case involving the trust fund recovery penalty) and then in United States v. Reorganized CF&I Fabricators of Utah, Inc., 518 U.S. 213 (1996)(in a case involving the excise tax for failure to properly fund a pension plan). In each case the Court determined that the label in the statute did not match the true nature of the statute.

Whether a liability in the Internal Revenue Code is a tax or a penalty has importance in the treatment of the liability in bankruptcy cases. Taxes can rise above other unsecured claims and have priority status in the payout process. Penalties cannot have priority status as unsecured claims. The latest liability to raise issues concerning its status as a tax or a penalty is the liability for failing to obtain health insurance. The liability arises because the Affordable Care Act (ACA) seeks to have as many individuals enroll as possible to make the pool of insured individuals better. Internal IRS guidance directs its employees to categorized the ACA penalty as an “excise tax” for bankruptcy purposes. See IRM 5.9.4.18.1 (“The individual SRP liability will be treated as an excise tax under USC § 507 (a)(8)(E).”)

For the reasons discussed below the fold, I do not think the courts are likely to consider the ACA penalty an excise tax which can achieve priority status. They are more likely to classify it as a penalty which will become a general unsecured claim.

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First, the ACA calls it a penalty and not a “tax.”  IRC 5000A(g) provides that “the penalty provided by this section shall be…assessed and collected in the same manner as an assessable penalty under subchapter B or chapter 68.”  The Congressional decision to label this exaction a “penalty” and not a “tax” was a critical reason why the Supreme Court held that challenges to the penalty were not barred by the Anti-Injunction Act.  National Federation of Independent Business v. Sebelius, 132 S.Ct. 2566, 2582-3.  The Court found that, although the label did not matter for constitutional purposes, it did matter for purposes of figuring out the relationship of the ACA penalty with other statutes because statutes “are creatures of Congress’s own creation. How they relate to each other is up to Congress, and the best evidence of Congress’s intent is the statutory text.”  As in the NFIB case, here we have to figure out the relationship between the use of the work “tax” in the bankruptcy code and in the tax code.  Accordingly, the Congressional decision to label the payment as a penalty, and to direct that it be collected in the same manner as other assessable penalties, establishes a strong presumption that it is not a tax for purposes of other statutes, including the Bankruptcy Code.

Therefore, I don’t see a bankruptcy court treating the ACA as an excise tax or any other kind of tax.  I’m betting the IRS guidance is calling it an excise tax because section 5000A is in the excise tax chapter.  Theoretically, one might defend the penalty as an excise tax because it is imposed on taxpayers for engaging in certain transactions—or failing to engage in specified transactions, which is economically the same thing.  But I don’t see either of these two rationales for treating the ACA penalty as an excise tax as being very strong.

 

A good case to consider is In re Marcucci, 256 B.R. 685 (D. N.J. 2000), where the district court agreed with four bankruptcy courts that certain payments mandated by the State of New Jersey—payments quite similar in structure and purpose to the ACA penalty—were not excise taxes but were penalties.  In Marcucci, the court considered the character of a “motor vehicle surcharge” that New Jersey imposed on drivers who were considered high risk or convicted of certain traffic offenses.  These mandated payments to the state were to help the state fund a pool of money intended to even out the risk among all drivers.  The surcharges had been imposed by private insurers but the New Jersey legislature decided that the market was unfair and inefficient and so rather than indirectly regulating surcharges, decided to have the surcharge program administered by the DMV.   The state argued that these were excise taxes but the court disagreed.

The court first noted that “in cases where the Supreme Court has considered whether a particular exaction was a tax for bankruptcy purposes, the Court looked beyond the titular label given to the exaction and examined its actual operation” and “[t]he proper analysis therefore is to assess whether the attributes of the state’s claim, as provided by state law, fit the definition of a tax within the meaning of the Bankruptcy Code.”

The court then decided that the surcharge’s function was more like a penalty than a tax.  “In contrast to a neutral tax, the surcharge system is designed to deter poor driving habits. As discussed above, the legislative history of the Insurance Reform Act implies that the surcharges are intended to penalize “bad drivers”. That the surcharge system requires payment of outstanding surcharges before allowing a driver to return to the roadways should not be confused with a general tax imposed upon all drivers for the privilege of driving. A motor vehicle surcharge is not a generic exaction imposed to raise revenue for the government, but a penalty imposed as a result of specific motor vehicle violations. The State merely appropriates the monies obtained from specifically established assessments to fund the Merit Rating Plan.”  (internal quotes and citations omitted)

The NJ surcharge at issue in Marcucci is quite similar to the ACA shared responsibility payment.  The ACA penalty is imposed more as a consequence for violating the Individual Mandate (and, consequently, to encourage compliance) than to raise revenue.  See Jordan Barry and Bryan Camp, “Is the Individual Mandate Really Mandatory,” Tax Notes, June 25, 2012, p. 1633.

Second, however, just because the ACA penalty is not a tax does not automatically disqualify it from priority status.  Some penalties get priority status in bankruptcy and some do not.  Section 507(a)(8)(G) describes the kind of penalties that get priority status as “[a] penalty related to a claim of a kind specified in this paragraph and in compensation for actual pecuniary loss.” The legislative history provides that such claims cannot be punitive in nature and that in regard to taxes such claims represent collection of the principal tax liability under the misnomer of a “penalty” See 124 Cong. Rec. H. at 11,096 and 11,113 (Sept. 28, 1978).  For this reason, these types of penalties are called “pecuniary loss penalties.”  All other penalties are nonpecuniary loss penalties and they are treated as general unsecured claims.

I think it likely that a bankruptcy court would consider the ACA penalty to be a nonpecuniary loss penalty.  First, note that the penalties described in 507(a)(8)(G) must be BOTH “related to” a tax described in paragraph (8), AND have the purpose of compensating the government for actual pecuniary loss.  The ACA penalty is sui generis.  It is simply not connected to any of the taxes described in paragraph 8.  Therefore, it cannot be a pecuniary loss penalty, even if it was, in some sense, designed to compensate the government for some pecuniary loss.  Further, I really do not see a court finding that the purpose of the penalty is to compensate for pecuniary loss.  The NJ state government made a bold attempt to convince the court in Marcucci that the surcharge imposed on bad drivers was

In addition to the priority issue I would be remiss to omit a word about dischargeability.  The starting point for discharge of non-priority tax penalties is governed by §523(a)(7).  Non-pecuniary loss penalties may not get priority status, but they also may not be discharged in bankruptcy if they arose within three years prior to the petition date.  The one exception to the 523(a)(7) rules are for debtors who successfully complete their Chapter 13 plans. They get a “super discharge” which, per §1328(a) includes an unqualified discharge of all non-pecuniary loss penalties. Chapter 13 debtors who fail to complete their plans, however, get the usual rules. §1328(b).

Here’s what the relevant part of §523(a)(7) provides:

A discharge…does not discharge an individual debtor from any debt-

 

***

 

(7) to the extent such a debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty-

 

(A) relating to a tax of a kind not specified in paragraph (1) of this subsection; or

 

(B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition;

***

.

11 U.S.C. § 523(a)(7).

The Ninth Circuit did a nice job in parsing this forest of double negatives in McKay v. U.S., 957 F.2d 689 (9th Cir. 1992). Here’s that Court’s explanation,

Carefully parsed, the section initially makes nondischargeable a “debt that is for a fine, penalty or forfeiture payable to and for the benefit of a governmental unit.” Withdrawn from this class, however, are any such fines, penalties, or forfeitures that are “compensation for actual pecuniary loss.” These are dischargeable. The double negative, “does not discharge” and “not compensation for actual pecuniary loss,” accomplishes this end.

Another group of penalties are withdrawn from the nondischargeable group. These appear in parts (A) and (B) of § 523(a)(7). Part (A) withdraws tax penalties attributable to taxes which are not nondischargeable. That is, part (A) makes dischargeable tax penalties attributable to dischargeable taxes. This follows because part (A) relates “to a tax of a kind not specified in paragraph (1) of this subsection.” 11 U.S.C. § 523(a)(7)(A) (emphasis added). Those types specified in paragraph (1) are not dischargeable taxes. In relevant part “paragraph (1) of this subsection” makes not dischargeable “any debt” that is “for a tax … with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. § 523(a)(1)(C).

The other group of penalties withdrawn from the nondischargeable group is described in part (B). It is quite straightforward. It makes dischargeable any tax penalty “imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition.” A penalty imposed on unpaid taxes accruing more than three years before the filing of the bankruptcy petition is dischargeable.

Conclusion:

The bottom line for me is that bankruptcy courts will likely treat the ACA penalty as a general unsecured claim, which means it stands way back in the payout line. The trick is to be sure that the due date of any return that omits paying the ACA penalty is older than three years before the bankruptcy petition date unless your client is one of those rare debtors who successfully completes their Chapter 13 plan, and then they do not need to worry about that.

 

Bankruptcy Court Jurisdiction over a Tax Claim

The bankruptcy code, in Section 505(a), gives the bankruptcy courts the authority to hear the merits of a tax liability.  That authority, however, is not limitless – at least in the eyes of some courts.  The reason for the grant of jurisdiction over tax claims to the bankruptcy courts stems from the need of speedy resolution of tax claims in order to keep them from slowing down the distribution of assets.  Sometimes, tax cases can take quite a long time to resolve, and allowing the bankruptcy court to resolve them can clear the path for a more expeditious distribution of assets.  The recent bankruptcy case of In re Bush, provides insight on a limitation to the bankruptcy court’s jurisdiction over tax claims.  In reversing the bankruptcy court, the district court makes a logical decision.  Not all courts view the issue presented here as jurisdictional.  Some courts consider this issue within the discretion of the bankruptcy court.  On these facts, I think most bankruptcy courts would abstain from hearing the tax matter.  In the Southern District of Indiana, and perhaps in the 7th Circuit, the bankruptcy court may simply lack the discretion to decide where no bankruptcy purpose exists for making the tax determination.

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The Bushes brought a case in Tax Court to determine their tax liability for 2009, 2010 and 2011. For those years, the IRS asserted a deficiency in tax of about $107,000 and fraud penalties of about $80,000.  Before trial of the Tax Court case, the parties reached agreement that the Bushes owed the IRS $100,138 in additional income taxes for the years at issue.  The parties did not settle the fraud penalty issue and it was set to go to trial with petitioners arguing that their actions were merely negligent, which would substantially reduce the applicable penalty.

On September 14, 2014, the morning the trial in Tax Court was set to begin, the Bushes just happened to file a Chapter 13 bankruptcy petition. The opinion does not comment on the coincidence of the timing of this filing; however, it does bring out that the filing stayed the Tax Court proceeding under B.C. 362(a)(8).  The IRS did not appreciate the stay and requested that the bankruptcy court lift the stay to allow the Tax Court case to proceed.  The bankruptcy court declined.  The Tax Court left town.  The Tax Court case has sat in animated suspension since the day of September 14, 2014, waiting for something to lift the stay or waiting for a bankruptcy court determination that it could incorporate into a decision of the Tax Court. (Here the stay was lifted in March 2015 when the Bushes received their discharge and then the Tax Court continued the case because of the possibility that the bankruptcy court would decide the penalty issue.) Once a petitioner properly invokes the jurisdiction of the Tax Court, the subsequent filing of a bankruptcy case and the subsequent decision of the case by the bankruptcy court does not terminate the Tax Court case.  The Tax Court still enters a decision when the stay is lifted.  If the case comes back to it for the Tax Court to decide all or part of the issues, it will enter the decision at the conclusion of the case as is normal.  If the bankruptcy court decides the case, the Tax Court will enter a decision to reflect the decision of the bankruptcy court because it has decided that the 505(a) decision of the bankruptcy court does not relieve it of the obligation to do so.

So, with the Tax Court case in suspended animation, the Bushes ask the bankruptcy court to decide whether they owe the fraud penalty or the negligence penalty for the years 2009-2011. They did not attempt to disavow the agreement reached on the underlying liability before filing their bankruptcy petition.  The IRS objects to the bankruptcy court deciding the case and makes two arguments.  First, it argues that the bankruptcy court lacks jurisdiction and alternatively, it asked the bankruptcy court to abstain.  The bankruptcy court denied the request by the IRS that it hold it lacked jurisdiction and similarly declined to abstain; however, it did agree to allow the IRS to appeal its rulings.

The District Court, noting the lack of uniformity on this issue among various bankruptcy courts, districts, and circuits, found that B.C. 505 does not allow a bankruptcy jurisdiction over “matters that do not otherwise satisfy 28 U.S.C.A. 1304, the statute that establishes bankruptcy jurisdiction.” It found that B.C. 505 is not an independent grant of jurisdiction.  The determination of the amount that the debtors owe for their tax penalties does not satisfy the “arising in” jurisdiction of the bankruptcy court.  The debtors seek to have a substantive tax matter decided by the bankruptcy court based on the B.C. 505 procedure.

In addition to the problem of core proceeding, the tax decision is not related to the bankruptcy proceeding. Critical to this consideration is the fact that the decision of the bankruptcy court on the debtors’ penalties in this situation is not going to change the outcome of the bankruptcy case.  The Bushes did not have enough assets to distribute to the IRS for the penalties they will owe whether those penalties turn out to be the fraud penalties or negligence penalties.  Since the decision by the bankruptcy court will have no impact on the bankruptcy case, the District Court does not believe that the taxes, in this circumstance, meet the requirement of core proceeding or related proceeding.

Because the District Court finds that the bankruptcy court cannot exercise Section 505 jurisdiction over the taxes, the case will eventually get kicked back to the Tax Court for a determination of the applicable penalties. That raises the question of discharge and what difference will the Tax Court’s decision make here.  I have discussed the discharge provisions as they relate to penalties before here and here.  The taxes at issue in the case cannot be discharged because they are income taxes entitled to a priority either under B.C. 507(a)(1)(A) or (C) because, at the time of filing the petition in the bankruptcy case on September 14, 2014, less than three years had passed since the due date of the 2011 return excepting the taxes for that year from discharge under the application of B.C. 507(a)(1)(A) and 523(a)(1)(A).  Because the taxes for 2009 and 2010 could still be assessed at the time of the bankruptcy petition due to the statutory notice of deficiency and the Tax Court petition, B.C. 507(a)(1)(C) and 523(A)(1)(A) except those two years from discharge.

The penalties travel a different path since they cannot achieve priority status. To determine the dischargeability of the penalties, it is necessary to look at 523(a)(7) which has a three year look back period from the time of the filing of the bankruptcy petition to the time the penalties arose.  The penalties arose on the filing of the returns.  If the returns for each year were filed on or before the due date, the penalty claim for 2009 and 2010 will be discharged by the bankruptcy and only the 2011 penalty claim would survive bankruptcy.  If the 2010 return was filed using an extended due date, it too may be excepted from discharge since the extended due date would have been October 15, 2011, which was within three years of the filing of the bankruptcy petition.

If only one year of the penalties matters, why did petitioners go to all of this trouble? An even greater question is why didn’t they wait until April 16, 2015 to file the bankruptcy petition and then they could have eliminated all of the penalties with the filing of a bankruptcy petition.  The Tax Court trial taking place on September 14, 2014, would almost certainly not have resulted in an assessment until after April 16, 2015 absent a bench opinion.  By sticking with the Tax Court case and then filing a bankruptcy petition after April 15, 2015, the Bushes could have eliminated all of the penalty liabilities, whether fraud or negligence.  The timing of the filing of their bankruptcy case clearly seemed motivated by the timing of the Tax Court trial, yet the timing was bad for them.  The only sound basis for the timing of their filing was the greater possibility that the bankruptcy court would find negligence than the Tax Court would have found.  The penalty determination may not have made much difference on the Bushes obligation to pay the penalties themselves but it does have an impact on whether they can discharge the taxes.  If the Tax Court or Bankruptcy Court determines they committed fraud on their returns, the taxes can never be discharged as long as the statute of limitations on collection keeps the liabilities open for collection because of B.C. 523(a)(1)(C).  I do not know the strategy driving the decision to file bankruptcy on the day of the penalty trial.  Unless the Bushes had a lot more faith in the bankruptcy judge finding their actions negligent rather than fraudulent, it seems misplaced.