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

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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.

Comments

  1. Peter Francis Geraci says:

    Sounds like the IRS is arguing judicial estoppel without doing so. Both the 7th circuit and the Illinois S Ct have authority that would defeat such an argument attempting to apply Sec 521 duty as only element of judicial estoppel. Illinois App Ct 2nd District just ruled so in Knott v Farm and Fleet

  2. David Cohen says:

    It seems to me that the Trustee has standing to demand the refund (assuming no limitations issue) The Debtors would be entitled to any surplus from the estate after the Trustee made diligent efforts to advise creditors to file claims.
    The rights of the Debtors are thus secondary to the bankruptcy estate.

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