Tax Refunds and the Disposable Income Test

We welcome back occasional guest blogger Marilyn Ames, who like me is retired from the Office of Chief Counsel, IRS and who did a lot of bankruptcy work when she worked for the government.  She discusses today a recent 5th Circuit case allowing the debtor to keep an earned income tax credit despite some local rules in Texas requiring her to turn a part of it over.  Although the 5th Circuit does not base its decision on the fact that the refund resulted from the earned income tax credit, that fact plays an important role.  Keith

As illustrated by the Covid-19 payments recently dispersed by the Internal Revenue Service and the use of the IRS to carry out portions of Obamacare, Congress frequently uses the IRS and the Internal Revenue Code as a means of administering social programs that have little or nothing to do with taxes. One of the problems of using the IRS to execute these types of programs is that courts assume that all provisions in the Internal Revenue Code are tax-related, which can, at worst, result in decisions at odds with the purposes of these programs, and at best, create precedent that fails to acknowledge Congressional intent.

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The Fifth Circuit’s recent decision in the bankruptcy case of Matter of Diaz (found here or at 2020 WL 5035800) illustrates this issue. While the Fifth Circuit reached what is clearly the right conclusion under the Bankruptcy Code, it did so without recognizing why its decision was correct as a matter of policy. The Diaz case involves the amount of a tax refund that must be turned over as part of a Chapter 13 plan as disposable income, to be paid to general unsecured creditors. The bankruptcy court, the district court and the Fifth Circuit all failed to state why the debtor had a refund, but the Fifth Circuit does provide enough facts for an educated guess to be made that Ms. Diaz’s refund for 2017 resulted from the earned income credit. During 2017, Ms. Diaz worked as a medical assistant, and earned $2,644.16 per month, or a total of $29,791 for the year. During this year, she was a single parent with two children.  She filed bankruptcy on December 1, 2017, but her bankruptcy schedules filed later included her refund for 2017 in the amount of $3,261. Assuming that Ms. Diaz filed a return showing three exemptions and claiming the standard deduction for a head of household of $9,350, her return for 2017 would have showed a taxable income of $8,291 and a tax liability of $828. Making another assumption that she qualified for the earned income credit, the EITC for 2017 would have been $3,208, or about the amount of the refund she claimed on her return. (The tax liability on her return could have been offset by the child tax credit, resulting in a refund of any withholding, and she could also have been entitled to the additional child tax credit, but close enough given the facts available.)

Ms. Diaz filed bankruptcy in the Western District of Texas, which uses a standard form for Chapter 13 plans. Section 4.1 of the standard form provides that the debtor must turn over any tax refunds in excess of $2,000 to be disbursed to creditors pursuant to the plan by the Chapter 13 trustee. The only exception to turning over these funds is if the debtor’s plan provides for payment of 100% of the general unsecured claims, the debtor files a notice requesting that she be permitted to keep the excess refund amount, and the trustee does not object. Ms. Diaz could not make such a request, as her plan provided for only 12% of the general unsecured claims to be paid. Rather than filing a plan providing for the excess amount of $1,261 from her 2017 refund to be turned over to the Chapter 13 trustee, Ms. Diaz filed a plan that divided the total amount of her refund by 12 months, and then included that portion in her monthly income.  Provision 4.1 of the standard form was then stricken through. When the refund was included as part of her monthly income, the plan was adequate to meet the requirements of the Bankruptcy Code.

This gerrymandering did not sit well with the Chapter 13 trustee, who objected to the plan as it did not meet the provisions of Section 4.1 of the standard plan.  Ms. Diaz argued that the plan violated both the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. The bankruptcy court and the district court for the Western District of Texas disagreed, holding that the district court had authority to require that a standard Chapter 13 plan be used pursuant to the provisions of Federal Rule of Bankruptcy Procedure 3015.1, and that tax refunds are disposable income under Bankruptcy Code § 1325(b)(2) that must be included in the plan. The bankruptcy court rejected the debtor’s argument that her tax refund was similar to payments received for dependent adult children that are excludable from a debtor’s disposable income, apparently not recognizing that all or part of the debtor’s refund was probably attributable to the EITC, which is computed based on the number of dependents a taxpayer has. The district court affirmed the ruling of the bankruptcy court with even less consideration of why the debtor was entitled to a refund.  The bankruptcy court opinion can be found here (586 BR 588) and the district court opinion can be found here (2019 WL 4545613).

The Fifth Circuit disagreed that the debtor was required to turn over the refund, relying on Bankruptcy Code § 1325. If a plan does not provide for an allowed unsecured claim pursuant to § 1325(a), the plan cannot be confirmed unless the debtor includes all projected disposable income to be paid out to general unsecured creditors. Ms. Diaz’s plan did not provide for her unsecured creditors pursuant to § 1325(a), so she could only have a plan confirmed that included all projected disposable income. Noting that district courts may not adopt local rules or create standard plans that abridge, enlarge or modify any substantive right, the Fifth Circuit focused on whether the tax refund in excess of $2,000 was part of the debtor’s projected disposable income that had to be turned over to the Chapter 13 trustee.

Although the Bankruptcy Code does not define projected disposable income, § 1325(b)(1)(B) does state how it is to be calculated. Disposable income is the current monthly income received by the debtor, less “amounts reasonably necessary to be expended” for the debtor’s maintenance and support, plus any qualifying charitable contributions and business expenditures. Current monthly income is calculated by averaging the debtor’s monthly income in the six full months preceding the bankruptcy petition. The definition of “amounts reasonably necessary to be expended” is included in §1325(b)(3), and is different depending on whether the debtor has monthly income, when calculated for a year, greater than the median family income of the applicable state.  This amount can vary depending on the number of individuals in the household. If the debtor has current monthly income, when calculated over 12 months, greater than the applicable state median family income, only those expenses included in Bankruptcy Code § 707(b)(2) are included as amounts reasonably necessary.  If the debtor has less than the applicable median amount, all amounts for the maintenance or support of the debtor or the debtor’s dependents are included.

In the Diaz case, Ms. Diaz’s current monthly income, projected over 12 months, was less than $59,570, the median income for a family of her size in Texas in 2017. The expenses she claimed on her bankruptcy schedules totaled far less than the IRS National Standards for a family of the same size.  The Fifth Circuit concluded that “[W]e find it entirely plausible that Debtor will use her ‘excess’ tax refund of $1,261 for expenses that are reasonably necessary for her family’s maintenance and support.” Because the standard form required Ms. Diaz to turn over the tax refund in excess of $2,000 without determining whether the excess was an amount reasonably necessary to be expended, it violated her substantive right as a below-median income debtor to retain any refund reasonably necessary to be expended for her family’s support.

Although reaching the correct decision under the Bankruptcy Code, the Fifth Circuit failed to consider whether the refund was generated by the EITC and, if so, whether that fact should be considered in determining whether a debtor should be required to include these funds. The earned income tax credit was enacted in part to provide relief for low-income families. Hopefully, the provisions of Bankruptcy Code § 1325(b)(1)(B) expanding the amounts that can be considered to be amounts reasonably necessary to be expended for the maintenance and support of families with incomes below the median income of the state will be sufficient to continue to protect the relief Congress granted to low-income families through the EITC provisions. However, the fact that Ms. Diaz was required to appeal her case to the Fifth Circuit in order to protect her rights argues for an opinion that more explicitly recognizes the purposes of the EITC.

Notice is a Big Deal When Dealing With Tax Debts in Bankruptcy

A pair of recent cases demonstrate the importance of notice.  In one case where the outcome shocked me, the IRS loses out on a $90,000 trust fund recovery penalty.  In the second case, which provided a routine result still worth the reminder, the purchaser of property loses in an effort to remove the federal tax lien in a quiet title action.

Notice to the government when trying to obtain relief from something the IRS has done or seeks to do can make or break a case.  Generally speaking, a fair amount of protection exists for the IRS regarding notice, because it needs protection in order to insure that the information gets to the right place in time for the IRS to react properly to the request of a third party seeking to cut off rights the IRS would seek to assert or preserve.  Because it receives such a volume of mail, establishing systems that allow the IRS to properly recognize and respond to important documents plays a huge role in having the system work properly.  One of these cases demonstrates what happens to the IRS when the notice does not arrive at the places set up to respond, while the other cases demonstrates what happens when the party seeking relief fails to follow the very precise rules for providing notice to the IRS when seeking to cut off its lien rights.

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Taxpayer Escapes Liability As Court Finds Adequate Notice of Objection to a Proof of IRS’s Claim

In Nicolaus v. United States, No. 19-1155 (8th Cir. 2020) the Eighth Circuit reverses the bankruptcy and district courts handing a victory on procedural grounds to a debtor in a case in which the IRS filed a claim for the Trust Fund Recovery Penalty (TFRP).  We don’t know if the TFRP assessment against Mr. Nicolaus should exist on substantive grounds because the Eighth Circuit determines that the failure of the IRS to respond to his objection to the claim provides a basis for disposing of the claim.  The issue in the case stems from an interpretation of the bankruptcy rules.  As I mentioned above, the outcome shocks me and, I am sure, the government.

Mr. Nicolaus filed bankruptcy.  The IRS timely filed a proof of claim.  Mr. Nicolaus objected to the proof of claim and sent notice of the objection to the IRS at the address listed on the proof of claim.  Although the Eighth Circuit’s opinion does not state this address, it would be an address at the IRS either in the local Iowa office or the centralized bankruptcy office in Indianapolis.  Nothing happened.  After 21 days and no response from the IRS, the bankruptcy court sustained the debtor’s objection and disallowed the claim.  A year later, after the bankruptcy case had closed and Mr. Nicolaus had long since celebrated his easy victory over the large liability, the IRS filed a motion to vacate the order disallowing the claim, based on a lack of personal jurisdiction because of the improper service of the objection to claim.  While it may seem harsh to have a motion filed a year later, the timing does not impede the ability of the IRS to set aside the disallowance and probably reflects the amount of time the case took to cycle from the bankruptcy into collection mode, where someone at the IRS actually took notice of the disallowance.

The bankruptcy court agreed with the IRS that service of the objection was improper and it vacated the order disallowing the claim.  Because of the type of debt, the discharge Mr. Nicolaus received could not discharge the liability which meant that the IRS could come after him post-discharge to collect the debt.  B.C. 507(a)(8)(C) provides that a debt for taxes a taxpayer collects on behalf of the IRS receives treatment as a priority claim no matter how old the debt.  If a debt has priority status, an individual cannot discharge it based on the exception to discharge in B.C. 523(a)(1)(A).  So, the issue of the disallowance of this debt has a significant impact on Mr. Nicolaus.

At the time of filing the objection Federal Rule of Bankruptcy Procedure 3007(a) provided “[a]n objection to the allowance of a claim shall be in writing and filed.  A copy of the objection with notice of the hearing thereon shall be mailed or otherwise delivered to the claimant, the debtor or debtor in possession, and the trustee at least 30 days prior to the hearing.”  I will note that earlier the court described the default occurring after 21 days but don’t focus on that issue.  Footnote 2 of the opinion notes that “[W]ith an effective date of December 1, 2017, an amendment to Rule 3007(a) now expressly requires objections to a federal agency’s claim to be mailed to the Attorney General and the local United States Attorney’s Office. The pre-amendment version applies here, however, because Nicolaus filed his objection before the effective date of the 2017 amendment.

At issue in this case is whether the debtor needed to serve the Attorney General of the United States and the local United States Attorney’s Office under the prior version of the rule.  The lower courts looked at Bankruptcy Rule 9014(b) governing service in contested matters and found that it required service in the manner required by Bankruptcy Rule 7004, which clearly requires service on the AG and US Attorney; however, the Eighth Circuit noted that in 9014(b) the key word was “motion” triggering this type of service and the objection was not a motion.  The Eighth Circuit did not find the advisory notes to the rules controlling but rather the plain language of the rule as it read prior to its amendment.  Accordingly, it reversed and Mr. Nicolaus once again has his victory which through this litigation became a hard earned victory, albeit on procedural rather than substantive grounds.

The amendment to the rules almost certainly means that the government will not seek a ruling from the Supreme Court on this issue.  The rule appears to have been changed to partially resolve a split in authority on how to interpret 3007, with different bankruptcy courts taking contrary approaches. Compare In re Hensley, 356 B.R. 68 (Bankr. Kan. 2006) (holding that service of a claim objection need not follow Rule 7004) with In re Boykin, 246 B.R. 825 (Bankr. E.D. Va. 2000) (holding the reverse). In addition, the Advisory Committee notes for the 2017 amendment suggest a need to centralize and standardize service on the government, stating that “the size and dispersal of the decision-making and litigation authority of the federal government necessitate service on the appropriate United States attorney’s office and the Attorney General[.]”Not many cases will still exist from before 2017.  So, Mr. Nicolaus may be the last beneficiary of the Eighth Circuit’s interpretation of the bankruptcy rule.

Purchaser Loses As Failure to Follow Notice Rules Led To No Extinguishing of Tax Lien

In contrast to the victory achieved by Mr. Nicholas, another case decided on July 6, 2020 went the opposite way based on a failure to give proper notice to the IRS.  In LN Management LLC Series 7241 Brook Crest v. Brandon Jhun, No. 2:14-cv-01936 (D. Nev. 2020) the District Court determined that the purchaser of property could not quiet title to remove the IRS lien.  The plaintiff purchased property at a non-judicial foreclosure sale.  Prior to the foreclosure sale the IRS assessed taxes against the owners of the property for 2008 and 2009 on October 12, 2009 and June 7, 2010, respectively.  The IRS properly recorded its notice of federal tax lien on May 18, 2011.  I previously discussed the notice requirements of 7425 here

The property owners failed to pay their homeowners association fees, and the HOA brought a foreclosure action in 2013.  The HOA did not mail foreclosure notices to the IRS.  The plaintiff bought the property.  At some point, presumably after purchase, the plaintiff noticed the federal tax liens encumbering the property and brought this action.  The law is so well settled on this issue that it’s hard to know why the purchaser bothered with this suit but maybe it hoped for the same luck as Mr. Nicolaus.

In order to extinguish the federal tax lien in a non-judicial foreclosure sale when the IRS has properly filed notice of the lien more than 30 days before the sale, the party bringing the action must give notice to the IRS in the manner described in IRC 7425(b)(1), or the sale will not extinguish the federal tax lien.

A party trying to extinguish the federal tax lien under these circumstances must follow very specific steps for notice.  Once the IRS raised its objection, the plaintiff did not even respond.  At that point it must have realized the futility of its case.  Because the IRS did not seek to foreclose its lien or respond to alternate grounds for relief, the court granted the motion for summary judgement on the quiet title portion of the case but remanded the parties to discuss the remaining issues.

The plaintiff should have performed a title search before purchasing the property, just as the HOA should have done before filing its complaint.  The purchaser may have thought that it bought the property for a bargain.  By now, it has realized that the bargain just embroiled it in a quagmire.  Purchasing property encumbered by the federal tax lien requires careful planning.  That obviously did not occur here because of the failure of notice in the specific manner required by the statute in order to give the IRS the opportunity to participate in the foreclosure proceeding.

Using Bivens to Attack Flora

In Canada v. United States, 125 AFTR2d 2020-960 (5th Cir. 2020) the taxpayer brought a Bivens suit seeking damages against the revenue agents because the agents caused the IRS to assess against him a tax shelter penalty under IRC 6707 in an amount so high payment of the penalty was a practical impossibility. If this story sounds similar, remember the case of Larson v. United States, 2018 U.S. App. LEXIS 10418   (2nd Cir. 2018) discussed here and here.  Larson is not the only other case to reveal this problem.   Other cases with this same problem include Diversified Group Inc. v. United States, 841 F.3d 975 (Fed. Cir. 2016), which tried unsuccessfully to argue that the penalty was divisible, and the three circuit cases litigated by Lavar Taylor seeking unsuccessfully to get a foot in the door using the merit litigation provisions of Collection Due Process discussed here.  The ability of the IRS to assess a non-divisible penalty under IRC 6707 in a staggering amount puts taxpayers back in the boat they were in prior to the creation of the Tax Court. It also reminds us that 100 years ago Senators pushed for the creation of the Tax Court in order to prevent individuals from seeking bankruptcy as a refuge from taxes they could not contest judicially without full payment.

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In Canada, bankruptcy is exactly where he went so that he could litigate the merits of his tax liability under B.C. 505(a) since he did not have enough money to meet the Flora rule.  The taxpayer won the merits of his case in bankruptcy beating back the incredibly high penalty amount assessed by the IRS. United States v. Canada (In re Canada), 574 B.R. 620, 623 [119 AFTR 2d 2017-1752] (N.D. Tex. 2017).  After succeeding in essentially eliminating the liability through the bankruptcy proceeding, he turned and argued that the agents who caused the assessment of this penalty knew that he had no prepayment forum where he could litigate the liability and knew they were wrongfully forcing him into bankruptcy.  He brought this Bivens suit seeking to recover damages and attorney’s fees from the individuals he blamed for being forced into bankruptcy.  The Fifth Circuit, affirming the lower courts’ dismissal of the case, carefully analyzed the factors necessary for a Bivens action, before pointing out that precedent in recent decades disfavors expansion of the original decision and two cases decided shortly thereafter.  The court also points out that if successful, his suit would provide an end run around the Flora rule of full payment.

Because I think the Flora rule should not apply to non-deficiency cases, I am not too saddened by an end run around Flora.  I also applaud the ingenuity of the argument here; however, the Supreme Court has made it clear in the decades following Bivens that it does not want to expand the grounds for obtaining recovery from government agents.  The result here comes as no particular surprise.  I found heartening the success of Mr. Canada in removing the penalty at the bankruptcy level.

For anyone not familiar with Bivens cases and the IRS we have discussed them previously here and here.  Government agents at all agencies need protection from personal suits brought concerning actions taken in the scope of their employment.  Interpreting that scope broadly makes sense as we don’t want to chill the government employees from doing their job.  At the same time if government employees do something so egregious and outside the scope of their employment, it also makes sense that at some point the immunity that protects them from personal liability goes away.  Bivens brings out facts where the immunity goes away, but the Supreme Court wants and needs to carefully control the circumstances where that exists.  The Fifth Circuit in Canada looks at the history of the case law after Bivens in concluding that the actions of the revenue agents in assessing the 6707 penalty against Mr. Canada did not rise to the level of action that could give rise to a personal liability against them.

Canada argues that the district court below improperly considered the special factors by applying a “sound reason” standard rather than a “convincing reason” one. Canada asserts the latter is what Ziglar requires.

The Fifth Circuit finds that Canada cannot fit himself into one of the narrow paths for application of Bivens.  It points out that if what he seeks is some form of compensation for his efforts to rid himself of the 6707 assessment, he had other paths available:

It is unclear why Canada did not simply file an application for fees in the bankruptcy court or in the initial district court. Canada states the IRS’s appeal to the district court deprived the bankruptcy court of jurisdiction to consider his fee request. Canada also contends that the appeal forecloses the IRS’s untimeliness argument or is a compelling reason to extend the 26 U.S.C. § 7430‘s 30-day period. These arguments make little sense. He could have filed a motion for the recovery of fees at any time during the pendency of the case in the bankruptcy court. Canada also had the option of moving to reopen the bankruptcy case once the initial district court’s ruling on appeal became unappealable. See 11 U.S.C. § 350(b) (“A case may be reopened in the court in which such case was closed to administer assets, to accord relief to the debtor, or for other cause.”). Similarly, Canada had the ability to ask the initial district court to award him fees anytime between the start of the appeal and 30-days after the IRS could no longer appeal the district court’s order. There is no convincing reason why Canada could not have filed an application for fees under 26 U.S.C. § 7430 in one of those two courts before August 2017 because of an appeal that ended on May 8, 2017. Nevertheless, assuming arguendo that his proposition is accurate, he still could have filed this lawsuit before the 30-day time period lapsed.

While I am sympathetic with Mr. Canada because the current interpretation of the Flora rule essentially forced him into bankruptcy, the Fifth Circuit’s opinion makes sense to me.  Bivens does not seem like the right place to go for the wrong he has suffered.  Bringing an application for fees seems more appropriate even though I understand this might not adequately compensate him for the trouble he has endured.  The real answer lies in removing the Flora rules as a barrier to litigating the correctness of certain penalty assessments.  Until that problem goes away, others will use their creative energies similar to the way Mr. Canada has done.  The problem is not the agents.  The problem lies with the current interpretation of Flora which prevents, as a practical matter, taxpayers from contesting certain assessable penalties.  It also lies with Congress which has created the assessable penalties leaving taxpayers no alternative but bankruptcy should they seek to contest the liability.  Congress knew better than this a century ago when it created the predecessor to the Tax Court.

Discharge of Late Filed Return Takes a Turn in Taxpayer’s Favor – Has the Objective Test of Colson Migrated Out of the 8th Circuit?

In the case of In re Starling, 125 AFTR2d 2020-2587 (Bankr. S.D.N.Y 2020) the bankruptcy court holds against the IRS in a case involving the filing of a Form 1040 after an assessment based on a substitute for return.  The case runs contrary to lots of case law but none at the Second Circuit level.  I anticipate the IRS will appeal this aspect of the case and maybe others.  Thanks to Christine Speidel for bringing the case to my attention and Ken Weil for providing me with background research as we discussed the case.  I have posted many times on this issue but not since the beginning of 2020.  Look here for a collection of the posts.

The case also involved a claim for damages under IRC 7433.  The bankruptcy court determined that the debtor could not obtain damages from the IRS because he failed to exhaust administrative remedies; however, it determined that the private debt collector who sent notices to the debtor after a referral of the debt from the IRS did owe damages, since it lacked the immunity available to the IRS on this issue.

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Mr. Starling failed to file his 2002 individual income tax return despite notices from the IRS requesting that he do so.  Eventually, the IRS prepared a substitute for return and made an assessment of tax for 2002 in 2005.  Two years later, the taxpayer filed a Form 1040.  Six years after filing the Form 1040, Mr. Starling filed a chapter 13 bankruptcy petition.  After completion of the plan payments Mr. Starling received a discharge in May 2016.  Although he had paid the priority claim of the IRS through his plan, Mr. Starling found that the IRS did not consider the 2002 year discharged.  In the chapter 13 case the 2002 taxes would have been classified as general unsecured claims because of their age and as general unsecured claims would generally have been eliminated when Mr. Starling received his discharge.  This seems to have been his expectation.

The IRS did not believe the 2002 taxes were discharged because it made its assessment based on an SFR.  I am almost certain that the IRS instructions coded into its computer and given to its bankruptcy employees would treat the 2002 debt in this manner everywhere in the country except in the 8th Circuit.  Because it believed that the 2002 debt survived the bankruptcy discharge and because it remained unpaid, the IRS referred the debt to one of the private debt collectors (PDC) with whom it has a contract, and the PDC sent Mr. Starling letters seeking payment on the outstanding liability.  Sending those types of collection demand letters regarding a discharged debt would violate the discharge injunction in BC 524.

Because Mr. Starling felt that his chapter 13 discharge eliminated the 2002 liability, he brought a contested matter seeking a determination regarding discharge and seeking contempt against the IRS for violating the discharge injunction.  The IRS defended the action arguing that the exception to discharge in BC 523(a)(1)(B)(ii) applied to the 2002 liability because Mr. Starling filed the Form 1040 for 2002 after the IRS had processed a substitute for return and made an assessment based on the substitute.  Since the IRS had already processed a return for Mr. Starling for 2002, it argued that the subsequent submission of the Form 1040 for that year failed the Beard test and, therefore, did not trigger the late filed exception in B.C. 523(a)((1)(B).

The issue here has existed for over 20 years since the 6th Circuit’s decision in the Hindenlang case.  In that case the court decided that the filing of a Form 1040 after the assessment of the liability could serve to trigger a discharge but the late return must have been filed prior to an IRC 6020(b) assessment triggered by the IRS.  Most courts look at the issue agreed with Hindenlang but the 8th Circuit in Colson did not.  The split in authority and the uncertainty resulting from the split caused the IRS to push for and Congress to adopt an amendment to B.C. 523 in 2005 intended to resolve this situation.  Unfortunately, the 2005 amendment did not resolve the uncertainty but injected more uncertainty into the situation.  Instead of two theories regarding what should happen in this situation, the amendment created a third without resolving the original dispute.

The three possible outcomes, in order of likelihood from least likely to most likely, are 1) the debtor’s objective filing of the Form 1040 after the IRS makes the SFR assessment begins the two year period described in B.C. 523(a)(1)(B) allowing debtor to obtain a discharge by waiting two years after filing the delinquent Form 1040 before filing a bankruptcy petition – the Colson view which is the prevailing view in the 8th Circuit; 2) the debtor’s filing a return late, even one day late, prevents the debtor from ever obtaining a discharge for the taxes related to the late return based on an interpretation of the flush language of the 2005 amendment to BC 523(a) in the unnumbered paragraph at the end of that provision – the one day late rule which is the prevailing view in the 1st, 5th and 10th Circuits and most recently repudiated by the 11th Circuit in In re Shek, 937 F.3d 770, 776 (11th Cir. 2020) (providing a definition of applicable to overcome the one day rule).; and 3) the debtor can file a late return and discharge it by waiting two years before filing bankruptcy after the filing of the late return but the late return must be filed prior to an IRC 6020(b) assessment triggered by the IRS – the Hindenlang view.

The bankruptcy court in Starling chooses the path less travelled and essentially follows Colson.  This potentially presents large problems for the IRS if it stands because it requires the IRS to reprogram its computers and issue supplemental instructions to its bankruptcy staff for all bankruptcies in the Southern District of New York.  For that reason and for the reason that the Colson theory has not caught on elsewhere, I expect an appeal to the district court on this issue.  Because the IRS does not agree with the one-day rule, it will appeal arguing that a subjective test should apply and that Mr. Starling knew when he filed the Form 1040 that the IRS had already assessed his taxes for 2002, causing his Form 1040 not to meet the Beard test based on his knowledge of the circumstances. 

So far, there may only be one case applying the subjective test in which a debtor has prevailed on the Beard test that has not been reversed on appeal.  That case is Briggs, Sr. v. United States (In re Briggs, Sr.), 511 B.R. 707 (Bankr. N.D. Ga. 2014).  At trial, the tax was found dischargeable.  The District Court affirmed.  Briggs, Sr. v. United States (In re Briggs, Sr.), N.D. GA. No. 15-2427 (June 7, 2017).  In Briggs, the debtor thought his business partner had filed his return.  Their custom was for the business partner to prepare the return, the debtor to sign it, and the business partner to file it.  The business partner did not file the return.  The IRS’s notice of deficiency was mailed to the business partner’s address and not the debtor’s, so the debtor did not know the return was nonfiled.  As part of a lawsuit, the debtor had done a forensic accounting to determine revenue and expenses.  Upon learning of the nonfiling and SFR assessment, taxpayer filed a return, which was found to be a valid return.

I previously wrote a post on Shek here.  Although Shek is an 11th Circuit case it involves state income taxes owed to Massachusetts.  Massachusetts convinced the 1st Circuit in the Fahey case that the flush language added to the end of BC 523 in 2005 means that a return filed one day late prevents it from ever receiving a discharge.  Shek did not involve an intervening substitute for return but a clean question of the application of the one-day rule.  Thanks to an amicus brief by University of Michigan law professor John Pottow, the 11th Circuit rejected the one day rule argument, finding that the language added in 2005 did not require this result.  

The Massachusetts Department of Revenue wisely, in my opinion, chose not to seek cert from the Supreme Court based on the direct split between the 1st (and 5th and 10th) Circuits and the 11th Circuit.  Because almost all of the Massachusetts Department of Revenue cases exist in the 1st Circuit, it had much to lose by taking the case to the Supreme Court and little to gain.  So, we must wait for another circuit decision before the Supreme Court will have the opportunity to fix the problem.  Of course, Congress could step in and try again to fix the problem without creating a fourth split in possible outcomes.  I know there are some debtor’s attorneys in the 1st Circuit looking for another chance to take on the Fahey decision.  Maybe the 1st Circuit will take another look at this issue and the next split will come there.

In addition to the issue of discharge, the bankruptcy court in Starling also addressed the issue of damages.  Mr. Starling sought damages from the IRS for seeking to collect the tax liability after discharge.  The bankruptcy court found that he could not obtain damages from the IRS, because he did not exhaust administrative remedies by making a request to the IRS before bringing the action.  If he had made a request to the IRS, he likely could have recovered damages, because the IRS would have told him his position on the discharge issues was wrong.

Although the bankruptcy court could not award damages against the IRS because the waiver of sovereign immunity required exhaustion of administrative remedies, it decided that it could award damages against the PDC, which lacked the same sovereign immunity protection cloaking the IRS.  While I am not a fan of PDCs, I expect this aspect of the decision will also be appealed, both because of the argument regarding the applicability of the exception to discharge and the argument of the PDC’s relationship to the IRS and reliance on the IRS.

Chapter 7 Brings an Opportunity to Use IRS Liens to Satisfy Unsecured Creditors

The Fifth Annual Tax Controversy Institute will be held online on July 17th.  This Institute is sponsored by the University of San Diego School of Law and the tax law firm of RJS Law.  Here is a link to further information about the Institute’s program and a place to sign up for virtual tickets.  The keynote speaker is Sharyn Fysk (Director of the IRS Office of Professional Responsibility), and the Institute is presenting an award to Professor Carr Ferguson acknowledging his lifetime of achievement in the tax field

The ABA Tax Section May meeting continues online.  Find information about the online program here.  It continues with two or three programs each week through the end of July.  Note that for readers of this blog many of the tax controversy programs from committees that focus on tax procedure occur toward the end of the program.  Here are some of those programs and the dates:  July 14  Civil & Criminal Tax Penalties – panel descriptions;  July 22  Court Procedure & Practice – panel descriptions;  July 29  Administrative Practice – panel descriptions; and  July 30  Standards of Tax Practice – panel descriptions.  You can purchase tickets to individuals committee sessions or to the overall meeting.


In the case of United States v. Hutchinson, 125 AFTR 2d 2020-1968, (EDCA 2020) the district court sustains the decision of the bankruptcy court avoiding portions of the IRS lien.  Based on the prior precedent in the circuit and the language of the statute, the outcome is not surprising.  The fact that the Department of Justice appealed the decision from the bankruptcy court suggests that it may press to take the matter further.  The outcome here results from Congressional efforts in the bankruptcy code to allow unsecured creditors to get paid before the IRS gets paid for a debtor’s bad acts.  Due to the timing of the filing of the federal tax liens at issue in this case and the IRS practice of paying down liabilities in the order of tax, penalty then interest, the IRS loses most of the value of its liens even though it had filed lien amounts for taxes exceeding the value of the equity.  A tough result for the IRS that the court could have explained better but a good result for creditors who might not have expected anything out of this bankruptcy case.

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 The case results from Congressional generosity in chapter 7 cases in order to provide something for the unsecured creditors.  A very high percentage of chapter 7 cases are “no asset” cases meaning that unsecured creditors get nothing.  Here, the trustee uses the IRS lien and the front-end loading of the penalties owed on the liabilities reflected in the lien to reach a favorable result for the unsecured creditors.

At the time of the filing of the bankruptcy, the IRS had the following liabilities owed to it for which it had filed a notice of federal tax lien:

Recording DateTaxInterest on TaxPenalty
05/23/2011$0.00$6,450.15$44,500.11
05/23/2011$62,913.27$17,794.31$87,599.43
07/25/2011$40,436.77$11,403.79$30,549.31
06/14/2016$67,050.11$4,938.42$42.00
06/14/2016$36,337.67$2,052.10$0.00
Total:$206,737.82$42,638.77$162,690.85

Bankruptcy Code section 724(a) provides “(a) The trustee may avoid a lien that secures a claim of a kind specified in section 726(a)(4) of this title.”  Section 726(a)(4) provides “fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim;”

The combination of these two sections allows the trustee to avoid a federal tax lien securing a penalty.  No one in the case disputed this result.  At issue in Hutchinson is the effect of avoiding the lien for the penalty.  The court stated that the issue in the case was “Whether the bankruptcy court erred in denying the government’s motion to abandon property of the bankruptcy estate based on the determination that avoided and preserved penalty portions of liens were not of inconsequential value to the estate.”

Later in the case the court stated the issue another way which perhaps provide more clarity regarding the actual dispute:

Here, the question is whether the tax and interest portions of the IRS’s five liens enjoy a higher priority over the penalty portions of the liens, despite each lien being comprised of tax, interest, and penalties at recordation. It appears that the law does not clearly delineate the extent to which certain categories of avoided and preserved liens might confer greater rights to the estate by operation of § 551, than rights the actual creditor would have held following avoidance of its lien. What priority do avoided penalty liens take? That is the question here.

The IRS filed a motion seeking a court order that the trustee abandon the property because the property was fully encumbered and would bring no value to the estate.  The taxpayer had property worth about $190,000.  A senior lien stood ahead of the IRS liens, leaving about $110-120,000 in value to which the federal tax liens attached.  As you can see from the values listed above in the chart regarding the IRS liens, the tax alone was over $200,000.  The IRS argued that because more tax was owed than the value of the equity, nothing existed for the trustee to administer.  The property should be jettisoned from the estate so that the IRS could go after the property to satisfy its lien interest.

Countering the IRS argument, the trustee said that because some of the lien was for penalties which the trustee could avoid, the avoidance should occur and the unsecured creditors should benefit from the avoidance. 

The statute provides no guidance regarding how the lien avoidance impacts the payment to the creditor.  The oldest liens get paid before the newer liens.  Looking at the oldest liens in the group of five, the amount of unpaid penalty on the older liens is substantial.  The trustee argues that he should approach the first lien and avoid the penalty amount of that lien.  This would put $44,500.11 into the pot for the unsecured creditors.  Then the trustee should go to the next lien and create a pro rata basis for treating that lien up to the value of the equity in the property.  If the first lien for a total of $51,950.26 eats into that much of the equity in the property, there is approximately $65,000 in equity left as the trustee moves to the second lien.  The trustee can avoid a pro rata amount of the second lien based on the percentage of the lien attaching to equity and the percentage of the penalty to the overall amount due on the lien.  This allows the trustee to avoid another $-X- from the second oldest recorded notice of federal tax lien which will go to the unsecured creditors.

Because the court did not engage in exactly the process I have described, I cannot say for certain that this is what it has held but I believe this was the trustee argument with which the court agreed.  The court notes that there is little or no case law on this issue but cited to a pair of earlier cases involving the avoidance provisions of B.C. 724 to support its conclusion that the bankruptcy court got it right.

The IRS argues that because the tax due on its liens exceeds the amount of the equity, the property should be abandoned without going through a test like the one described above. 

Because the specific fact pattern described here occurs infrequently, DOJ and the IRS may decide not to appeal the decision.  I did not read the briefs filed by DOJ which would have allowed me to come to a better understanding of the government’s argument.  The basic concepts determined by the bankruptcy court and the district court seem correct to me even though it creates a harsh result for the IRS in this situation.  Congress decided in section 724 to sacrifice the liens of governmental entities for the benefit of unsecured creditors.  It did not specify how the avoidance of the penalty part of the liens would work vis a vis the tax on the liens.  Working the liens from oldest to newest also makes sense to me.  So, the outcome makes sense. 

The court goes into an explanation of the interplay of BC 551 with BC 724 to allow unsecured creditors to step into the shoes of liens secured by penalties.  BC 551 preserves the position of the IRS lien for the unsecured creditors and does not allow junior lienholders to move up in this situation because the reduction of the IRS lien payment results from bankruptcy and not from any infirmity in the IRS lien itself.  I will not go through the whole BC 551 analysis here as it plays an important role for the unsecured creditors and for the decision of the court not to abandon the property but does not impact the outcome between the IRS and the trustee.  I agree with the court’s analysis of the way section 551 works generally and works specifically in this case.

Because of the absence of case law governing this situation, it will be interesting to see whether the government appeals.  The trial section clearly disagrees with the outcome as evidenced by its appeal of the bankruptcy court decision.  The case could result in an interesting discussion in the room of lies.

Bankruptcy and Farm Debt

The provision for farmers in the bankruptcy code is unusual, in part, because Congress placed it in an even numbered chapter while leaving the rest of the bankruptcy in odd numbered chapters and, in part, because of the amazingly different way Congress treats debts owed by farmers.  The case of In re Richards provides a glimpse of some of the unusual provisions in chapter 12 of the bankruptcy code.  At issue is whether the IRS can offset a tax refund against debts owed by the farming couple.

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When chapter 12 came into the bankruptcy code in the early 1980s, the nation was in the midst of a farm crisis.  Interest rates had reached stratospheric highs, and many farmers were going bankrupt as a result.  Movie makers even took notice of the crisis.

In creating chapter 12 Congress created a remedy that kept most farmers from filing bankruptcy.  The basic remedy allowed farmers to rewrite their debt through chapter 12 to reduce the debt to the current value of the land and to reduce the interest rate to the current interest rate.  Knowing what would happen in a bankruptcy case, most banks worked with their debt-laden farm clients to restructure debt and avoid the cost of bankruptcy to all parties.

Even the generous provisions allowing farms to rewrite their debt did not work for all farmers and some still needed to file bankruptcy.  Congress decided that it needed to create additional relief in the last major bankruptcy reform package in 2005.  In that legislation it recognized that sometimes farmers sold part of the farm in order to generate cash and that such sales often involved low basis property, which created large capital gains and the resulting tax debt.  To address this problem, Congress passed BC 1222(a)(2)(A) which transforms priority tax claims into general unsecured claims.  This is a huge deal in allowing farmers to confirm plans and to discharge the taxes that do not get paid.  I will not go into a long explanation of why but trust me that this is important for both reasons.

Because even BC 1222(a)(2)(A) did not provide enough protection for farmers who sold property while the bankruptcy case was pending, Congress subsequently pass BC 1232 to allow farmers to strip priority status off of sales occurring after the filing of a bankruptcy petition.  A good deal for farmers.

The Richards confirmed their chapter 12 plan and in the plan was the following language that “no creditor shall take action to collect on any claim, whether by offset or otherwise, unless specifically authorized by this Plan”. That same paragraph later recites that “[t]his paragraph does not curtail the exercise of a valid right of setoff permitted under §553”.

Section 553 preserves a creditor’s right to offset if it exists outside of bankruptcy law.  Generally speaking, debts need to be mutual and pre-petition in order to allow offset in bankruptcy.  The court noted the current split of authority concerning whether the IRS can offset a liability of a debtor once a plan is confirmed.  The court provided:

Courts are divided as to whether a confirmed plan under §1141, §1227 or §1327 bars the IRS from exercising its §553 setoff rights. Courts within the Seventh Circuit have held that, absent an express plan provision extinguishing such rights, a creditor’s §553 rights survive confirmation. Section 553 provides that “this title does not affect any right of a creditor to offset a mutual debt” and courts have reasoned that the “effect of confirmation” provisions are contained in “this title” (Title 11) and thus, do not affect the creditor’s §553 rights. U.S. v. Munson, 248 B.R. 343, 346 (C.D. Ill. 2000 (§553 trumps §1327); In re Bare, 284 B.R. 870, 874-75 (Bankr. N. D. Ill. 2002) (“confirmation of a debtor’s plan . . . does not extinguish prepetition setoff rights, especially . . . where the plan does not specifically treat those setoff rights”). However, a creditor’s §553 setoff rights may be extinguished by express provision under a confirmed plan. Daewoo Int’l (America) Corp. Creditor Trust v. SSTS Am. Corp., No. 02 Civ. 9629 (NRB), 2003 WL 21355214 at *4 (S.D.N.Y. 2003) (“[i]ndeed, where there is a specific provision in the confirmation order prohibiting setoff claims, courts have indicated that the right to setoff may not survive the confirmation plan”); IRS v. Driggs, 185 B.R. 214, 215 (D Md. 1995); In re Lykes Bros. Steamship Co., 217 B.R. 304, 310 (Bankr. M.D. Fla. 1997) (holding that §1141 takes precedence over §553 where plan of reorganization specifically prohibited setoff).

We have been writing about offset quite a lot lately because of the role it plays in the EIP payments and in other matters here, here and here. We are also adding a new section on offset into Chapter 14A of the Saltzman and Book treatise “IRS Practice and Procedure.”  Bankruptcy adds another level of issues involving offset.

Here, the bankruptcy court decides that it does not need to get into the debate over the effect of confirmation, because the offset performed by the IRS in this instance did not satisfy the requirements of §553.  The refund was post-petition while the debt to which the IRS made the offset was prepetition, meaning that the debts lacked the necessary mutuality.  As such it violated the language of the plan in this case.

While the bankruptcy court decides that the IRS should not have offset the debt owed by the debtor against the post-petition refund, it also determines that it does not have the power to order the IRS to turn over the refund in the current proceeding.  It suggests that the debtor initiate a BC 505 proceeding to determine the correct amount of the refund and through that process obtain the refund it seeks.  The case provides a useful reminder of the impact of bankruptcy on the ability of the IRS to offset and also the special provisions of chapter 12.

Given the pressure that the pandemic places on farmers, not to mention the pressure that U.S. trade policy has placed on them, chapter 12 may become more prominent in the near future.  Be aware that it has provisions for farmers quite different that those applying to debtors in other chapters.  Approach any chapter 12 case with caution to get to know the lay of the land.

Following Through on Promises

The case of In re Somerset Regional Water Resources, LLC, et al, No. 19-1874 (3d Cir. 2020) triggered in me a culturally insensitive response.  Growing up in Richmond, Virginia in the 1950s I was exposed to all sorts of sayings and cultural norms that do not fit well into 2020.  For the most part I think have little difficulty moving past the things I learned that were flat out wrong or were very culturally insensitive.  For example, in my Virginia history textbooks in the 4th and 7th grade when I was learning about the wonderful specialness of Virginia within the context of American and world history, I got to read about the happy slaves that came over from Africa.  Virginia is a great and special place but the history books it purchased for public school consumption in the 1950s and 1960s did not make it special in a good way. 

Virginia was a segregated society in my childhood and youth.  African American children were prevented by law from attending school with me until I reached the 10th grade.  I can remember many aspects of society that segregation impacted such as water fountains labeled “For Whites.”  Outside of my office now is a picture with a sign such as this, reminding me daily of past practices and laws that have thankfully moved into our history books and out of our lives.  I do not mean to suggest we have entered a post-racial society, but it is a society quite different than the one of my childhood and on this issue one that has greatly improved.

This case immediately brought to my mind a childhood phrase that I had not thought about in several decades.  The phrase is “Indian giver.”  Hopefully, most of my readers have not heard it and are puzzled by it.  It was used by children, and perhaps adults,in the 1950s in Richmond to refer to someone who promised to give something but who reneged on the promise.  Given the history of treaties between European settlers and native Americans, it would seem that the phrase should have been “White Man giver,” but it was not.  Thankfully, this offensive phrase seems lost to history but my childhood memories were rekindled in reading the case.  Rather than simply repress the memory of the phrase, I thought I would try to talk about it in a culturally sensitive way.  I apologize to anyone offended by the fact that I had this memory and chose to talk about it.

On to the case itself.

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A chapter 11 bankruptcy was filed by the LLC listed above in the case caption, its sole owner, Larry Mostoller, and his wife, Connie Mostoller.  The debtors’ largest lender agreed to lend another $1 million needed to keep the business afloat if Mr. Mostoller pledged a forthcoming personal tax refund as collateral for the loan.  In the negotiations all parties expected the refund to be about $1 million.  The refund would be generated by large business losses allowing the debtor to take them back to prior profitable years, 2013, 2014 and 2015, thereby obtaining a refund through the net operating losses.

The debtor got the loan and got the refund but then argued to the court, in an effort to avoid giving the creditor the refund, that the pledge of the refund related only to 2015 and not to the two other years. The debtor admitted that the interpretation of the agreement he urged the court to accept would render the collateral worthless but he, apparently was not bothered by that.  Not surprisingly, the creditor was bothered by this attempt to reform the agreement and keep it from receiving repayment of the loan.

The debtor lost the reformation argument in the bankruptcy court and the district court before continuing to pursue it before the Third Circuit.  If nothing else, his argument was good for the legal economy.

The cash infusion failed to save the company and the loan went into default.  Shortly after default Mr. Mostoller refused to file a refund claim for 2015 but did file claims for 2013 and 2014 which were the years really generating the refund from the carryback of the losses.  The Third Circuit’s opinion states that he testified that he “agree[d] that [the] Trust [aka the lender] gets half of the tax refund, minus the federal taxes due,” with the other half going to his wife.  At some point the trust agree to that proposal; however, when the refund came, he sought the whole amount.  In support of this position, the debtor made three arguments: (1) the bankruptcy court lacked subject-matter jurisdiction to decide the dispute; (2) the agreement unambiguously limited the refund to 2015; and (3) the refund was owned by Mr. and Mrs. Mostoller as tenants by the entirety preventing the trust from reaching it since the agreement was only between Mr. Mostoller and the trust.

Constitutional Argument re Scope of Bankruptcy Court Jurisdiction

Each of the courts looking at these arguments had little trouble knocking them down.  The constitutional issue of the bankruptcy court’s scope created quite a stir in the early 1980s after the passage of the 1978 Bankruptcy Code.  The issue went to the Supreme Court in the case of Northern Pipeline Construction Company v. Marathon Pipe Line Company, 458 U.S. 50 (1982).  The Supreme Court did limit the scope of bankruptcy courts in that case and laid the foundation for future disputes concerning that scope. Central to the outcome of that case was whether a dispute falls within the bankruptcy court’s statutory jurisdiction over core proceedings and whether the dispute could only have arisen in bankruptcy.  Here, the court found that the dispute fell within the bankruptcy court’s statutory jurisdiction found in 28 U.S.C.157(b)(2) because 157(b)(2)(D) confers jurisdiction over “orders in respect to obtaining credit.”  The court also found that without the loan order by the bankruptcy court the debtor could not have obtained the emergency financing it needed and could not have continued to survive.

Interpretation of Agreement

With respect to the interpretation of the agreement, the Circuit Court, following the lead of the lower courts and following Pennsylvania contract law, found the relevant provision of the contract ambiguous.  It also found that given the facts surrounding the negotiations the interpretation of the lender best resolved the ambiguity in the agreement.  The court spends several pages parsing through the language of the agreement and the negotiations surrounding the agreement in order to reach this result.  This case really turns on this issue and the court was correct in addressing it fully.  Because of the fact-specific nature of the inquiry, I do not feel as though this aspect of the decision advanced the law very far but it did clearly explain why the arguments made by the debtor did not work.

Tenancy by the Entireties

Finally, the court addressed the tenancy by the entireties argument.  For states like Pennsylvania that give full weight to the common law interpretation of tenancy by the entireties, creditors of one party must be careful.  The IRS fought battles regarding the impact of tenancy by the entireties ownership for decades before the Supreme Court resolved most of the issues in United States v. Craft, 535 U.S. 274 (2002).  See prior discussions of Craft here and here. Here, the Third Circuit, a court well-versed in tenancy by the entireties law, looks at the tax refunds at issue in the context of the state property rights laws and federal tax law. It finds that “federal tax law provides that spouses’ ownership of a refund depends on how they owned the income that generated that refund understate property law.”  We have talked about a slightly different but similar issue of splitting refunds here and here

The Court gave no indication that it follows the blog but it walked through the issue of the ownership of joint refunds in appropriate fashion.  It first cited Ragan v. Commissioner, 135 F.3d 329, 333 (5th Cir. 1998) where that court explained that a joint return does not create “new property interests for the husband or wife in each other’s income tax overpayment.”  The 5th Circuit held that because the income on the return at issue belonged to the husband alone, the wife had no interest in the refund.  The Court then cited several other Circuit Court decisions before holding that “we now join our sister circuits in adopting this rule.”  After announcing that it adopted the prevailing law of the circuits around the country with respect to federal law treatment of federal tax refunds, the Third Circuit then looked at the facts of the Mostollers’ case with respect to Pennsylvania law.

In Pennsylvania, tenancy by the entirety requires the parties be married (no problem here) plus the “four unities of time, title, possession and interest.”  It explained that satisfying these unities requires that the spouses must “(1) have their interests vest at the same time, (2) obtain their title by the same instrument, (3) have an undivided interest in the whole, and (4) own interests of the same type, duration and amount.”  None of the unities existed here and they never merged their separate interests into a tenancy by the entireties interest.  So, the debtor must turn over half of the refund to the lender.

Conclusion

Maybe the Third Circuit could have issued a per curiam affirmance and did not need to spend 20 pages recounting the facts and laying out the resolution of the law. The tenancy by the entireties argument seems to have been an issue of first impression in the Third Circuit, perhaps driving the decision to write out in detail why Mr. Mostoller could not go back on his agreement.  The case provides some insights on the constitutional limits of bankruptcy courts to decide cases and the appropriate method for determining ambiguous agreements. Mostly, it provides an equitable result in a situation in which someone tried to act inequitably, and get the court’s blessing, in a court of equity.

Affluent Lifestyle plus Ignoring Tax Debts Equals No Discharge

I have discussed the exception to discharge under BC 523(a)(1)(c) previously here, here and here.  These cases usually merit some discussion because they contain the kinds of facts that allow us to get a little riled up and actually root for the IRS.  The case of United States v. Harold, No. 16-05041 (Bankr. E.D. Mich. 2020) proves no exception to the general rule of these types of cases.  The IRS does not pursue this exception to discharge often but when it does the facts usually make for a mildly interesting blog post.

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Dr. Harold, the debtor here, is a medical doctor with an OB/GYN practice.  The court says that she has a successful, busy practice and works long hours.  At issue in this case are unpaid federal tax liabilities for 2004 through 2012 and 2014 which she could discharge in her chapter 7 case unless the exception for attempting to evade payment applied.  The court spends a paragraph talking about her husband, a former CPA who lost his license as a result of a conviction for a false statement on a bank loan application, bank fraud, tax evasion and filing a false return.  These actions took place prior to their marriage in 1993 and he now owns a consulting firm, Fidelity Refund Services.  Dr. Harold did not have experience in financial matters, and her husband handled all of her tax matters.

Their returns were routinely filed on extension or late.  She owed liabilities ranging from $5,000 to $42,000 for the years at issue despite averaging about half a million dollars in gross revenue from her practice during those years.  There appears to be some dispute as to the amount owed but it is at least $250,000.  During the years at issue the IRS sent at least 84 collection notices, very few of which Dr. Harold saw, because she worked long hours and her husband usually picked up the mail and handled the tax matters.  She did, however, know there were outstanding tax liabilities for many years.

The court then described the spending of money during the years at issue.  Spending drives these cases.  Many people owe the IRS but those who have enough money to spend on items that support an affluent lifestyle while not paying the taxes receive the scrutiny of the IRS in discharge cases.  The court first described the purchase of a new home in 2005 along the Detroit River waterfront.  This purchase created financial problems, because they could not sell their prior home and carried two mortgages until finally losing the original home to foreclosure in 2009.  They sent their children to private grade schools and high schools paying a total of $64,247 in tuition for their daughter and $ 89,474 for their son.  Then they sent their children to private colleges paying $118,390 for their daughter to attend Boston University and $53,088 for their son to attend Loyola University.

During these years the family took multiple family vacations to Mexico, Alaska, Puerto Rico, Orlando, Washington, D.C., Paris, Las Vegas, Hawaii, and Dubai in addition to numerous trips to go and visit colleges.  They drove expensive cars: a Jaguar, a Mercury Mountaineer, two Cadillacs, to Lincolns, a Lexus and a Harley Davidson motorcycle.  The debtors also actively sought to place their home beyond the reach of the IRS through a sale and leaseback scheme described by the court.

The court then worked through the existing Sixth Circuit law regarding BC 523(a)(1)(c) and the evidence needed to show an attempt to evade or defeat payment of the tax liability.  The court found that the evidence “overwhelmingly demonstrates that the Debtor engaged in conduct to evade or defeat the payment of her tax liabilities for the years 2004-2012 and 2014.”  The court recounted all of her pre-bankruptcy expenditures but seemed even more convinced by the post-filing efforts to insulate the family home from the federal tax lien.

Her actions convinced the court that she willfully intended not to pay her taxes.  It pointed out that all of her expenditures resulted from “voluntary, conscious and intentional choices.”  It did not matter that she delegated the handling of tax matters to her husband.  She knew his past tax issues and she knew the choices she was making regarding the non-payment of taxes.  The court applied her knowledge and action to the standards established by the Sixth Circuit in the case of Stamper v. United States (In re Gardner), 360 F.3d 551 (6th Cir. 2004).  The Gardner case established the mental state requirement of proof that the debtor had a duty to pay, knew of the duty and voluntarily or intentionally violated the duty. 

Dr. Harold argued that she did not voluntarily or intentionally violate the duty to pay her taxes because she had a strong religious need to send her children to Catholic schools and she relied on her husband to manage the family financial affairs.  The court quickly rejected these arguments.

The use of 523(a)(1)(c) to deny a debtor a discharge for willful non-payment of taxes began in a Sixth Circuit case almost 15 years after the adoption of the “new” bankruptcy code in 1978.  The case of Toti v. United States, 24 F.3d 806 (6th Cir. 1994) was the first circuit level court to approve of the use of the discharge exception in this way.  Since that time courts have struggled at times to decide both the standard for holding the taxpayer liable for the taxes and the amount of lavishness necessary to cause the bankruptcy court to say enough.  Here, the IRS clearly established that Dr. Harold went too far.  The case provides another lesson on the perils of maintaining a high lifestyle while putting off payment of taxes.  I seem to write about it every couple of years simply as a reminder that high personal expenditures while failing to pay taxes serves as a recipe for losing the ability to discharge old taxes in a bankruptcy case.