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.

Belair Woods – The Ghouls Continue

In the recent case of Belair Woods, LLC v. Commissioner , 154 T.C. No. 1 (2020) the Tax Court once again goes into its court conference room to have a discussion about the fallout from the Graev opinion and IRC 6751(b).  Because Congress is really slow and has been sitting on his reappointment for a long time, neither the court nor we as consumers of the court’s opinions have the benefit of Judge Holmes’s views on the most recent iteration of a procedural statute written by someone with no background in tax procedure.  This post is dedicated to him and his coining of the term ‘Chai Ghouls’ to describe the many situations the Tax Court would face in trying to provide meaning to this statute.  So, the court is once again tasked with making sense out of nonsense. 

The court deeply fractures, again, over what to do with this statute, and this time it is deciding when the IRS must obtain supervisory approval of the decision to impose the penalty.  The taxpayer argues that the approval must come at the first whiff of the imposition of the penalty, because even at the earliest stages, mention of the imposition of a penalty can cause the penalty to be used as a bargaining chip and that’s what Congress seemed to be wanting to prevent.  This is a logical argument and persuades almost half of the voting judges.  Judge Lauber, writing for a plurality, picks a later time period – the issuance of a formal notification and finds that the IRS had obtained the appropriate approval by that point (for most of the penalties in contention.)

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The case involves a TEFRA partnership.  Normally, in a TEFRA partnership, the IRS issues a 60-day letter (much like the 30-day letter outside TEFRA) and finally an FPAA (the ticket to the Tax Court that is the basis of this case).  Here, the IRS got managerial approval of the penalty before the 60-day letter, which showed a penalty.  Problem is that about two years earlier, the agents had sent a calculation of the potential 60-day letter income adjustments (including showing the penalty) to the partners and suggested a conference to discuss what was effectively this proposed 60-day letter.  But, the agents did not obtain penalty approval before sending this pre-60-day letter. 

Judge Lauber plus seven judges hold that it is time to create as bright a line as possible, citing United States v. Boyle, 469 U.S. 241, 248 (1985) (bright-line rule for late-filing penalty in the case of filing agents), and that the required approval moment should be when a penalty “is embodied in the document by which the Examination Division formally notifies the taxpayer, in writing, that it has completed its work and made an unequivocal decision to assert penalties.”  In this case, the pre-60-day letter was just a proposal.  It was not the critical moment.  Judge Lauber cites the opinion in Kestin v. Commissioner, 153 T.C. No. 2, at slip op. pp. 26-27 (2019), for the similar proposition that a letter suggesting section 6702 penalties might be applied if the taxpayer does not correct a frivolous return is also not a critical moment for managerial approval under section 6751(b).

In a separate concurring opinion, Judge Morrison writes:

 “On the facts of this case, I agree with the opinion of the Court that the 60-day letter was the initial determination to impose the penalties. However, I do not agree with any suggestion in the opinion of the Court that the initial determination to impose the penalties may only be ‘a formal written communication to the taxpayer, notifying him that the Examination Division has completed its work and has made a definite decision to assert penalties.’”

Judge Gustafson and six dissenters agreed with the taxpayer that the pre-60-day-letter was the critical moment for managerial approval of the penalty on these facts. Thus, only 8 of the 16 judges voted for the proposition that the initial determination to impose the penalties may only be ‘a formal written communication to the taxpayer, notifying him that the Examination Division has completed its work and has made a definite decision to assert penalties’”. It appears that there is still no bright line — at least one than can be cited outside the TEFRA partnership context of Belair Wood.

Bryan Camp has written an excellent post on this case which can be found here.  I agree with Bryan’s analysis and will not rehash why it’s a good analysis, but anyone interested in this issue should read his post.  Bryan concludes that Judge Lauber’s reasoning makes the most sense.  Because Bryan does such a good job of explaining the case and the various reasons behind the decisions made by judges on this issue, I want to focus on another issue.  Why doesn’t Congress understand what assessment means, and why doesn’t it fix an obvious mistake, instead leaving Tax Court judges to scratch their heads and spend inordinate amounts of time bonding in a conference room?

When I teach assessment, I almost always poll my students by asking how many of them have ever had taxes assessed against them.  Almost no students raise their hands admitting to such a terrible tax gaffe.  They think, like most people and certainly like most members of Congress, that an assessment is a bad thing.  In reality, assessment is a neutral act of recording a liability on the books and in most instances is a good and important act, because it is a necessary predicate to obtaining a refund of federal taxes.

The Congressional misunderstanding of assessment comes through loud and clear in IRC 6751(b).  I will circle back to IRC 6751(b), but before doing so, I want to spend a little time with an even greater screw-up by Congress in misusing the term ‘assessment’.  The greater example I want to offer is found in Bankruptcy Code 362(a)(6) passed in 1978 as part of the new bankruptcy code adopted that year.  This code replaced the bankruptcy code of 1898 which had been substantially updated in 1938.  The adoption of the new bankruptcy code in 1978 followed almost a decade of debate and discussion.

One of the primary features of the bankruptcy code is the automatic stay.  The stay protects the debtor and creditors from aggressive creditors who might seek self-help and reduce the property available to all creditors or property available to the debtor through the exemption provisions.  The stay is a good thing.  Congress placed the stay in BC 362 and in paragraph (a) enumerated 8 different things impacted by the stay.  Because the stay does not stop everything, Congress inserted in paragraph (b) a list of (now) 28 actions not stopped by the stay.  So, what went wrong?

Bankruptcy code 362(a)(6) provides:

Except as provided in subsection (b) of this section, a petition filed under section 301, 302, or 303 of this title, …, operates as a stay, applicable to all entities, of—

(6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title;

If BC 362(a)(6) stays any act to assess that arose before the commencement of the case, then it stops the IRS from assessing the liability reflected on a return for a year that ended before the filing of the bankruptcy case.  We have had years since 1978 when over 1.5 million new bankruptcy cases were filed.  The vast majority of those cases were filed by individuals.  A decent percentage of those cases were filed during the first 3 and ½ months of the year and most of those returns sought refunds.  So, how could the IRS send to these individuals in distress their tax refund when it could not assess the liability?  Keep in mind also that in 1978 we were still in an era of paper filing.  So, the IRS would need to set these returns to the side to be processed once the stay lifted, and they would sit in rooms in the Service Centers around the country waiting for the stay to lift, so the IRS could perform the simple act of assessment and then send out the tax refund.

You can imagine that debtors in this situation did not really want to hear about the problem Congress created with the language of 362(a)(6) prohibiting assessment as though making the assessment was a bad thing.  The IRS faced a choice of what to do to avoid potentially tens of thousands of stay lift motions that would really be unnecessary if the statute were worded properly to reach its intended result.  Sixteen years later, in 1994, the IRS finally convinced Congress to amend BC 362(b)(9) to permit assessment in this circumstance.  The statutory language creating the stay on assessment still exists in 362(a)(6) as a lasting testament to Congressional misunderstanding of assessment, but finally the IRS did not have to stack returns in rooms in the Service Centers in order to move cases along.

Because it took over 15 years for problems in IRC 6751(b) to come to everyone’s attention, perhaps under the timeline of BC 362(a)(6) we still have another decade or more before Congress will get around to fixing its mistaken understanding of assessment in 6751.  The Congressional sentiment of stopping the IRS from using penalties as a bargaining chip makes sense and is probably bipartisan.  With help from the tax community, Congress could make amendments that would allow courts and the IRS to properly administer the statute. We could wish, however, that it will recognize the problem more quickly this time.  In the meantime, the court conference room at the Tax Court will continue to get plenty of use as the court tries to make sense of nonsense.

Is the One Day Late Interpretation of Bankruptcy Code 523 Finally Headed to the Supreme Court?

After the passage of the 2005 amendments to the bankruptcy code an issue developed concerning the discharge of taxes on late filed returns.  The 2005 amendments resulted from the appointment of a commission in 1994 to look into needed changes to the bankruptcy code after almost two decades of experience with the code.  The commission appointed a subcommission to look into the tax issues impacting bankruptcy matters.  The commission and the subcommission did excellent work fairly quickly and turned their recommendations over to Congress.  Congress struggled to come to closure on the recommendations stemming from this effort.  Finally, in 2005, about eight years after the recommendations came forward, Congress passed comprehensive legislation reforming the bankruptcy code.  One of the big issues on the tax piece of the recommendations concerned the need to address the many taxpayers who filed bankruptcy seeking relief but who had neglected to file their tax returns over numerous years.

Congress addressed the delinquent return filing in numerous code sections including a new and unnumbered code section at the end of BC 523(a) concerning the discharge of taxes for non-compliant taxpayers.  For some reason it chose not to put a number or a letter before this paragraph but simply stuck the new paragraph onto the end of 523(a).  Having made life difficult for everyone seeking to cite to the new material, Congress went further by making this unnumbered and unnamed subparagraph difficult to understand.  I have written numerous blog posts on the interpretation of this section including one last October.  For a sampling of the posts, see here, here, here and here.  In some I predicted that this issue would be resolved in the Supreme Court if Congress did not fix the language of the statute.  Since no one expects Congress to fix anything, this means it’s up to the Supreme Court to resolve the language.  In the recent decision of Massachusetts Department of Revenue v. Shek, — F.3d __ ( D.C. Docket Nos. 5:18-cv-00341-JSM; 6:15-bkc-08569-KSJ) (11th Cir. Jan. 23, 2020) a perfect conflict case has arisen.  The opportunity for a Supreme Court resolution seems quite possible though by no means certain.

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The Massachusetts Department of Revenue (MA DOR) is now the litigant in cases before the First and the Eleventh Circuits with the circuits reaching opposite conclusions.  Five years ago, in the case of Fahey v. Massachusetts Department of Revenue, 779 F.3d. 1 (1st Cir. 2015), the First Circuit interpreted the last paragraph of BC 523(a) to mean that if a taxpayer filed a return late, even one day late, the taxpayer could never discharge the tax liability for that year.  In reaching this conclusion the First Circuit joined two other circuits in holding that the plain language of the statute required this result.

Since the Fahey case, other circuits have demurred when given the opportunity to adopt the one-day rule.  No decision has yet reached the Supreme Court.  The Eleventh Circuit’s decision creates a clear conflict.  It not only specifically considers and directly rejects the decisions of three circuit courts but does so with a plaintiff who was also the litigant in the First Circuit’s decision. 

MA DOR filed a claim in the bankruptcy of Mr. Shek for unpaid taxes for a year in which he did not timely file his state tax return.  MA DOR did not receive full payment of its claim in the bankruptcy case and instituted collection action against Mr. Shek after the lifting of the stay and the granting of the discharge.  Mr. Shek opposed the collection action of MA DOR, arguing that the discharge eliminated the liability and that the actions of MA DOR violated the discharge injunction.  MA DOR countered that he filed his tax return late for the period at issue and BC 523(a) excepted this liability from discharge because of the late filed return.  The litigation started in the bankruptcy court and has now moved on to a circuit court decision.

The Eleventh Circuit looked carefully at the language of the paragraph added in 2005 to determine if it could find a meaning different than the meaning of the three circuits and to find a meaning consistent with the language of BC 523(a)(1)(B).  With the help of an amicus brief from University of Michigan law professor John Pottow, the Eleventh Circuit found a way to interpret the new paragraph in a way that did not result any late filing automatically creating an exception from discharge.

The language added in 2005 sought to provide a definition of the term “return” which was not previously defined in the tax code or the bankruptcy code.  The Eleventh Circuit described the new language as follows:

In 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”), which for the first time added a definition of “return” to the Code. The definition states:

For purposes of this subsection, the term “return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or similar State or local law.

11 U.S.C. 523(a)(*).

The Eleventh Circuit described the dispute as follows:

The dispute in this case concerns the first sentence of the hanging paragraph’s definition of “return”, which provides that a “return” for purposes of § 523 means “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).” DOR raises two arguments in an attempt to demonstrate that Shek’s putative return, which was filed seven months late, does not qualify as a “return” under § 523(a)(*). First, DOR argues that the return did not satisfy “applicable filing requirements” because it did not comply with Massachusetts’ April 15th tax return deadline. Second, and relatedly, DOR argues that the “applicable nonbankruptcy law” here is Massachusetts law, and that Massachusetts defines a “return” by reference to its timeliness. We address each argument in turn.

In analyzing this argument, the Eleventh Circuit conceded that MA DOR’s argument had some merit:

DOR’s syllogism—a return must comply with “applicable filing requirements,” and a filing deadline is an “applicable filing requirement,” so a return that does not meet its deadline has not complied with “applicable filing requirements”—has some force to it….  We do not, however, agree that the phrase “applicable filing requirements” unambiguously includes filing deadlines….  But it is not obvious that this is the interpretation Congress intended in drafting the hanging paragraph. Notably, this understanding of the word “applicable” would add little to the phrase “applicable filing requirements” that the phrase “filing requirements,” standing alone, would not already encompass. We must strive, if possible, to give meaning to every word of the Code.

The Court then turned to the argument made by Professor Pottow:

He notes that the Supreme Court, in interpreting a different section of the Code, has described “applicable” as meaning something different from “all”; it requires an analysis of context and typically means “appropriate, relevant, suitable or fit.”….  The amicus argues that the “appropriate, relevant, suitable or fit” filing requirements are those concerning what constitutes a return. For example, “applicable” filing requirements could refer to considerations like a return’s form and contents—aspects of the putative return that have a material bearing on whether or not it can reasonably be described as a “return”—but not to more tangential considerations, like whether it was properly stapled in the upper-left corner, or whether it was filed by the required date. This approach makes common sense; in a definition of what constitutes a “return,” it makes sense that the term “applicable” would relate to matters that are relevant to the determination of whether the document at issue can reasonably be deemed a “return.”

The Court describes both the MA DOR and the amicus arguments as plausible interpretations of the language of the statute.  Given that both are plausible, the argument made by the amicus makes the most sense because it provides the most harmony with the other parts of BC 523.  The Court points out that the MA DOR makes BC 523(a)(1)(B)(i) almost a legal nullity and that as a practical matter almost no factual situations exist that prevent this outcome because so few taxpayers agree to the substitute for return by creating a 6020(a) return.  The court had previously analyzed that the only way the MA DOR argument really worked was in situations in which the taxpayer filed a form 6020(a) return.  The court also noted that the IRS did not agree with MA DOR’s interpretation of the statute.  The court concluded:

We think it is deeply implausible that Congress intended § 523(a)(1)(B)(ii) to apply only in such a handful of cases despite no such limitation appearing in that provision itself. It would be a bizarre statute that set forth a broad exclusion for discharge of tax return debts, but limited the application of that exclusion via an opaque and narrow definition of the word “return.” It would be even stranger to enact the broad exclusion in § 523(a)(1)(B)(ii), only to later amend the statute, not by changing the text of § 523(a)(1)(B)(ii) itself, but with a different definitional provision that would cabin § 523(a)(1)(B)(ii) into applying only to the “minute” number of § 6020(a) returns. If Congress had intended this result, it could have achieved it in a much less abstruse manner simply by stating in § 523(a)(1)(B)(ii) itself that that section applied only to § 6020(a) returns.

I agree with the Eleventh’s Circuit’s interpretation of the correct way to read the statute.  After it disposed of the main argument, the Court still had to deal with an argument based on the statutes in Massachusetts.  While acknowledging that this also was a close case, the court rejected the specifics of the Massachusetts statute as a basis for not excepting the liability from discharge.

So, will MA DOR take this case to the Supreme Court and if it will, what will the Supreme Court do?  MA DOR may decide to stick with the bird in the hand.  It has the decision it wants in the First Circuit where the vast majority of persons owing MA DOR reside.  If it files a cert petition, it risks losing the argument and losing a major legal source for keeping open its assessments after a bankruptcy discharge.  Because of this possibility, MA DOR may take a pass on the opportunity to go to the Supreme Court.  The upsides do not outweigh the possible downsides.

On the other hand, many Massachusetts taxpayers live outside of Massachusetts.  Allowing the decision to stand allows these persons to discharge their taxes when persons still living in the state (or at least in the First Circuit) remain liable.  Massachusetts may feel that it is best to have a definitive answer.  If Massachusetts did file a cert petition, it is very possible that the solicitor general would lend a voice to granting cert because of the impact of this issue on the IRS (and potentially other parts of the federal government.)  Those living in circuits in which the issue is already decided will have their own views as well.  People in the Ninth Circuit will not want to roll the dice on the chance that the Supreme Court could reverse their current situation.

Should Bankruptcy Trustee Be Paid When Taxes Exceed Assets in the Estate?

The case of In re: Patrick Hannon and Elizabeth Hannon; No. 12-13862 (Bankr. D. Mass. 2019) presents a situation in which the IRS argues that the bankruptcy trustee and law firm representing the trustee should not receive compensation from the estate assets, because the trustee should have abandoned the assets since the trustee could not bring value to the unsecured creditors of the estate.  The bankruptcy court rejected the argument of the IRS and allowed the trustee and the law firm to take their fees from assets that would otherwise go to satisfy outstanding debts due to the IRS.  The case brings to light the sometimes tricky determination regarding assets and lienholders in a bankruptcy case.

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The Hannons owed money to the IRS but at the outset of their bankruptcy case the amount owed to the IRS had yet to be conclusively determined.  The Hannons originally filed their bankruptcy case as a chapter 11 seeking to reorganize their debts, they converted the case to chapter 7 in 2013 recognizing that reorganization would not work and they needed to liquidate their assets.  In a chapter 11 case debtors generally control their assets without a trustee.  In a chapter 7 the bankruptcy court appoints a trustee to liquidate the assets.  When a case converts from chapter 11 to chapter 7 the fluidity of the financial situation can make it quite difficult for the incoming trustee to know exactly what the debtor owes and exactly what the estate owns (or the value of what it owns.) 

In this case it appears that both the amount of debt and the value of the assets were, at least somewhat, in question.  If the trustee could determine that the amount owed to lienholders would prevent any property from reaching general unsecured creditors, the trustee should have abandoned the assets of the estate so that the secured creditors could use their lien interests to dispose of the properties, while the estate became a no asset estate with nothing available to unsecured creditors.  Trustees serve unsecured creditors and secured creditors generally take care of their own interests.  If a trustee administers property encumbered by a lien, the trustee brings no value to the estate for the benefit of unsecured creditors, while potentially reducing the amount that the lienholder could otherwise obtain upon the sale of the liened property.  Essentially, the IRS argues here that the trustee should have known that the estate did not have any property available for unsecured creditors and should have turned over the property of the estate to the lienholders and quietly backed out of the case.  The bankruptcy court must decide if the trustee acted properly under the circumstances or acted in a manner that negatively and improperly harmed the interests of the secured creditor.

Although the bankruptcy court in Massachusetts handled the bankruptcy aspect of the case, the litigation between the Hannons and the IRS took place in Maine for reasons not explained in the opinion.  When the conversion from chapter 11 to chapter 7 occurred in January of 2013, the litigation between the Hannons and the IRS had not concluded.  So, the amount owed to the IRS in the case remained unknown.  The Hannons and the IRS reached an agreement in July of 2013 resulting in a final judgment entered in November of 2013.  At the time of the agreement, paragraph 8 of the document contained the following provision:

The Trustee shall continue to sell or otherwise liquidate the Estate’s personal and real property in the ordinary course.

Additionally, the bankruptcy court noted:

In December of 2013, the IRS assented to a motion filed by the trustee in the IRS Lien Avoidance Action to suspend all deadlines in the proceeding until the trustee completed his liquidation of the estate’s assets. The assented-to motion states: “[T]he parties have recently conferred regarding the within Adversary Proceeding and have agreed that it will be most cost-effective to allow the trustee to complete his liquidation of all Estate assets before expending additional resources in this matter.”

From the perspective of the IRS, having the trustee liquidate the estate assets can provide good value.  The trustee does the work of cleaning up title and selling the assets.  These acts can take considerable time and effort.  The IRS does not always do a good job of this and does not always bring the maximum value.  The trustee can sometimes handle estate assets much more efficiently and cost effectively.  So, agreements between the IRS and the trustee allowing the trustee to administer property that might be fully encumbered can make sense.  The assets also could be wasting assets where having the trustee administer them during a period of dispute concerning the scope of a lien makes additional sense.  On the other hand, if the assets of the estate are entirely encumbered with the federal tax lien, perhaps the IRS feels that it can obtain the best value without having someone in the middle.

Despite the language of the agreement, the IRS objected to the trustee’s fees and the attorney for the trustee’s fees.  The bankruptcy court denies the motion of the IRS to reduce or eliminate the fees allowing them to be paid by the estate, which means that less assets in the estate remain with which to satisfy the IRS debt.  The failure to pay the IRS debt in full or as fully as possible also has implications for the debtors if the tax debts were non-dischargeable.  The debtors would prefer to see the IRS paid and eliminate a debt the IRS will pursue after the bankruptcy estate.

Although the court allowed most of the trustee’s fees, it did trim them with respect to action taken after the extent of the debt due to the IRS and the value of the property became clear.  This caused a small reduction in the amount of the trustee’s fees and the legal award.  Without much more information about who knew what when, I have no basis to conclude that the decision incorrectly allowed the fees.  Twice the IRS agreed to allow the trustee to continue working with assets of the estate.  The IRS should have known when it made those agreements that the trustee deserved compensation for those efforts.  The question I would have concerns the reasonableness of those efforts under the circumstances but not whether the trustee should receive some compensation.  The case points out the difficulties all parties face when uncertainty exists concerning the amount owed and the value of assets and the need to immediately control the assets.  Both the IRS and the trustee in this situation need to carefully document their interactions if they want to show that action was properly taken or not taken.

Limited Ability to Offset Tax Refunds

The case of U.S. Dept. of Housing and Urban Development v. Larry Edward Wood et ux.; No. 5:19-cv-00302 (S.D. W. VA. 2019) shows a limitation on the government’s right to set off a tax claim against a debt owed to another federal agency.  The outcome here did not surprise me (except maybe that HUD was not required to pay something for offsetting a prepetition debt in violation of the automatic stay.)  The law has evolved to allow the IRS to offset an income tax refund against another income tax liability, but there is no exception in the automatic stay allowing the offset of a tax refund to satisfy the liability of another government agency (or even another type of tax.)

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Mr. and Mrs. Wood bought a mobile home in 2008.  They borrowed almost $40,000 to make the purchase.  The Department of Housing and Urban Development (HUD) guaranteed the loan.  Unfortunately, the Woods defaulted in 2014 causing HUD to cover the debt and then to come after them to satisfy the outstanding debt which by that point totaled about $23,000.  In December of 2015, HUD certified the debt to Treasury so that it could benefit from the Treasury offset program (TOP).  This paid off in early 2017 when HUD scooped up over $9,000 of a federal tax refund that would otherwise have gone to the Woods.  Perhaps because of the loss of this refund or perhaps because of other causes, or both, the Woods filed a bankruptcy petition on March 21, 2018.

Their 2017 tax refund of over $6,000 was scheduled for payment after they filed their return on March 26, 2018, but instead was sent to HUD to continue paying off the debt on the mobile home.  The Woods brought an adversary proceeding in bankruptcy court arguing that the offset of their 2017 was barred by the bankruptcy laws.  They made two arguments in support of their position.  I will discuss both below.  The argument regarding the automatic stay surprises me, as the law clearly bars offset in this situation.  The bankruptcy court held for the Woods and in this decision, the district court sustains the decision of the bankruptcy judge.

Outside of bankruptcy, the TOP offset presents no problem for HUD.  At issue here is the difference, if any, brought about by the bankruptcy code once the Woods filed their petition.

Exempt Property Argument

Bankruptcy allows debtors to claim certain property of the estate as exempt from creditors.  As a threshold matter the court looks at whether the refund is property of the bankruptcy estate.  It cites a split in the circuits in situations in which the refund is less than the amount owed to the government and decides to follow the majority rule that in all situations the refund is property of the estate.  Just because property comes into the estate, however, does not mean that it is available for creditors and Congress allows debtors to exempt certain property in order to protect that property and provide debtors with some amount of assets moving forward after bankruptcy.

BC 522 sets out the rules for claiming these personal exemptions.  BC 522 has its own exemption provisions but also allows states to opt for their own exemption rules which almost all states have done.  Some states have very generous exemption rules while others, typically states in the east heavily reliant on common law, provide more miserly exemptions for debtors.  In West Virginia the Woods could claim this refund as exempt and they did so.  The bankruptcy court determined that the exempt trumps the offset provisions in 553.  As such, the debtors could recover the refund taken from them by offset.  This does not mean that their liability to HUD is forgiven or forgotten, but only that HUD cannot take this refund while the Woods remain in bankruptcy to satisfy the outstanding debt.

Automatic Stay Argument

The court next looks at the automatic stay and its impact on the taking of the refund.  BC 362 sets out the automatic stay in paragraph (a) where there are eight separate provisions providing coverage from creditors once the debtors file their bankruptcy petition.  Subparagraph (7) stays offset during the bankruptcy case.  This provision came into the law in 1978 with the enactment of the current bankruptcy code.  It caused major headaches for the IRS because it had to turn off its computers to avoid violating the stay.  Finally, in 2005 the IRS succeeded in convincing Congress to provide some relief from this provision.  As with the relief it provided in 1994 with respect to the stay on assessment found in subparagraph (6), that really threw a wrench into the tax system, Congress did not change BC 362(a)(7) but instead added an exception to the list of exceptions found in 362(b).  In this case it added subparagraph (b)(26).  The fact that there are 26 subparagraphs in the section dealing with exceptions to the automatic stay says Congress has lots of actions it wants to continue despite the stay.

BC 362(b)(26) allows offset despite the prohibition on offset in (a)(7) but the allowance only allows offset in a narrow circumstance.  The exception “constrains the reach of the automatic stay by excepting from violating the automatic stay, the setoff under applicable nonbankruptcy law of an income tax refund . . . against an income tax liability.”  This exception to the automatic stay does not allow the IRS to offset an income tax refund against an outstanding trust fund recovery penalty or against any other type of tax debt.  Furthermore, it does not allow the offset of the income tax refund against any other type of federal debt.  Aside from the narrow allowance made plain in the statutory language, prior case law also made clear that the income tax refund could not be offset against other federal debt.  I have trouble understanding what the DOJ lawyers representing HUD thought they could argue here.  I did not pull the briefs filed to see if they had some terrific argument that does not leap out from a reading of the opinion or of the statute.

HUD also argued that equity should allow it to offset the debt based on a retroactive annulment of the automatic stay.  The bankruptcy court took only a few sentences disposing of this argument.

The case demonstrates the limited scope of the exception to the automatic stay regarding offset.  While the exception provides a significant benefit to the IRS, it provides no benefit to other federal agencies.  If they want to use TOP while an individual’s bankruptcy case exists, someone will need to go back to Congress and get (b)(26) expanded.  I don’t expect that to happen anytime soon.

Lien Priority Litigation

The case of Shirehampton Drive Trust v. JP Morgan Chase Bank et al.; No. 2:16-cv-02276 (D. Nev. 2019) presents a relatively straightforward lien priority fight.  The case shows the continued fallout from the great recession.  It also shows the perils of purchasing property at a foreclosure sale.  When a federal tax lien exists, such a purchase becomes especially perilous, as the purchaser discovers here.  I remember as a district counsel attorney having to deal with a few unsophisticated purchasers at foreclosure sales who discovered to their sorrow that the property which they thought they had purchased at such a bargain, would cost them much more than anticipated because of a federal tax lien that the sale did not defeat.  The Shirehampton case does not break new ground but merely serves as a cautionary tale.

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In 2008 Louisa Oakenell purchased property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (“the property”). The property sits in a community governed by the Essex at Huntington Homeowners Association (“HOA”). The HOA requires its community members to pay dues.  At the time she purchased the property, she already owed the IRS significant income tax liabilities for 2005 and 2006.  The court described the relevant facts as follows:

This matter concerns a nonjudicial foreclosure on a property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (“the property”). The property sits in a community governed by the Essex at Huntington Homeowners Association (“HOA”). The HOA requires its community members to pay dues.
 
Louisa Oakenell borrowed funds from MetLife Home Loans, a Division of MetLife Bank, N.A. (“MetLife”) to purchase the property in 2008. To obtain the loan, Oakenell executed a promissory note and a corresponding deed of trust to secure repayment of the note. The deed of trust, which lists Oakenell as the borrower, MetLife as the lender and Mortgage Electronic Registration Systems, Inc., (“MERS”) as the beneficiary, was recorded on December 24, 2008. MERS assigned the deed of trust to Chase in May 2013.
 
Oakenell fell behind on HOA payments. The HOA, through its agent Red Rock Financial Services, LLC (“Red Rock”) sent Oakenell a demand letter by certified mail for the collection of unpaid assessments on June 26, 2009. On July 21, 2009, the HOA, through its agent, recorded a notice of delinquent assessment lien. The HOA sent Oakenell a copy of the notice of delinquent assessment lien on July 24, 2009. The HOA subsequently recorded a notice of default and election to sell on October 21, 2009 and then a notice of foreclosure sale on September 18, 2012. Red Rock mailed copies of the notice of default and election to sell to Oakenell, the HOA, Republic Services, the IRS, and Metlife Home Loans. Red Rock did not mail a copy of the notice of default and election to sell to MERS. On January 28, 2013, the HOA held a foreclosure sale on the property under NRS Chapter 116. Shirehampton purchased the property at the foreclosure sale. A foreclosure deed in favor of Shirehampton was recorded on February 7, 2013.

In addition to falling behind on her HOA payments, however, Oakenell also stopped paying federal income taxes. The IRS subsequently filed notices of federal tax liens against Oakenell at the Clark County Recorder’s office on May 1, 2009 and June 24, 2009. As of October 1, 2018, Oakenell had accrued $250,953. 37 in income tax liability plus daily compounding interest.

For any reader not familiar with the federal tax lien, a quick detour into lien law may help.  For a more detailed discussion of this lien law, refer to Saltzman and Book, “IRS Practice and Procedure” at chapter 14.04, et seq.  When the IRS makes an assessment, it sends a notice and demand letter (required by IRC 6303) almost immediately thereafter.  If the taxpayer fails to pay the tax within the time prescribed in the notice and demand letter, the federal tax lien comes into existence relates back to the date of assessment and attaches to all of the taxpayer’s property and right to property.  The lien also attaches to all after-acquired property as long as the lien remains in existence.  In this case the federal tax lien would have attached to the property Ms. Oakenell purchased immediately upon closing; however, at that time the lien was known only to the IRS and Ms. Oakenell, since the IRS had not yet made the lien public by filing a notice of the lien.

In 1966 Congress passed the legislation establishing the lien priority rules that still apply today.  Congress gave the federal tax lien the broadest possible power; however, it limited that power by creating a first in time rule in IRC 6323(a).  That first in time rule allows a competing interest to defeat the federal tax lien if perfected prior to perfection of the federal tax lien.  Perfection of the federal tax lien occurs when the IRS files the notice in the appropriate place.  In this case the fight concerns the timing of the filing of the lien and not the location.

Because the notice of federal tax lien was filed here prior to the filing of the lien for the HOA, the federal tax lien defeats the lien of the association.  HOA fees seem a lot like local real estate taxes; however, if competing with the federal tax lien, the two types of ownership liens operate differently.  The real estate taxes, even though they arise after the existence of the filing of federal tax lien, come ahead of the filed federal tax lien because of IRC 6323(b)(6)(a).  Congress added this subparagraph in 1966 to avoid circular priority problems which arose when a real estate taxes went unpaid after the filing of a notice of federal tax lien.  Prior to 1966 courts had to struggle with the situation, because the purchase money mortgage defeated the IRS lien, the IRS lien defeated the later arising real estate taxes and the real estate taxes defeated the purchase money mortgage.  With the passage of this provision, Congress had the IRS step back in order to allow the real estate taxes to come before the IRS; however, it did not do the same for HOA fees.  As a consequence, the IRS defeats HOA fees that get recorded after the notice of federal tax lien.  Since that happened here, the purchaser bought the property subject to the substantial tax liabilities secured by the federal tax lien.  A very unfortunate result for the purchaser and one that should never occur but which does with surprising frequency.

In addition to the Shirehampton case, another lien priority case was recently decided, United States v. Patrice L. Harold et al.; No. 2:18-cv-10223.  I will discuss the Harold case in an upcoming post.

Debtors Still Trying to Fight Against One Day Rule

The case of In re Kriss, 2019 Bankr. LEXIS 3039, (Bankr. D. N.H. 2019) shows that debtors in the First Circuit (and undoubtedly the 5th and the 10th) still struggle with the one-day rule interpretation of their circuits.  I have not written about this issue in some time but it still haunts those living in the wrong places.

As a quick reminder of the issue for those who may have forgotten or who have not read about it previously, three circuits have interpreted the language added to the unnumbered paragraph at the end of B.C. 523(a) in 2005 to mean that if a debtor files a tax return even one day late the debtor can never discharge that liability.  The IRS does not agree with that interpretation of the bankruptcy code and the circuits looking at the issue most recently have not agreed with the issue; however, until the Supreme Court takes up the issue, Congress decides to clarify the language in the bankruptcy code or the circuits reverse themselves, taxpayers in these three circuits can obtain no relief of the tax debts through bankruptcy if they file their returns late.  For a detailed discussion of the issue, see the prior posts here, here and here.

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Mr. Kriss did not file his tax returns for 1997 and 2000 timely.  The IRS prepared substitute for returns for these years and made relatively substantial assessments.  Mr. Kriss later filed returns which the IRS treated as claims for abatement and used as a basis for reducing his liability.  Mr. Kriss also did not timely file returns for 2008 through 2011.  He filed a chapter 13 bankruptcy petition on June 19, 2012, and filed the late returns for 2008 through 2011 in July, 2012 as required by B.C. 1308(a) which provides:

Not later than the day before the date on which the meeting of the creditors is first scheduled to be held under section 341(a), if the debtor was required to file a tax return under applicable nonbankruptcy law, the debtor shall file with appropriate tax authorities all tax returns for all taxable periods ending during the 4-year period ending on the date of the filing of the petition.

The timing of his bankruptcy filing made the liabilities for 2009-2011 priority claims under B.C. 507(a)(8)(A)(i) and the status of the taxes for these years as priority claims required that Mr. Kriss provide for full payment of these liabilities in his chapter 13 plan.  The older periods did not have priority status but rather were classified as general unsecured claims and did not require full payment in the plan.  As in many chapter 13 cases general unsecured claims received little or nothing.

This case picks up after Mr. Kriss has completed his plan.  As with the situation described in the recently blogged case of In re Widick, the post discharge receipt of a bill from the IRS for taxes he thought had disappeared moved Mr. Kriss into action.  In this case the post discharge action of the IRS results in three issues addressed by the bankruptcy court: 1) the one day rule discussed above; 2) the collection of post discharge interest addressed in the Widick post; and 3) damages for wrongful collection.

With respect to the one-day rule issue as it applies to the general unsecured claims for 1997 and 2000, the IRS not only sent Mr. Kriss the first notice of liability, it sent him a seriously delinquent notice (meaning the non-payment of this debt would impact his passport), and it filed suit against him to reduce the liability to judgment.  In response he admitted that:

the Late Filed Returns were untimely and does not contest that under the “one-day late rule” set forth in Fahey, the tax debts from those years are nondischargeable. Instead, the Debtor urges this Court to reconsider Fahey, reject the “one day late rule,” and adopt an alternate analysis set forth by the United States Tax Court in Beard v. Commissioner of Internal Revenue, 82 T.C. 766 (1984). The Debtor suggests that if the analysis in Beard were adopted, the Late Filed Returns may qualify as returns and, if so, any debts relating to the corresponding tax years were discharged.

Not surprisingly, Mr. Kriss does not get anywhere with the bankruptcy court on this argument.  The bankruptcy court’s hands are tied by the circuit decision.  It goes through the motions of explaining the Fahey decision and his argument before stating the obvious – that it cannot change the applicable precedent.  If he wants to make this argument, he has only just begun and must pass through the district court on his way to the First Circuit to try to pursued that court to reconsider its decision.  The bankruptcy court notes that he is not the first person to seek a reconsideration of the First Circuit’s decision in Fahey.  As I have written before, the Fahey decision does not make good sense to me (or to the IRS), but the IRS easily wins this issue.  It can continue to collect on the 1997 and 2000 liabilities and Mr. Kriss’ inability to file his returns on time will haunt him for decades once the IRS obtains a judgment.

Next, the court turns to the liability for the priority liabilities that the IRS seeks to collect after bankruptcy.  Mr. Kriss paid the priority tax claim in full during the bankruptcy case.  Because he did not timely file the returns for the three priority periods on the claim, the debt for these three years is non-dischargeable.  As discussed in the Widick post, a debtor does not pay interest during a bankruptcy case except in situations of fully secured claims.  Here, Mr. Kriss did not pay interest on the priority claims and the IRS wants that interest from him after discharge.

The problem the IRS faces stems from its form letters, which do not mention interest but state that Mr. Kriss has unpaid taxes.  Any attempt to collect taxes violates the discharge injunction while the effort to collect interest after the discharge is permitted because of his late filing of the taxes.  The bankruptcy court holds for the IRS to the extent it seeks to collect taxes but finds that it cannot rule on the summary judgment motion of either party until it has more facts regarding whether the IRS seeks only to collect interest or, as stated in its notices, it also seeks to collect tax. 

The IRS could fix this problem going forward by rewriting its form letters.  The collection of post discharge interest on priority claims arises in only a small percentage of its collection cases, but it needs to acknowledge that these cases represent a special situation and adjust its collection practices accordingly.  By sending out its normal collection letters in these situations, it causes confusion for the debtors and the courts.  The situation already confuses debtors if their bankruptcy attorneys have failed to alert them to this issue.  The IRS should not compound the confusion by using letters with inappropriate descriptors of the liability.

The last issue concerns the liability of the IRS for violating the discharge injunction.  The IRS argues that it has no liability, no matter how the second issues turns out, because Mr. Kriss did not seek to mitigate his damages.  The court quickly agrees with the IRS to the extent that he seeks damages for emotional distress but fails to grant summary judgment to the extent that Mr. Kriss has actual damages, saving the decision on that issue until further factual development occurs.  The court notes that the topic of exhaustion of administrative remedies has been the subject of much litigation stating:

[L]ess conclusive is the IRS’s argument that the Debtor is not entitled to attorney’s fees and costs, actual damages and/or sanctions resulting from the IRS’s post-discharge collection activities because he failed to comply with the exhaustion of administrative remedies requirement found in both 26 U.S.C. § 7430(b)(1) (awarding costs and certain fees) and 7433(d)(1) (governing civil damages for certain unauthorized collection actions). While the IRS admits that this issue has not been definitively decided by the First Circuit, it cites to cases such as Kuhl v. United States, 467 F.3d 145, 148 [98 AFTR 2d 2006-7379] (2d Cir. 2006), for the proposition that administrative exhaustion is jurisdictional in an adversary proceeding seeking attorney’s fees, and that failing to exhaust administrative remedies divests this Court of jurisdiction per 26 C.F.R (Treas. Reg.) § 301.7430-1.
 
Many other courts have “painstakingly” considered the issue of administrative exhaustion with repect (sic) to motions for awards of attorney fees, actual damages, and sanctions relating to discharge injunction violations, arriving at various and differing conclusions utilizing different statutory provisions and treasury regulations for their decisions. See In re Langston, 600 B.R. 817, 825 [123 AFTR 2d 2019-1262] (Bankr. E.D. Cal. 2019) (providing an extensive review of cases addressing this issue from multiple jurisdictions with varying outcomes). For example, in contrast to the Kuhl case cited by the IRS, the court in In re Graham, No. 99-26549-DHA, 2003 WL 21224773 [91 AFTR 2d 2003-2142] (Bankr. E.D. Va. Apr. 11, 2003) found that it had jurisdiction to award damages in the form of litigation costs to debtors who alleged IRS violations of § 524, even where they had not exhausted their administrative remedies, holding that: “26 U.S.C. § 7433(e)(2)(A) states that the exclusive remedy for recovering damages for violations of the Bankruptcy Code is to petition the bankruptcy court,” and within that section “there is no mention … of the need to exhaust administrative remedies.” Id. at *2. The Graham court held that 26 U.S.C. § 7433(e) was “quite clear” that the “bankruptcy court is the exclusive remedy for the violation of Bankruptcy Code provisions.” Id. (emphasis in original).

The ability to obtain damages for a stay violation is something we discuss at some length in IRS Practice and Procedure at 16.11[2].  You might look there if you face this issue.  Here, Mr. Kriss will not receive damages if he cannot show that the IRS has violated the discharge injunction and that may turn on whether the IRS seeks to collect anything more than interest in the priority claims.  Even if the IRS has tried to collect more than interest on the priority claims, he may have trouble showing actual damages the IRS has created by sending the post-discharge bill.  This will leave him seeking attorney’s fees for fending against the wrongful collection and trying to convince the court to impose sanctions.