Refund Offset versus Bankruptcy Exempt Property Claim

An important bankruptcy case was decided by the Fourth Circuit last spring that I missed, perhaps due to the pandemic – at least that’s my excuse because both Carl Smith and Nancy Ryan brought it to my attention at the time.  It came to my attention again last month thanks to Michelle Drumbl who directs the tax clinic at Washington and Lee and who will serve as interim dean there in the coming academic year.  This past semester Michelle was on sabbatical in Northern Ireland with her family but, as with most sabbaticals, she was writing during her time away from school producing at least one article on the cross over topic of bankruptcy and taxes.  Fortunately for me, she asked that I take a look at her draft of the article which caused me to finally pay attention to an interesting case that I ignored when Nancy and Carl brought it to my attention.  Michelle’s forthcoming article focuses on the case of Copley v. United States, 125 AFTR 2d 2020-XXXX (4th Cir. 2020) involving the issue of the interplay of IRC 6402, BC 362(b)(26), BC 522, BC 541 and BC 553

In prose the case concerns whether the IRS can offset a pre-petition income tax refund that the taxpayer claimed as exempt in his bankruptcy case against a pre-petition income tax debt.  The debtor argues that when the refund became exempt property it received a type of protection from the IRS offset not otherwise available, while the IRS argues the opposite.  The Fourth Circuit holds that exempting the refund does not protect it from offset.  I found this outcome totally unsurprising; however, the fact that the Fourth Circuit decision reversed the decisions of the two lower court judges in Richmond I happen to know as well as the absence of authority on this point did surprise me.  See the bankruptcy court’s opinion here and the district court’s opinion here.

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The Copleys filed a chapter 7 bankruptcy in May 29, 2014 listing the IRS as a priority creditor for over $13,000 claiming as exempt their 2013 tax refund of $3,208.  Virginia provides debtors a fairly stingy exempt property option, as do many former English colonies along the East Coast.  It allows the debtor to protect “money and debts due the householder not exceeding $5,000 in value.”  The Copleys used the exemption to elect to protect their 2013 refund and neither the IRS nor anyone else objected.  After making their exemption election, the Copleys filed their 2013 tax return on June 6, 2014, and the IRS offset the refund pursuant to IRC 6402 and BC 362(b)(26) which came into existence in the 2005 bankruptcy refund legislation and permits the IRS to exercise its offset rights despite the automatic stay prohibition against offset in BC 362(a)(7).  The automatic stay exception limits the IRS to offsetting pre-petition refunds against pre-petition debts of the same type of tax.  Here, the debt and the refund both satisfied the conditions of type and time.  No one objected to the offset based on a stay violation of BC 362(a)(7) rather the fight turns on the power of the exemption versus the power of the right to offset.

In appealing the case the IRS made two arguments.  First, it argued that the 2013 refund never became part of the Copleys’ bankruptcy estate.  Second, it argued that their right to exempt the property does not supersede the IRS right to offset.

The property of the estate argument raises the question of whether the Copleys even had the right to exempt the refund since they could only exempt property of the estate.  The IRS argued that:

A taxpayer can only have a property interest in a tax refund, not a tax overpayment, and the taxpayer can only have an interest in a refund if the overpayment exceeds preexisting tax liabilities.  Because the Copleys’ overpayment did not exceed their preexisting tax liabilities, the government asserts that their interest in the refund was valueless and, therefore, did not become part of the bankruptcy estate. (emphasis in original)

The Fourth Circuit did not buy this argument and that did not surprise me.  It pointed to the expansive nature of the concept of property of the estate, citing prior Fourth Circuit law as well as Supreme Court law.  The Court did note in footnote 3 that offset under IRC 6402 is discretionary which is inconsistent with the government’s position.  Two prior Fourth Circuit cases went to the Supreme Court that dealt with property of the estate.  I suspect this circuit may be more sensitive to this issue that almost any other circuit given that history.  Here, it cited to one of those prior cases that dealt explicitly with offset, Citizens Bank of Md. v. Strumpf, 516 U.S. 16 (1995) in pointing out that three things had to happen before offset could take place and none of those things had happened at the time of the bankruptcy petition.  In the IRS’s defense Strumpf and the other case, Patterson v. Shumate, 540 U.S. 753 (1992) pre-dated the 2005 amendment to IRC 362 excepting certain offsets from the automatic stay; however, that change did not remove the property from the estate under BC 541.  Rather than spending much of its time focusing on whether the Copleys’ refund became property of the bankruptcy estate, quickly concluding that it did, the Fourth Circuit moves on to describing the primary issue as one of the preservation of the right of offset despite the fact that the refund became part of the bankruptcy estate.

The IRS relied on the case of IRS v. Luongo, 259 F.3d 323 (5th Cir. 2001) where the debtor did not claim the refund as exempt until after the offset occurred.  The facts in Luongo were:

On May 19, 1998, Appellant Luongo filed for relief under Chapter 7 of the Bankruptcy Code. At the time of her filing she owed the IRS $3,800 in unpaid taxes from her 1993 tax year. On August 15, 1998, Appellant filed her 1997 income tax return showing an overpayment of $1,395.94. The bankruptcy court entered an order on September 10, 1998 discharging Appellant’s personal liability for her 1993 income tax deficiency. Subsequently, in November 1998, the IRS executed its claim to setoff and applied all of Appellant’s 1997 tax overpayment to her unpaid 1993 tax liability. 

Only after discharge and after offset did the debtors in Luongo seek to reopen their bankruptcy case and claim the refund as exempt.

Luongo involved a number of arguments not present in Copley but one of the argument the IRS won and on which it relied here was that the refund was not part of the estate.  The Fourth Circuit in Copley says that it does not dispute that conclusion of the Luongo decision.  I cannot reconcile the Copley decision and the reason for the Copley decision with that statement but, in the end, it does not matter whether the refund comes into the estate or not because of the decision of the Fourth Circuit on the second issue.

The second issue pits BC 553 preserving a creditor’s right to offset against BC 522 and the debtor’s right to exempt property.  The court acknowledges a conflict between BC 522 which protects exempt property against “any” prepetition debts and IRC 6402 which permits the IRS to offset “any overpayment” against preexisting liabilities.  It finds that BC 553 resolves the apparent conflict.

The critical language of BC 553 states “this title does not affect any right of a creditor to offset a mutual debt.”  That broad language, which caused me not to think that this case presented much of an issue, persuades the Fourth Circuit that the IRS can still make the offset even through the Copleys exempted the property.  It views acceptance of the Copleys’ argument as one which would violate the statutory directive of BC 553.  The court notes that BC 553 does not create the right of offset but only preserves an existing right.  Since IRC 6402 created a clear existing right, BC 553 steps in to preserve that right.

The court then addressed the Copleys’ arguments and knocked them down.  The one that most interested me was the argument that bankruptcy courts had the discretion to decide if BC 553 would apply.  The Fourth Circuit found that while bankruptcy courts could strike down a creditor’s attempt to offset, the basis for doing so derived from the questioning of the validity of the right of offset and not from some equitable discretionary ability to do so.

I think the Fourth Circuit got it right on both counts.  The refund comes into the estate but the IRS, or any other creditor with a valid right of offset, can exercise that right with the proper permission of the statute or the bankruptcy court.  Despite what I think, the lower courts here found the IRS could not offset.  This issue does not have much case law even though the bankruptcy code is well into middle age.  Perhaps, other debtors in other circuits will make this argument to see where it leads.

Fifth Circuit Says 1040 plus 1099 equals 945, Reversing District Court’s Calculation of What is a Return

In Quezada v. IRS, No. 19-51000 (5th Cir. 2020) the Fifth Circuit determined that the Form 1040 filed by the Quezadas and the Forms 1099 issued by his business to its workers started the running of the statute of limitations for backup withholding. The decision reverses the district court which had reversed the bankruptcy court. We discussed those decisions here and here, respectively. You can read the prior posts for background on what is a hotly contested matter with significant monetary implications for the Quezadas as they seek to emerge from bankruptcy and for the IRS as it tries to prevent consequential adverse precedent regarding what constitutes a return.

I plan to follow this post tomorrow with a victory for the IRS in another circuit rendered just a few days after Quezada.  I don’t know if this decision has enough administrative importance for the IRS to warrant consideration of a cert petition or if there is a sufficient conflict in the circuits but I expect the IRS and DOJ will give the matter more than glancing thought.  The IRS very much wants a per se rule because of its desire for ease of administration.  It does not want to triangulate documents on the wrong forms or submitted to the wrong place in order to make a judgment whether a taxpayer has effectively filed a return.  Decisions like Quezada act like sand in the efficient running of its return processing machinery.  The decision also raises questions concerning why the IRS took so long to act on what were clearly deficient Forms 1099.

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The issue presented here arises as a statute of limitations question. Did Mr. Quezada file a return that started the running of the statute of limitations, or rather, since we know he did not file the specific return at issue, did he file other returns or other documents that could take the place of the required return? In some ways this case takes the court into the type of analysis it would use in an informal claim case. Although Mr. Quezada makes no claim for a refund, he argues that he provided the IRS with enough information to trigger a running of the statute of limitations, just as an informal claim would trigger a satisfaction of the statute of limitations for filing a claim without actually using the process prescribed by the IRS.

Mr. Quezada ran a stone mason business.  He had a number of individuals working for him at various times during the years at issue.  These individuals were treated as subcontractors and not as employees and the case does not question that designation.  In 2014 the IRS assessed deficiencies against him dating back to 2005 for his failure to backup withhold for 2005 through 2008.  The court explains why the IRS made the backup withholding assessment:

A Form 1099 shows the name and address of the payee and how much he was paid. Each payee for whom a payor files a Form 1099 must provide a “Taxpayer Identification Number” (TIN). See 26 U.S.C. § 3406(a). A personal identifying number, like a social security number, can serve as a TIN. 26 C.F.R. § 301.6109-1(a)(1)(i). The payor must list the payee’s TIN on the Form 1099. Id. § 301.6109-1(c). If “the payee fails to furnish his TIN to the payor in the manner required,” the payor must withhold a flat rate for all payments to the payee and send the withholdings to the IRS. 26 U.S.C. § 3406(a). This is called “backup withholding”; the flat rate the payor withholds acts as a “backup” in case the payee fails to pay taxes on the underlying payments.

Mr. Quezada reported the payments he made to subcontractors working for his business but almost all of the Forms 1099 he filed reporting those payments failed to include the individuals TIN as required by the statute and regulations. In each of the years almost all of the Forms 1099 he issued were deficient in this way. For reasons not explained, the IRS did not make an assessment against Mr. Quezada for the failure to engage in backup withholding with respect to the deficient Forms 1099 until more than three years after the filing of his income tax returns and the Forms 1099 for the four years in question. At issue concerns an assessment against him of over $1.2 million.

The purpose of backup withholding is to prevent individuals the IRS cannot identify from the Form 1099 from avoiding payment of their taxes with no practical way for the IRS to check whether they paid or not.  Here, it is unknown whether the subcontractors actually paid their taxes meaning that the assessment against Mr. Quezada would result in a windfall to the IRS or whether the assessed amount would allow the IRS to recover taxes it would otherwise lose because of the poor quality of the Forms 1099.

In his bankruptcy case Mr. Quezada contested the timeliness of the assessment of backup withholding. The Fifth Circuit sets out its view of the IRS argument:

Form 945 is thus the “return required to be filed by” a taxpayer who, like Quezada, is required to backup withhold. 26 U.S.C. § 6501(a). Quezada failed to file a Form 945. So, the argument goes, he never filed “the return,” and the limitations period never began to run under § 6501(a)‘s “[g]eneral rule.” The IRS thus contends the analysis ends here: Form 945 is the only document that can constitute “the return,” and Quezada failed to file it. Appeal concluded. In support of its argument, the IRS invokes Lane-Wells, which the IRS construes to create a per se rule requiring the taxpayer to file the return designated for the tax liability at issue; if the taxpayer does not file that specific return, the limitations clock never begins to run.

The court rejects the per se rule finding that Lane-Wells did not create such a rule not only finding that Lane-Wells did not create the per se rule the IRS argues that it held but citing to several circuit court decisions it says support the filing of a return based on other returns or documents.  The Fifth Circuit says it aligns itself with these other circuits and holds that:

‘the return’ is filed, and the limitations clock begins to tick, when the taxpayer files a return that contains data sufficient (1) to show that the taxpayer is liable for the tax at issue and (2) to calculate the extent of that liability.

Having decided that Mr. Quezada need not have filed Form 945 in order to start the clock ticking, in order words that there exists an “informal return” doctrine, the court then looks at what he did file to determine if the returns filed sufficiently met the test it stated.  The court decides that the Forms 1040 and 1099 did provide the IRS with enough information to create an informal Form 945.  The forms filed contained enough data to show he had a backup withholding liability.  The Forms 1099 showed the amount paid and the person paid thus allowing the IRS to calculate the amount of backup withholding that Quezada should have made.  Case over.

The case obviously matters to businesses that fail to make proper backup withholding when they lack the payees TIN. Does the test adopted by the Fifth Circuit create principles that will assist taxpayers in other circumstances? If so, what are those circumstances and how broadly could this test apply.? No doubt, there will be taxpayers out there willing to test the limits of this opinion.

Tomorrow, in a different context but with the same ultimate question of whether a return was filed, we will look at a case that came out the other way.

Collection Due Process Request Tolls Statute and Prevents Bankruptcy Discharge

Job Announcement: The Temple University Beasley School of Law was recently notified that it will receive funding from the IRS to open and operate a Low Income Taxpayer Clinic (LITC) on its Main Campus in North Philadelphia which will also serve taxpayers in northeastern Pennsylvania. It is therefore soliciting applications for the position of Visiting Practice Professor of Law and Director of the LITC, which is expected to operate on a part-time basis during 2021. The position will begin on January 15, 2021 or as soon thereafter as practicable, and will run through the end of the calendar year. The Clinic Director will be expected to establish and operate the LITC, including developing a panel of pro bono attorneys and performing community outreach, and to take a leadership role in applying to the IRS for a multi-year grant, which will likely need to be submitted in June, 2021. In addition, the Clinic Director will be expected to develop and teach a course through which students can enroll to participate in the LITC for academic credit in 2021.

It is anticipated that this part-time, visiting position will be enhanced and converted into a clinical faculty position upon receipt of a multi-year grant from the IRS. A national search for an individual to fill the clinical faculty position will be conducted if the multi-year grant is received; the individual selected to fill the part-time visiting position will be eligible for consideration for the clinical faculty position. 

Minimum Qualifications: Candidates must have an excellent academic record and a J.D. degree, as well as experience working in an LITC or equivalent organization, either as a student or practicing lawyer, or other tax practice experience. Candidates must have sufficient tax law expertise to perform and oversee the substantive and procedural aspects of client representation, and be either admitted to practice before the U.S. Tax Court or eligible for such admission.

Temple University values diversity and is committed to equal opportunity for all persons regardless of age, color, disability, ethnicity, marital status, national origin, race, religion, sex, sexual orientation, gender identity, veteran status, or any other status protected by law; it is an equal opportunity/affirmative action employer, and  strongly encourages veterans, women, minorities, individuals with disabilities, LGBTQI individuals, and members of other groups that traditionally have been underrepresented in law teaching to apply.

To Apply: Potential candidates are encouraged to contact the selection committee’s Chair, Professor Alice Abreu, at lawfsc@temple.edu with the following: 1) cover letter and/or statement of interest; 2) resume or CV; 3) the names, affiliations, and contact information for at least three individuals who can serve as professional references; and 4) any other material that demonstrates the candidate’s ability to succeed in the position, such as a publication, brief, or similar document.

Applications should be submitted as soon as possible; interviews, which will be conducted online, could begin as early as January 4, 2021. The position will remain open until filled. Keith.

I have written on more than one occasion about the importance of timing when filing a bankruptcy in order to discharge taxes.  The debtor, or her lawyer, in today’s case, In re Alexander, Dk. No. 19-05033, Adv. Pro No. 19-5033 (D. Conn. 2020) appears to have considered the timing of the filing of the bankruptcy and may have filed bankruptcy primarily for the purpose of discharging the taxes.  Unfortunately for the debtor, a request for a Collection Due Process (CDP) hearing filed before bankruptcy extended the period during which an income tax liability could receive priority status under BC 507(a)(8)(A)(i) and that knocks one of the periods out of alignment with the discharge provisions.  The general rules regarding priority status have a few exceptions designed to protect the IRS and this is one.  Since cases addressing this exception rarely arise, it’s worth a look at how the exception works and why Ms. Alexander continues to owe taxes for 2015.

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Ms. Alexander owed taxes for 2011, 2012, 2013, 2014 and 2015.  She timely filed her returns for these years.  For the last of these years, 2015, she timely filed her return on October 17, 2016 based on an extension and the weekend rule. 

At the time Ms. Alexander filed her bankruptcy petition she was represented; however, her attorney passed away during the adversary proceeding and she did not replace her attorney nor did she really participate after that point.  The bankruptcy petition was filed on October 31, 2019.  Absent the exception for CDP hearings, the timing of the filing of the bankruptcy could not have been more perfect.  It comes slightly more than three years after the due date of the return, as extended, for the most recent tax year.  Under the provisions of BC 507(a)(8)(A) all five of the years at issue would have failed the tests to become priority claims.  Having failed that test and having become general unsecured claims, the taxes for these periods would not fit the discharge exception in BC 523(a)(1) and the IRS would write them off once the bankruptcy court granted the discharge.

One reason I believe that taxes motivated the filing of this bankruptcy provision results from the fact that Ms. Alexander filed an adversary proceeding on December 15, 2019, only six weeks after filing the bankruptcy petition.  I pause here to note that Ms. Alexander’s chapter 7 case was a no asset case which is common.  The IRS and other creditors would have received instructions from the bankruptcy court not to bother submitting a proof of claim because it would have been a waste of time and effort.  She would receive a discharge very quickly and go on her way with many of her debts removed without any payment.

Ms. Alexander did not need to file an adversary proceeding to obtain a declaration regarding the discharge of her taxes.  After the granting of a discharge the IRS abates any taxes discharged by a debtor’s case without the need for the debtor to affirmatively bring such a proceeding.  At that point if the IRS fails to discharge a debt the debtor believes the IRS should have discharged, then the debtor could bring an adversary proceeding seeking a determination regarding the discharge.  Her affirmative effort to do so even before the IRS would make its own determination shows that getting rid of the taxes may have served as a primary motivator for the filing of the bankruptcy case.  In a case such as this the filing of the adversary proceeding may have disadvantaged Ms. Alexander.  If she had waited to see what the IRS did the possibility, arguably remote, exists that the IRS would have written off all of the periods.  By bringing the adversary proceeding she insured that her taxes would be scrutinized by the bankruptcy unit, the IRS attorneys and the Department of Justice attorneys.

Whether the IRS might have mistakenly written off 2015 we will never know.  In response to the adversary proceeding, the IRS filed a motion to dismiss the first four years agreeing that they were dischargeable and removing the need to argue about them in the adversary proceeding.  With respect to 2015, however, the IRS filed a motion for summary judgment setting forth why the taxes for that year achieved priority status and because of that status were excepted from discharge by BC 523(a)(1)(A).  This post will focus on the issues raised in the motion for summary judgment.

As discussed above, she filed her 2015 return on October 17, 2016 and her bankruptcy on October 31, 2019.  Because she timely filed her return and because the bankruptcy filing is more than three years after the due date, under the general rule of 508(a)(8)(A)(i) the tax for 2015 fails the test.  However, the priority rules have exceptions.  One of the exceptions, added in the bankruptcy code changes of 2005 after the adoption of CDP in 1998, suspends or tolls the time period in BC 508(a)(8)(A)(i) for the time during which a CDP case is pending.  The language of the statutory exception appears at the end of the three rules for priority claims set out in 507(a)(8)(A) and provides:

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

The exception exists to give the IRS the full three-year period.  Without this rule a taxpayer could sit in a CDP case for a long time (a real possibility, especially if the taxpayer goes to Tax Court) running out the three-year period while the IRS has no opportunity to engage in enforced collection.  The exception preserves for the IRS the full period of time for a year to receive priority status in bankruptcy, which not only increases its chances of receiving payout in the bankruptcy case but also protects it from discharge under BC 523(a)(1)(A).

Ms. Alexander requested a CDP hearing on February 10, 2017 and remained in CDP status until October 28, 2017.  This period plus the additional 90-day period must be added to the three year period after the due date of filing the return that would normally apply to the determination of priority status in this situation.  When these additional days get added into the picture, the filing of the bankruptcy case occurred too soon to allow the 2015 year to avoid the priority designation.  The bankruptcy court does the math:

At first glance, the Plaintiff’s 2015 tax return date of October 16, 2016 falls outside of the three-year look-back period; given the October 31, 2019 petition date, three years prior would be October 31, 2016. However, the time period the Plaintiff was in Collection Due Process must be extracted from the three years pursuant to section 507(a)(8). The Plaintiff was in Collection Due Process from February 10, 2017 to October 28, 2017. Accordingly, the three-year look-back period did not run consecutively from October 31, 2016 to October 31, 2019, but rather was tolled by the Collection Due Process.

There are 1095 days in the three-year period. The number of days from October 31, 2019 (the petition date) to October 28, 2017 (the end of the Collection Due Process period) is 733 days. 362 days remain of the three-year look-back period (1,095 days minus 733 days equals 362 days). The remaining 362 days, by virtue of the Collection Due Process tolling period, is counted back from February 10, 2017 (the start of the Collection Due Process period), which results in February 14, 2016 as being the end of the three-year look-back period. The Plaintiff’s tax return due date of October 16, 2016, therefore, fell within the three-year look-back period, making her 2015 tax liability a priority claim under section 507(a)(8)(A)(i) that is an exception to discharge under section 523(a)(1)(A).

The case does not break new ground or present an especially difficult legal issue.  It does demonstrate the care that must be taken when choosing the moment for filing bankruptcy if taxes drive that moment.  Here, it appears they did.  So, this is a sad outcome for Ms. Alexander who apparently went into bankruptcy thinking that it would take care of her back taxes.  The good news for her is that bankruptcy did discharge four of the five years for which she owed.

Creditor Tries to Amend Taxpayer’s Return

If someone owes you money and a debt to the IRS stands between you and the ability to receive payment, wouldn’t it be nice if you could review the person’s return, find mistakes that would reduce the liability and file an amended return in order to significantly reduce or eliminate the liability to the IRS and open up a payment path for yourself?  Essentially, Morris v. Zimmer, No. 17-20543 (W.D. PA. 2020) involves that fact pattern, with the twist that Mr. Zimmer filed a petition in bankruptcy court initiating a chapter 7 proceeding.  Unfortunately for the competing creditors, the Morrises, the bankruptcy court does not allow their arguments to reduce Mr. Zimmer’s tax liability for reasons discussed below.

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Mr. Zimmer filed bankruptcy in the summer of 2019 back when the living was easy.  While most chapter 7 cases of individuals occur as no-asset cases because no assets exist for the trustee to distribute to unsecured creditors, Mr. Zimmer must have had assets, because the IRS filed a proof of claim in his case for just over $12,000 reflecting the unpaid tax from the amount of tax self-reported on his 2016 return.  Taxpayers occasionally end up fighting with the IRS about whether they owe the amount of tax self-reported; however, those types of disputes occur less frequently than ones where the IRS seeks to increase a reported liability.  Here, the much, much less frequent situation of a third party disputing the filed return occurs.

Because the 2016 tax debt stemmed from a tax return due within three years of the filing of the bankruptcy petition, the IRS would receive a priority for this unpaid liability pursuant to BC 507(a)(8)(A).  Having a priority claim does not guarantee payment but positions the IRS much better than the holder of a general unsecured claim.  I am guessing that Mr. and Mrs. Morris’ claim against Mr. Zimmer fell into the general unsecured claim category.  I do not know how much money the Morrises sought to recover but they made an unusual argument that would have required a fair amount of effort on their part to build.

They argued that during 2016 Mr. Zimmer resided part of the year in Canada and that he should have claimed a foreign tax credit that would have significantly reduced his outstanding liability.  They objected to the proof of claim filed by the IRS as inaccurate, since the IRS based its claim on the “incorrect” return filed by Mr. Zimmer.  So, the adversary proceeding on the claim objection results in a tax merits trial regarding Mr. Zimmer’s return, where Mr. Zimmer defends the correctness of his return from an attack by a creditor and not by the IRS.  The IRS essentially takes the position that Mr. Zimmer correctly filed the return.  For those who may think the IRS only goes after taxpayers, this case provides a nice example of role reversal.

Mr. Zimmer testifies that

he paid no Canadian taxes during the relevant period of time because the income he earned during the relevant period of time was earned outside of Canada. He also testified that he filed no Canadian tax returns because he earned no income in Canada, because Canada denied his ability to have a taxpayer identification number, and because the Canadian authorities would not extend Mr. Zimmer’s stay in the country.

Based on reading the opinion, it did not appear that the Morrises put on contrary testimony.  The court pointed out that in the absence of admissible evidence supporting a conclusion that the 2016 return was incorrect, it has no basis for changing the amount on the claim filed by the IRS.

In addition to arguing the legal incorrectness of the 2016 return, the Morrises also objected to the claim of the IRS on the basis that the IRS failed to attach a copy of Form 4340 (a type of transcript) to the claim itself, arguing that Bankruptcy Rule 3001(c)(1) requires a claim based on writing must attach the writing to the claim.  The bankruptcy court dismisses this objection stating:

The majority of courts to consider this issue in the context of claims by the IRS have concluded that because tax claims are based on statutory obligations rather than obligations created by a writing, Fed.R.Bankr.P. 3001(c) does not apply to proofs of claims filed by taxing authorities.

In support of this statement the bankruptcy court cites a host of cases.  Had the bankruptcy court held for the Morrises on this issue it not only would have reversed a fair amount of precedent developed in courts across the country but would have placed an unnecessary burden on the IRS in the claim filing process.

The Morrises also questioned the burden of production and the burden of persuasion.  They sought to shift to the IRS the burden to prove the correctness of the proof of claim.  The burden issue in tax merits litigation in bankruptcy proceedings was litigated with some frequency during the first two decades after passage of the current bankruptcy code in 1978.  I thought this issue was laid to rest by the Supreme Court’s decision in Raleigh v. Illinois Dept. of Revenue, 530 U.S. 14 (2000).  The bankruptcy court cites this opinion, after citing two lower court opinions, in support of its reasoning in denying this argument.  The court pointed out that the IRS during the trial established the prima facia validity of its claim by showing that the claim arose straight from the unpaid taxes self-reported by the debtor.  The court then spent some additional time rehashing the testimony of Mr. Zimmer regarding the foreign tax credit.

The Morrises made a fourth argument regarding the claim which the court addresses in a few sentences “for sake of completeness.”  This argument raises a rather esoteric tax issue to attack the claim:

Morris Creditors argue that certain tolling provisions of 11 U.S.C. § 108 and 26 U.S.C. § 6511 somehow bar the IRS’s claim. This argument is apparently being raised by the Morris Creditors because a taxpayer is required to notify the Secretary of Treasury of accrued but unpaid foreign taxes “before the date 2 years after the close of the taxable year to which such taxes relate,” 26 U.S.C. §905(c)(1)(B), and this time period has now passed.

The court explains that no evidence exits that Mr. Zimmer owed foreign taxes and so no basis for concluding this unusual basis for tossing a claim exists.

The IRS argued that the Morrises lacked standing to challenge the report liability on Mr. Zimmer’s return.  The court engages in a rather extensive analysis of Third Circuit law both before and after the passage of the Bankruptcy Code and concludes that the Morrises did have the right to challenge the claim filed by the IRS under BC 502.  I kept thinking about the inventive arguments made by Michael Saltzman in the case of Brandt Airflex seeking to push the envelope of BC 505, which specifically governs the litigation of tax merits in bankruptcy.  I was surprised that the court dealt strictly with BC 502 and did not address BC 505.  I was not surprised that the IRS objected to standing in this case.  I expect that it would do so again under similar circumstances.

The Morrises expended a lot of effort over a $12,000 claim.  The amount of effort here for the amount at issue surprises me.  I would understand if the IRS defended a small dollar issue because of the precedent, but for a private litigant to expend this much effort making some time consuming and technical arguments does not seem like a formula for reasonable return on the dollar even if they had succeeded.  Nonetheless, the case provides another example of things that can happen in a bankruptcy case that would not happen in any other tax context.

COVID Impairs Debtors (and IRS)

Going into bankruptcy can make taxpayers very anxious to pay the IRS, because the discharge provisions favor the IRS over many other unsecured creditors.  The last thing taxpayers going into bankruptcy want is a non-dischargeable tax debt coming out of bankruptcy, while funds of the bankruptcy estate go to pay general unsecured creditors who could be discharged in bankruptcy.  I am unconvinced this will ultimately happen in the chapter 11 bankruptcy cases of William Floyd Jr. and Joseph Floyd IV, but they have some concerns about it and tried to get the bankruptcy court to cause checks written to the IRS prior to bankruptcy to be paid to the IRS.

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You might ask why would they need to do this.  That’s where COVID comes into play.  Both men, and their spouses, with whom they filed joint returns but not joint bankruptcy cases, timely filed their 2019 tax returns shortly before the once in a lifetime (?) due date of July 15, 2020 and remitted payment with the returns of $38,792 (William) and $36,045 (Joe).  In both cases the checks remained uncashed at the time they filed bankruptcy on August 24, 2020.

The bankruptcy court stated:

the pleadings indicate that the Debtors fully intended to pay the tax debt prepetition, and only the failure of the IRS to process the tax returns in a prompt manner created the present situation. However, the debtors are not privy to the thoughts of the IRS in this matter. The IRS could be considering an audit or other action. Its motives are unknown. The Debtors’ assertion of possible criminal liability is far too remote, speculative, and unsupported by pleadings or evidence to be considered.

The bankruptcy court and maybe the debtors seem unaware of the extreme backlog of mail the IRS was seeking to process at the time of the filing of these returns.  I feel pretty certain that the IRS motives for failing to process the checks are clear – it was seeking to work its way through a mountain of mail.  It was not considering anything except putting one foot in front of the other in an effort to clear out the backlog.

In this case we see yet another impact of the closure of the IRS caused by COVID. 

The debtors argue that the failure to allow these checks to be paid could cause criminal liability in North Carolina and additional penalties and interest due to the IRS.  The court correctly swats away concerns of criminal prosecution against individuals who sought to timely comply.  The IRS also would likely abate penalties for non-payment if sufficient funds existed at the time the checks were sent.  That still leaves the debtors with concerns about the tax debts surviving bankruptcy simply because the IRS lacked the capacity to open and process its mail during the 2020 filing season.

Part of the bankruptcy court’s concern about audit stems from the reason the debtors entered bankruptcy in the first place – an alleged Ponzi type scheme headed by them.  If true, they could indeed face an audit of their returns which would increase their liabilities and cause tax liabilities on the other side of bankruptcy.

Their arguments were straightforward but unavailing.  First, they asked the bankruptcy court to allow the payment of this prepetition debt.  The bankruptcy court likened the uncashed checks for taxes to uncashed checks in other situations.  It pointed to the ordinary rule regarding prepetition debts:

The Bankruptcy Code does not explicitly authorize courts to allow preferential payment of pre-petition obligations in spite of the priority scheme or outside of a confirmed plan of reorganization.

To allow the payment of a prepetition debt outside of the scheme of payments pursuant to the chapter 11 plan their needs to be some benefit to the estate and not just a benefit to the debtors with respect to discharge.

Next, the debtors argued the checks should be honored based on the doctrine of necessity pursuant to BC 105(a).  This doctrine also bases payments on the need to pay some prepetition creditor out of order for the benefit of the estate.  The great concern in allowing payment of a prepetition creditor before confirmation of a plan is preference of one unsecured creditor over another pursuant to the scheme of priority under the bankruptcy code.  The court said there must exist a real and immediate threat that failure to pay the debt puts the bankruptcy in jeopardy.  Debtors could not make that showing here because the purpose of the payment benefited them but not necessarily the bankruptcy estate.

Debtors filed chapter 11 cases.  Most individual debtors do not go into chapter 11.  Individual debtors use chapter 11 when they seek to reorganize, rather than liquidate their debts, and their debts exceed the limitations of chapter 13.  These debtors will propose a plan of reorganization which will propose the full payment of the 2019 taxes in order to satisfy the plan confirmation requirements.  A successful bankruptcy will necessarily mean that the 2019 taxes get paid and debtors will not continue to owe the taxes after bankruptcy.  So, if everything in the bankruptcy cases goes according to the plan they will propose, they should have no problem.

Their effort to cause the special payment of the IRS as a creditor at the outset of their bankruptcy reflects their legitimate concern that everything will not work out.  Many chapter 11 cases fail on their way to confirmation or even post confirmation.  If they could have persuaded the bankruptcy court to allow payment of the tax debt at the outset of the cases they would have had less to worry about as the bankruptcy cases moved forward.  Of course, they would have had less incentive to complete their chapter 11 plans.

The decision of the bankruptcy court logically forces the debtors to wait before paying the IRS and forces the IRS to wait before receiving payment because it could not process their check prior to the filing of bankruptcy.  Had the IRS processed their checks in the 35-40 days it had the checks before the filing of the bankruptcy, both the IRS and the debtors would have lived happily after ever with respect to the 2019 tax year – at least until the IRS decided to audit the returns.

The payment to the IRS in this instance would not have been clawed back into the bankruptcy estate as a preference, because the payment fulfilled a current obligation and not an antecedent one.  COVID’s breakdown of functionality at the IRS denied it the ability to satisfy the liability of two of its accounts.  There must be other cases with similar facts where the inability to process the checks in a timely fashion could lead to ongoing headaches for the taxpayers and the IRS.

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.