Stipulations and Res Judicata in Quest for Bankruptcy Discharge

In Minor v. United States, Bankruptcy Case No. 2:13-bk-23787-BR (C.D. Cal. 2021), the district court addressed a debtor’s claim that a stipulation by the IRS barred the collection of taxes for the year covered by the stipulation.  Here, the district court affirmed the dismissal of the adversary proceeding based on the IRS request for a judgment on the pleadings.

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Mr. Minor filed his chapter 7 bankruptcy petition on May 24, 2013.  Already you have a clue that this will not be an ordinary chapter 7 case, since almost eight years have elapsed after the filing of the bankruptcy petition.  He received a discharge on May 18, 2015, almost two years after filing the bankruptcy petition.  On March 9, 2018, the IRS filed an amended proof of claim for $24,857,210.48 for secured liabilities, $997,869.07 for priority liabilities and $61,398.90 as a general unsecured claim.

Mr. Minor also owed taxes to the state of California, which filed its own claim.  The bankruptcy estate did not have sufficient assets to satisfy the state and federal claims for taxes.  The IRS and the state entered into a stipulation splitting the available assets.  With respect to the IRS claim the stipulation provided:

The IRS Claim shall be allowed as a secured claim in the amount of the IRS Sotheby’s Share in the amount of $586,604.12 (the ‘IRS Secured Claim’), a priority claim in the amount of $997,869.07 (the ‘IRS Priority Claim’), a general unsecured claim in the amount of $19,706,386.41, and a subordinated claim for penalties in the amount of $4,625,648.18.

The court approved the stipulation.  Afterward, the IRS notified Mr. Minor that he still owed $462,432 for 2009.  He brought this action arguing that the stipulation together with his discharge prevented that IRS from coming after him at this point to collect the unpaid taxes.

The parties agreed that the taxes for 2009 had priority status since the return was due less than three years prior to the filing of the bankruptcy petition (I assume he filed a request for extension of time to file the 2009 return since the normal due date for 2009 is outside the three year period.)  The parties agreed that priority taxes are excepted from discharge under BC 523(a)(1)(A).

At issue is the impact of the stipulation on the ordinary application of the discharge rules.  The IRS argues that the stipulation did not impact discharge but merely divided the available property in the estate.  Mr. Minor cites bankruptcy cases from other districts arguing that a stipulation can trigger discharge.

The bankruptcy and district courts point out that the stipulation did not discuss discharge and that Mr. Minor was not a party to the stipulation.  Because bankruptcy courts, pursuant to BC 505, can determine the amount of tax, a stipulation of a tax creditor to an amount of tax can serve as a final judgment binding the tax authority to the amount of tax stipulated.  That type of stipulation would address the merits of the liability and not simply split available assets for distribution from the estate.  Mr. Minor’s argument draws from cases involving a contest of the tax liability itself and seeks to import the result of a stipulation in that situation to a division among tax creditors in the same class attempting to divide a limited pot of funds.  The order of the bankruptcy court regarding the stipulation in this case binds the IRS and California with respect to the division of the funds but not with respect to their underlying liabilities.

Mr. Minor was not in privity with the parties entering into the stipulation.  No identity of claims exists in his case that would support a determination that the IRS bound itself to a lower recovery with respect to taxes excepted from discharge simply because it accepted a certain amount of payment from the available funds.  In describing the outcome and the arguments the court observed:

It must be noted that the United States’ main argument in this action seems to be that Minor’s 2009 tax debt is nondischargeable. However, as explained in Breland, 474 B.R. at 770, whether Minor’s 2009 tax debt is nondischargeable under § 523(a)(1)(A) is irrelevant. Whether the Stipulation discusses dischargeability is irrelevant. The only pertinent issue here is whether the IRS is bound, by res judicata, to the amount designated as the IRS Priority Claim in the Stipulation Order.

The court correctly notes that even though the 2009 meets the criteria for an exception to discharge, the possibility still exists that the IRS could have stipulated to a lower amount of debt, which could bind it.  Even though that possibility exists, that’s not what the IRS did here.  The debtor tries to read too much into an agreement between two parties, and the court correctly determines that splitting the available assets does not imply a settlement on the correct amount of the debt or the dischargeability of the debt.

Anti- Injunction Act and Bankruptcy Merits Litigation

In In Re Aero-Fab Inc., No. 3:10-bk-30836 (Bankr. S.D. W.Va 2021) the bankruptcy court refused to reopen a bankruptcy case to allow the debtor to challenge the trust fund recovery penalty (TFRP.) 

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The debtor filed a small business chapter 11 on October 8, 2010, and used the bankruptcy as a platform for selling the assets of the business rather than reorganization.  This was a legitimate use of the bankruptcy platform.  It sold the assets to a company owned by the son of the owner of Aero-Fab, Inc. and disclosed that relationship to the court.  At the time of the sale there were two liens filed against Aero-Fab.  One was to a bank and the other to the IRS.  The proceeds were distributed first to the bank, which appears to have had a superior lien since no one objected to that and second, with the remainder of the proceeds, to the IRS in an amount that did not satisfy the tax debt.  The purchasing company took the assets free and clear of liens.

On August 3, 2020, the purchasing company and Jeff Maynard, the son of the owner of Aero-Fab moved to reopen the bankruptcy case, alleging that the IRS sandbagged them by assessing a TFRP for unpaid post-petition taxes against Jeff Maynard. The court describes their argument:

The Reopen Movants assert that the trust fund tax assessment against Jeff Maynard is inappropriate and that the IRS should not be allowed to collect the trust fund tax. They rely on the following language in the final sale order: (1) that the Court will “retain jurisdiction of this transaction for the purposes of enforcing provisions of this order and the amended purchase agreement”; (2) that the “sale of property shall be free and clear of liens, claims, encumbrances, and interests with the liens to attach to the proceeds”; (3) that AFI took “title to and possession of the assets free and clear of any and all liens, claims, liabilities, interests, and encumbrances”; and (4) “all persons and entities are hereby prohibited and enjoined from taking action that would adversely affect [or] interfere with the ability of the Debtor to sell and transfer the assets.” This language forms the basis of the Reopen Movants’ claim that the IRS has “blatantly disregarded” the terms of the final sale order by assessing the trust fund tax against Jeff Maynard. The Reopen Movants assert that Jeff Maynard was indeed a purchaser (in addition to AFI), not a “responsible person,” and, thus, the IRS cannot assess this penalty against him. The majority of the Reopen Movants’ arguments address the legality of the trust fund tax assessed against Jeff Maynard and mostly address whether he has been improperly deemed a “responsible person.” They go so far as to file and discuss the transcript of the 2013 hearing approving the final sale order and point to sections they believe would absolve Jeff Maynard from the trust fund obligation.

Jeff Maynard argued that the Anti-Injunction Act (AIA) should not apply because he seeks not to enjoin the IRS from collecting but merely to enforce a prior order of the court.  The IRS argues that this is simply an attempt to have the bankruptcy court prevent the IRS from assessing and collection and that Mr. Maynard must instead bring a refund claim in district court or the Court of Federal Claims.

A party in interest may reopen a bankruptcy case pursuant to BC 350(b).  The Fourth Circuit has said that a party in interest is anyone “whose pecuniary interests are directly affected by the bankruptcy proceedings.”  Assuming that you meet the party in interest test, you bear the burden of proof to show that one of the three BC 350(b) bases for reopening exists: (1) to administer assets, (2) to accord relief to the debtor or (3) for other cause.  Here, the basis would be other cause since this request does not impact asset distribution or the debtor.  The Fourth Circuit requires compelling circumstances to reopen a case.  The first step is determining if reopening would be futile or a waste of resources and that’s where the AIA comes into play.

Les has written about the AIA several times, including posts on CIC Services a case now awaiting decision by the Supreme Court.  See some of his prior posts here, here and here.  The bankruptcy court notes the general rules regarding exceptions for the AIA:

The Supreme Court has articulated two exceptions to the AIA. The first exception, created in Enochs v. Williams Packaging & Navigation Co., allows injunctive actions against the IRS to proceed only if the plaintiff could prove two elements: (1) that under no circumstances would the Government ultimately prevail; and (2) that equity jurisdiction exists otherwise. Enochs v. Williams Packaging & Navigation Co., 370 U.S. 1 (1962). For the first element, “a court must determine, on the basis of the information available to the government at the time of the suit, whether, under the most liberal view of the law and the facts, the United States cannot establish its claim.” Judicial Watch, 317 F.3d at 407 (citing Enochs, 370 U.S. at 7) (internal quotation marks omitted).

The second exception was created in South Carolina v. Regan, wherein the Supreme Court opined that the AIA “could not stand as a barrier to injunctive relief in situations where . . . Congress has not provided the plaintiff with an alternative legal way to challenge the validity of the tax.” Judicial Watch, 317 F.3d at 407-08 (quoting South Carolina v. Regan, 465 U.S. 367, 373 (1984)) (internal quotation marks omitted). The issue in the Regan case was the constitutionality of state-issued bonds. Judicial Watch, 317 F.3d at 407. The basis for the exception “is not whether a plaintiff has access to a legal remedy for the precise harm that it has allegedly suffered, but whether the plaintiff has any access at all to judicial review.” Id. at 408 (citing Regan, 465 U.S. at 381) (emphasis in the original). “For most aggrieved persons, Congress has provided an alternative avenue to relief: a refund suit under 26 U.S.C. § 7422.” McKenzie-El v. Internal Revenue Service, No. ELH-19-1956, 2020 WL 902546, at *8 (D. Md. Feb. 24, 2020); see also Regan, 465 U.S. at 374-82. For example, the Seventh Circuit noted that the Regan exception did not apply in the matter before it because, should the party contesting the assessed tax want to challenge the tax, it could merely pay the tax and sue for a refund. LaSalle Rolling Mills, Inc. v. United States (In re LaSalle Rolling Mills, Inc.), 832 F.2d 390, 393 (7th Cir. 1987).

These exceptions are narrow, so as to prevent a “flood of lawsuits brought against the IRS . . . creating precisely the kind of judicial interference with the assessment and collection of taxes that the Act was designed to prevent.” Judicial Watch, 317 F.3d at 408

The court decides that the motion to compel in this case is really a request to enjoin the IRS from collecting, and nothing indicates that Mr. Maynard has tried to sue the IRS for a refund under normal TFRP procedures.  Although he attempts to characterize this as an action to enforce a settlement, the AIA contains a clear directive regarding this situation, and neither of the exceptions discussed above apply.  Because of the AIA, the court finds that reopening the bankruptcy case would “be a textbook example of futility and the wasting of judicial resources.”

We will soon have a decision from the Supreme Court in CIC Services discussed here and here.  That case addresses a very different aspect of the AIA than the Aero-Fab case but, if it creates another exception to the AIA or limits the AIA, the decision may be worth looking at for Mr. Maynard as he decides whether to further appeal this case or simply bring a TFRP case in district court. On March 17, Mr. Maynard appealed to the district court for the Southern District of West Virginia.

Taxpayer Finds Another Way Not to File a Return

Whether a taxpayer has filed a return impacts not only the statute of limitations and penalties but also bankruptcy discharge.  In December I wrote about whether a taxpayer had filed a return in the Coffey and Quezada cases each involving a situation in which the taxpayer did not file a tax return but where the taxpayer argued that what was filed with the IRS or, in the case of the Coffeys, with the Virgin Island tax authorities, constituted the filing of the return in question.  For those with a Tax Notes subscription, you can see an expanded discussion of the cases here.

Another case has come out addressing the issue of whether a return was filed.  In Harold v. United States, (E.D. Mich. 2021) the district court affirms a bankruptcy court’s order denying discharge to a debtor who sent a revenue officer (RO) his tax return for the year at issue prior to the due date of the return but never filed the return with the IRS at the appropriate service center.  The court determines that delivery of the return to the revenue officer under the circumstances of this case did not satisfy the requirement of the taxpayer to file the return.  The case demonstrates, yet again, the importance of following the correct procedures for submitting a return and the trouble that can follow if the taxpayer colors outside of the lines.

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 Mr. and Mrs. Harold requested the automatic extension of time to file their 2008 return.  Because they were engaged in collection issues with the IRS about that time, they hired a tax resolution company to negotiate an installment agreement.  On June 2, 2009, well before the extended due date for their 2008 return, their representative faxed materials to the RO assigned to the case and included in the package the first two pages of their 2008 return together with the statement that the 2008 return “was sent to the IRS for filing on June 1, 2009.”  On June 16, 2009, the representative faxed a full, signed copy of the 2008 return to the RO.  At a subsequent deposition the representative described this second sending as a courtesy copy.  The representative testified that he did not remember sending the 2008 return to the service center but that if he had done so, his practice would have been to send it by regular mail.

The Harolds did enter into an installment agreement (IA) in July of 2009.  This IA did not cover 2008 and the letter transmitting the IA made no mention of 2008.  The RO testified that she did not require the filing of post IA returns with her.  She also testified that she regularly directed taxpayers to file future returns with the IRS service center in accordance with normal filing procedure.

Fast forward to 2016 when a new RO enters the scene looking for outstanding returns from the debtors.  The debtors go back to the representative and request a copy of their 2008 return.  The rep provides a copy and says it was filed with the first RO on June 16, 2009.  The IRS assesses the liability for 2008 in 2016 when the second RO obtains the return and five days later Mrs. Harold files a chapter 7 petition.

The IRS filed an adversary proceeding seeking a determination, inter alia, that the 2008 tax liability is not discharged.  The relevant discharge provision is in BC 523(a)(1)(B).  This section excepts from discharges the taxes on a return filed late and filed within two years of the filing of the bankruptcy petition.  Here, the IRS will win, and prevent the discharge of the 2008 taxes, if the submission to the first RO fails to qualify as the filing of a return, since the submission in 2016 immediately prior to the filing of the bankruptcy petition would then become the time of the return filing.

The court notes that the Internal Revenue Code does not define the term “filed.”  It then looks to Sixth Circuit precedent found in the case of Miller v. United States, 784 F.2d 728 (6th Cir. 1986).  In Miller, the court defines the filing of a federal tax return as the time when it “is delivered and received.”  That definition, commonly known as the “physical delivery rule,” may not provide the most helpful guidance here as it relates to mailing of a return.  Mrs. Harold argues that the faxing of the return should count if the court does not believe that her representative sent the return by regular mail.

On appeal she abandoned the argument that her representative mailed the return.  Given his tepid testimony on this point, this concession makes sense.  She pins her hopes on the faxing of the return to the RO.  The IRS does not dispute the fact of the faxing of the return but only disputes the consequence.  She argues not only did faxing the return constitute filing but that doing so met a precondition to acceptance of the IA.  So, the acceptance of the IA validates the faxing of the return as a filing.

This argument sends the court to look at the Internal Revenue Manual to find the IRS internal guidance regarding the requirement for filing past due returns as a precondition to acceptance of an installment agreement.  IRM 5.14.1.2, 5.14.1.3, 5.14.1.4.2 as in effect at the time required the filing of past due returns prior to the acceptance of an IA.  The parties agreed that the IRS would not have entered into an IA if delinquent returns existed; however, the IRS argued the 2008 return was not delinquent in June of 2009 since Mrs. Harold and her husband had validly requested an extension until October 15, 2009.

Mrs. Harold makes a technical point concerning the extension in arguing that it lacked validity.  She argues the extension not only required a timely and proper request but also an extension of time for payment.  Since the time for payment had not been extended and since she owed taxes on the 2008 return, the extension was invalid and her return was delinquent in June of 2009.  Taxpayers who request an extension should pay the anticipated tax liability at the time of the request.  The failure to make a necessary payment with the request could allow the IRS to invalidate the request and treat a return filed after the statutory due date (April 15, 2009) as late.  In this case, however, the IRS transcript showed that the due date had been extended until October 15, 2009.  The RO would have looked at the transcript to determine if a delinquency existed and would have found none.  So, the filing of the 2008 return prior to the acceptance did not create an obstacle for the RO in creating the IA.  The district court followed the bankruptcy court in finding that the 2008 return was not delinquent in June of 2018.

The court then addressed whether the IRS should have accepted the fax of the return to the RO as a filing.  Everyone agreed that giving the return to the RO did not meet the IRS rules governing the proper place to file a return.  The court rejects the faxing of the return as a filing for two reasons.  First, it says it cannot presume Mrs. Harold intended the faxing as a filing in light of the language in the fax stating that the 2008 Form 1040 sent by her representative was a “courtesy copy.”  Second, the faxed return did not go to the proper place.

In rejecting the filing for the second reason, the district court disagreed with the bankruptcy court.  The bankruptcy court found that sending a return to the designated service center is not the only way to properly file a return noting that in Chief Counsel Advice 199933039 the IRS had acknowledged that if a RO requested a return they have the authority to “request and receive hand-carried delinquent returns.”  The district court says relying on the CCA is misplaced because it has no precedential value. 

I disagree with the district court’s conclusion on that point.  Giving the return to a RO or a Revenue Agent who requests a delinquent return has been and should be a recognized way to file a delinquent return.  Unless a taxpayer were given a clear caveat that an RO or RA who requested and received a delinquent return did not consider the transmittal of a return in that circumstance to constitute filing, many taxpayers would be deceived into thinking that they had filed.  The bankruptcy court got this right; however, the district court went on to say that the RO did not solicit the return here and that even if delivery to an RO who solicited a delinquent return could constitute filing, delivery without request does not.  I agree with the district court that delivery without request would not in ordinary circumstances meet the filing requirement, although even in this situation actions by the RO or RA could create an impression of acceptance as filing.

This opinion generated some good discussion among a handful of practitioners with whom I correspond on tax related bankruptcy matters.  Bob Pope noted the absence of a discussion of the one-day rule by the court.  That’s a good catch.  For anyone not familiar with the one-day rule read blog post on it here (citing to many earlier posts.)  Ken Weil notes that before filing bankruptcy Ms. Harold should have checked the IRS transcripts to make sure the 2008 liability was assessed in 2009, which would have allowed her to properly consider her risk before filing the bankruptcy petition.  He also notes he could not find a delegation of authority for an RO to accept a return, although the CCA suggests such a delegation exists.  Lavar Taylor provided an interesting war story involving a similar issue and the practices of ROs regarding returns received after requests.  Bryan Camp noted that the RO’s job has involved “collecting” delinquent returns going back to the 1860s but that he did not think the return would be considered filed until it made it to the office that made the assessment.

You do not want your client to test these waters.  Don’t give a delinquent return to an RO or an RA and expect that delivery to constitute filing.  Send a signed original to the proper service center.  Be aware of the arguments available if your client has delivered a delinquent return to an RO or RA but save those arguments for situations where you are cleaning up after someone else.

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.