Jurisdiction of Bankruptcy Courts to Hear Innocent Spouse Cases

The case of In re Bowman, No. 20-11512 (E.D. La. 2021) denies debtor’s motion for summary judgement that Ms. Bowman deserves innocent spouse relief.  On its own, the court reviews the issue of its jurisdiction to hear an innocent spouse issue as part of her chapter 13 bankruptcy case and decides that it has jurisdiction to make such a decision.  The parties did not raise the jurisdiction issue, which is not surprising from the perspective of the plaintiff but may signal a shift in the government’s position since it had previously opposed the jurisdiction of courts, other than the Tax Court, to hear innocent spouse cases.

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The court addresses the issue of its jurisdiction at the outset of the opinion.  It first cites 28 U.S.C. § 1334 and the Order of Reference from the district court before stating that this is a core proceeding.  This part of the opinion addresses the basic issue of bankruptcy courts’ jurisdiction in all issues, stemming from the litigation in the Marathon Oil case from 40 years ago (challenging the basic authority of bankruptcy courts under the then-newly-created bankruptcy code).

Moving past the bankruptcy court’s basic basis for jurisdiction, the court hones in on its ability to hear an innocent spouse case.  It first states:

Although it is true that “Section 6015(f) does not allow a bankruptcy court to exercise initial subject matter jurisdiction over an innocent spouse defense because only the Secretary [of the IRS] receives the equitable power to grant innocent spouse relief under that Section,” here, it is undisputed that the Debtor sought such relief from the Secretary in July 2019 and the Secretary denied the request.  

This aspect of jurisdiction would apply to any court hearing an innocent spouse case.  In essence, the statute requires a taxpayer claiming this relief to exhaust their administrative remedies before seeking to have a court determine relief.

Next, the court turns to its specific ability to hear an innocent spouse case and cites heavily from an earlier case from Texas:

Section 6015(e)(1) states that, in a case where an individual requests equitable relief under Section 6015(f), “[i]n addition to any other remedy by law, the individual may petition the Tax Court to determine the appropriate relief available to the individual under this section . . . .” 26 U.S.C. § 6015(e)(1)(A). It is unambiguous that a Tax Court—and not just the Secretary—may grant relief to an individual. Moreover, the remedy available in the Tax Court is “[i]n addition to any other remedy provided by law.” 26 U.S.C. § 6015(e)(1)(A).

11 U.S.C. § 505 is another “remedy provided by law.” Section 505(a)(1) specifically provides bankruptcy courts with remedial power over tax liabilities and penalties . . . . This statutory language provides a bankruptcy court with the power to determine the legality of taxes and tax penalties.

Pendergraft v. United States Dep’t of the Treasury IRS (In re Pendergraft), 119 A.F.T.R.2d (RIA) 2017-1229 (Bankr. S.D. Tex. Mar. 22, 2017)

Because it determines that the tax liability directly impacts the administration of the bankruptcy case and because the IRS has filed a proof of claim seeking to have Ms. Bowman pay the liability for which she seeks relief, the court finds that it has jurisdiction while also noting that the IRS has not objected to its jurisdiction.

The opinion is important for being only the second court to deal with the issue of whether a bankruptcy court has jurisdiction to decide § 6015 relief.  The court says that it does have such jurisdiction because 6015(e)(1)(A) (giving the Tax Court jurisdiction) is only “in addition to any other remedy provided by law” and that the bankruptcy court is another such remedy.  The court cites the Pendergraft case, which is the only other opinion from a bankruptcy court on this matter.  The court conveniently doesn’t mention all the district court opinions holding that 6015 relief jurisdiction does not exist in collection suits or (in one opinion) in refund suits, but resides only in the Tax Court.

The last district court case to render an opinion on this issue was Hockin v. United States, 400 F. Supp. 3d 1085 (D. Or. 2019).  We blogged on the Hockin case here.  In Hockin, the district court rejected earlier district court opinions and found it had jurisdiction to hear an innocent spouse case.  The case never went to trial because the parties settled.  The issue highlighted differences in the Tax Division of the Department of Justice where the trial sections argued that the district courts lacked jurisdiction while the appellate section simultaneously argued that they had jurisdiction and used that argument as a basis for dismissing innocent spouse cases filed late in the Tax Court as having missed a jurisdictional deadline.  The Tax Clinic at Harvard filed an amicus brief in Hockin pointing out the dissonance in the positions taken within DOJ, and the court noted the conflicting positions.

Perhaps the failure to raise jurisdiction as an issue in Bowman means that DOJ has abandoned the issue that only the Tax Court has jurisdiction to hear innocent spouse cases, or perhaps a split now exists within the trial sections at DOJ.  Another possibility is that DOJ distinguishes between district court and bankruptcy court cases raising this issue.  In its motion to dismiss in the Hockin case, DOJ stated:

The language of Section 6015(e)(3) explicitly strips the Tax Court of jurisdiction once a refund suit is filed in district court, which avoids parallel proceedings. But another court explicitly rejected Boynton. In re Pendergraft, 16-33506, 2017 WL 1091935, at *3 (S.D. Tex. B.R. Mar. 22, 2017). That court held that it could consider an innocent spouse defense as part of a bankruptcy court’s powers to determine the amount or legality of a tax under 11 U.S.C. § 505. The court was unconcerned with the possibility of inconsistent judgments, finding that jurisdiction cannot be “based on a hypothetical possibility that concurrent proceedings could produce inconsistent results. That issue, if it ever exists, should be left to Congress.” Id.

Pendergraft is an outlier decision, and it ignores Boynton’s most convincing point: if Congress intended to provide two equally accessible lanes for a taxpayer to seek review of an innocent spouse determination, why does Section 6015(e)(3) treat the process as a one-way street? The Tax Court is clearly divested of jurisdiction when a refund suit is filed in district court, yet the statute is silent on the reverse scenario. Section 6015 sets out a clear, detailed process for funneling review of innocent spouse determinations to the Tax Court. That statute provides no such scheme for the district courts.

DOJ did not try to distinguish Pendergraft because bankruptcy is different.  In Pendergraft, the DOJ argued that the availability of a Tax Court 6015 action precluded 6015 relief under BC 505. The Pendergraft opinion provides a lengthy response disagreeing with the DOJ and its citations — but one that does, in part, rely on the purpose of BC 505.  Section 505 grants jurisdiction to bankruptcy courts to resolve tax merits issues.  The Pendergraft court says that BC 505 is a remedy encompassed by the “in addition to any other remedy provided by law” clause in 6015(e)(1)(A).

Going past the jurisdictional issue, the court in Bowman declined petitioner’s invitation to grant her relief based on summary judgment.  Here is her motion and here is the DOJ response.  She sought relief under 6015(f) but did not submit an affidavit or much other information related to the factors that the IRS has established as required for relief in Rev. Proc. 2013-34.  The court found that insufficient evidence was presented to allow it to grant relief at this stage.  Of course, she can still succeed if she puts on adequate evidence at trial.  At least, based on the court’s finding of jurisdiction, she will have that opportunity.

Offsetting Stimulus Payments Due to a Taxpayer in Bankruptcy

The case of Lockhart v. CSEA, et al, No. 1:20-ap-00038 shows another facet of the offsetting of last year’s stimulus payments.  In this case the taxpayer owed past due child support, which was the one type of debt to which the stimulus payments could be offset; however, he argues that the offset in his situation violated the automatic stay of his bankruptcy case as well as the terms of the confirmed chapter 13 plan.  Though the court tosses certain claims, it leaves open the possibility that the offset of the refund violates the terms of the plan of reorganization.

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Before looking at the issues the court addressed regarding the offset, a couple issues deserve mention.  First, the offset took both the refund of Mr. Lockhart and his current spouse and applied it to his past due child support.  This issue was discussed in several posts last year collected here.  The court simply sends her to file an injured spouse form.  I am a little surprised the IRS did not just fix the problem without the need for that form.

Second, the IRS should not be a party to this case.  It gave Mr. Lockhart what he requested – the stimulus payment.  The IRS did not refuse to give him the payment or make the offset.  The offset occurred at the Bureau of Fiscal Services.  It seems to me that would be the appropriate focus of any wrong activity at the federal level and not the IRS.  Maybe it doesn’t really matter, but by focusing on the IRS, Mr. Lockhart, and perhaps the court, focus on the wrong point in time.  This is a common mistake for taxpayers subject to offset.  They often see the IRS as the source of their problem, but when the offset goes to an agency outside of the IRS, the offset occurs once the funds have been approved by the IRS.

The first issue the bankruptcy court addresses is sovereign immunity.  Both the IRS and the state agency assert sovereign immunity in seeking dismissal of the action.  I was surprised by the IRS arguments regarding sovereign immunity as described by the bankruptcy court.  The court found that B.C. 106 waived sovereign immunity in matters of this type.  That decision seems consistent to me with the determinations regarding sovereign immunity that have developed over the last quarter century since the bankruptcy code was amended; however, I have not looked at the brief filed by the IRS and perhaps there is a nuance I am missing.  The court essentially lumped the state and federal sovereign claims together and found a waiver as to both.  The fact that sovereign immunity was waived does not win the case for the debtor, but it does allow the case to move forward.

The debtor seeks to hold the parties in contempt for taking the stimulus payment and applying it to the past due child support because he confirmed a plan that provided he would pay out the almost $20,000 of past due child support during the life of the plan. The state child support agency countered that it was not bound by the confirmation order, an argument I assume is grounded in the failure to include it as a named creditor, and that the stimulus payment was not property of the estate, an argument that would be grounded in the language of the chapter 13 plan itself. A common provision of chapter 13 plans revests all property in the debtor upon confirmation in return for the promise to pay.

The court refuses to hold anyone in contempt, stating that more facts are needed, especially since neither the IRS nor the state agency were served with the bankruptcy petition.  It also makes an interesting note that the debtor does not appear to be performing under the plan.  If the debtor is not actually making their plan payments which will resolve the child support issue or if the debtor is running up additional child support obligations post-petition, that could put the offset in a different light.

With respect to the automatic stay, the state child support agency asserted a defense based on one of the exceptions to the automatic stay, B.C. 362(b)(2)(F).  The automatic stay creates a stay of eight actions specified in B.C. 362(a), one of which is collection by a creditor of a pre-petition debt and another of which is offset.  In a chapter 13 case, the automatic stay lasts from the moment of filing the petition until the end of the case, which could be five years later.  The bankruptcy code, however, in B.C. 362(b) contains a list of 29 exceptions to the automatic stay. 

If a creditor fits under one of the 29 exceptions, it can take the collection action even though such action is barred by the provisions of B.C. 362(a).  I am most familiar with the exceptions that apply to taxes, most of which are found in B.C. 362(b)(9), and I was not familiar with B.C. 362(b)(2)(F).  It excepts “the interception of a tax refund, as specified in sections 464 and 466(a)(3) of the Social Security Act or under an analogous State law.”  Here, the debtor argued that the stimulus payment was not a tax refund but rather a credit.  The bankruptcy court sided with the government arguments that the stimulus payment is a tax refund.  This decision could have implications beyond bankruptcy cases but given the language of the application exception to the automatic stay provides sufficient cover for the action from the perspective of fending off a stay violation argument.

This case provides no remarkable revelations but does examine the taking of the stimulus payment under the only offset provision available.  If the debtor is not keeping current on his chapter 13 plan, he may face a difficult task in getting the return of the stimulus payment or a contempt charge against the state agency.  If the federal government did not know of the bankruptcy, it’s hard to fault it for making an offset where the state left a marker on the Treasury Offset Program database.  Removing the marker upon the filing of bankruptcy should fall on the state agency that knew of the bankruptcy, and not the TOP program.

The Fourth Circuit and the Primacy of Refund Offsets in Bankruptcy

We welcome guest blogger Michelle Drumbl. Professor Drumbl runs the tax clinic at Washington & Lee Law School and teaches tax there as well. She started as a clinician at almost the same time I did, and it has been a pleasure to work with her over the years. Starting later this summer she will take on the role of acting dean at the law school which is quite a testament to her abilities. She is also the author of a relatively recently published book, Tax Credits for the Working Poor – A Call for Reform, quite a timely book given the recent boost in refundable tax credits authorized by Congress. She is also the co-author of the Examinations chapter of the 8th Edition of Effectively Representing Your Client Before the IRS. Today she writes on a recent 4th Circuit decision at the intersection of tax and bankruptcy and brings to our attention a forthcoming article she has written on the same intersection triggered by another 4th Circuit decision that came out last year. If you want a more in depth discussion of offset you can look at the article written by Michael Waalkes and me which will be published later this year in the Florida Tax Review. Keith

Income tax refund offsets have been a hot topic on Procedurally Taxing, especially of late. While there has been interest in offset bypass refunds and injured spouse relief since long before the pandemic, the CARES Act added some new wrinkles. As has been well documented on this blog, Economic Impact Payments generally were not subject to offset, with some limited exceptions such as past due child support. Offset questions came up again in the context of the Recovery Rebate Credit.

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As we followed the legislative and administrative changes and implementation, it sparked conversations about how and when the IRS should exercise its discretionary refund offset authority under section 6402. Nina Olson revitalized a proposal that she had made prior to the pandemic, urging the IRS to be more proactive in granting offset relief in cases of economic hardship. Along similar lines, the ABA Section of Taxation recommended that the IRS implement systemic offset bypass relief for three categories of taxpayers during the pandemic.

Meanwhile, the Fourth Circuit has also had occasion to think about section 6402 in the last year, not in the context of COVID or offset bypass refunds, but in the context of bankruptcy. Two recent decisions from the circuit underscore how powerful a collection tool section 6402 remains for the IRS, leaving no ambiguity as to where the circuit stands on a question that has divided lower courts.

Keith blogged about the first decision, Copley v. United States, 959 F.3d 118 (4th Cir. 2020). Anticipating an income tax refund for tax year 2013, the Copleys listed the refund as a homestead exemption on their bankruptcy schedule prior to filing their income tax return. The Copleys had outstanding federal income tax liabilities for tax years 2008, 2009, and 2010; the tax debt for 2008 and 2009 was dischargeable in bankruptcy, while the debt for 2010 was nondischargeable. Despite the Copleys’ exemption claim, the IRS used its discretionary authority under IRC 6402(a) to offset the refund, applying it to tax years 2008 and 2009. Of course, applying it to the dischargeable tax debt was in the best interest of the IRS while also the worst possible economic outcome for the Copleys: if the homestead exemption did not entitle them to keep the refund for their fresh start, presumably they would prefer that it be applied to reduce the nondischargeable tax debt.

The Copleys brought an adversary proceeding in bankruptcy court seeking turnover of their tax refund, asserting that they had properly claimed it as exempt under Virginia’s homestead exemption provision as allowed by BC 522. Ultimately the matter was decided by the Fourth Circuit, which held that the refund became part of the Copleys’ bankruptcy estate, but that BC 553(a) preserves the IRS’s right of offset notwithstanding the Copleys’ exemption rights under BC 522(c). I wrote a forthcoming article about Copley in which I traced the case law split on this issue and discussed the significance of the Fourth Circuit’s holding.

The lower court case law is mixed and at times confusing, in part because it includes cases in which the IRS offset tax refunds to tax debt and also cases in which the Treasury made TOP offsets to nontax debt. The Bankruptcy Code’s automatic stay rule generally prohibits offset against prepetition debts; however, in 2005, Congress enacted BC 362(b)(26),  an exception that allows the IRS to offset a prepetition income tax refund against a prepetition income tax liability. As Keith has discussed, this exception does not extend to TOP offsets – the automatic stay limits the government’s right to offset a tax refund against a nontax debt.

Copley is the first circuit court opinion to resolve the tension between BC 522 and 553 while also finding the tax refund was part of the bankruptcy estate. In the conclusion of my article, I queried whether courts might limit the Copley holding to offsets of tax refunds against tax debts, as distinguished from offsets of tax refunds against nontax debts. Last month, while the article was still in the editing stages with the South Carolina Law Review, the Fourth Circuit provided an answer.

In Wood v. U.S. Department of Housing &  Urban Development, 993 F. 3d 245 (4th Cir. 2021), the Fourth Circuit followed Copley, holding that the government’s right under IRC 6402 to offset a tax refund against a preexisting nontax debt prevails over the debtors’ right under BC 522(c) to claim an exemption in their tax refund.

The Woods defaulted on a HUD-backed loan, which was subject to the Treasury Offset Program. The Woods filed bankruptcy in March 2018 and a week later filed their 2017 income tax return. Pursuant to IRC 6402(d), the government offset the federal income tax refund against the outstanding debt to HUD. The Woods brought an adversary proceeding in bankruptcy court, asserting that the tax refund was part of their bankruptcy estate, was protected by the automatic stay, and was protected by exemption under BC 522. The government argued that the tax overpayment was not considered a tax refund under IRC 6402, was thus not part of the bankruptcy estate, and therefore was not subject to exemption and not protected by the automatic stay. At the time of the adversary proceeding, the Fourth Circuit had not decided Copley.

Keith blogged about Wood last year when the district court affirmed the bankruptcy court’s  finding that the exemption provision of BC 522 disallowed a setoff under BC 553. While acknowledging a split on the issue, the district court found that the tax refund was part of the bankruptcy estate; it then followed other bankruptcy courts within the Fourth Circuit in finding that “a properly-claimed exemption trumps a creditor’s right to offset mutual prepetition debts and liabilities.” However, as Judge Wilkinson noted in Wood, “those courts lacked the guidance of [the Fourth Circuit’s decision in] Copley.” Judge Wilkinson’s Wood decision refers to IRC 6402(a) (offset against tax debts) and 6402(d) (offset against TOP debts) as “sister provision[s].” Importantly, the Wood decision notes that an offset under section 6402(a)  is discretionary while an offset under 6402(d) is mandatory, with the result that “the case for a statutory setoff right is even stronger [in Wood] for § 6402(d) than it was in Copley for § 6402(a).”

But as the opinion notes, that “is not the end of the matter” because unlike in Copley, the Wood court still had to had to address the applicability of the automatic stay. The district court in Wood noted that BC 362(b)(26)’s automatic stay exception does not apply to a TOP offset, with the result that the Woods’ tax refund was protected by the automatic stay. The district court rejected the government’s argument for retroactive annulment of the stay. In his blog post, Keith expressed surprise that the DOJ lawyer representing HUD would argue that the United States had the right to seek a retroactive annulment of the automatic stay to allow the offset. Keith noted that other federal agencies would need to go to Congress and have 362(b)(26) expanded if they wanted to use TOP while an individual was in bankruptcy.

The Fourth Circuit in Wood did not find this problematic, however. While acknowledging that 362(b)(26) does not apply to an offset against a HUD liability, and that the government’s actions violated the automatic stay, the court also noted that the government can seek relief from the stay and that “barring exceptional circumstances, the government’s motion for relief from the automatic stay in cases of this kind should ordinarily be granted” (citing Cumberland Glass Mfg. Co. v. De Witt on this point).  In remanding Wood to the lower court to consider that question, the Fourth Circuit emphasized the Copley precedent and its finding that “the government’s statutory setoff rights under § 6402 trump the Woods’ right to exempt their overpayment.”

It remains to be seen whether other circuits will follow the Fourth Circuit’s holdings in Copley and Wood as to the primacy of IRC 6402. In the meantime, debtors and bankruptcy attorneys should take note. In my article I outline a few takeaways, each of which highlight the need for careful planning when a bankruptcy debtor has outstanding tax debt. While Keith and Nancy Ryan come to my mind as notable exceptions, it is my observation that tax lawyers are not typically also bankruptcy experts and bankruptcy lawyers are not typically also tax experts. These two Fourth Circuit cases, however, are a reminder that both types of lawyers must be cognizant of the ways in which the statutory worlds of bankruptcy and tax collide.

Sixth Circuit Holds that State Court Judge’s Failure To Pay Taxes Was Willful for Purposes of Bankruptcy Discharge Rule

Your bloggers have had lots on their plate this week, so we apologize for the lighter than usual coverage. Luckily, others, like Jack Townsend, who in addition to working with me to cover criminal tax in Saltzman and Book, has his own terrific blog, Federal Tax Crimes. Over there today he discusses United States v Helton, an unpublished Sixth Circuit opinion that addresses the exception for bankruptcy discharge in Bankruptcy Code Section 523(a)(1)(C) for a debt “with respect to which the debtor . . . willfully attempted in any manner to evade or defeat such tax.”  

The issue in these cases turns on what is needed to prove willfulness. In 2014 guest poster Lavar Taylor discussed the Ninth Circuit’s approach in What Constitutes An Attempt To Evade Or Defeat Taxes For Purposes Of Section 523(a)(1)(C) Of The Bankruptcy Code: The Ninth Circuit Parts Company With Other Circuits, Part 1 and Part 2  

Helton involves a Georgia state court judge who prior to his time on the bench ran up some pretty significant income tax debts. At the same time the taxpayer often frequented restaurants, drove a Mercedes, and made sizable charitable contributions. The case turned on whether Helton voluntarily and intentionally violated the duty to pay taxes.  According to the Sixth Circuit (internal cites omitted), “[t]hat element is met when the taxpayer has the financial means to meet his outstanding tax liabilities but makes a conscious decision not to apply those monies toward his tax debt.”

The opinion concluded that Helton’s “discretionary spending—lavish when compared to the pittance he allocated toward his taxes—amply supported the district court’s finding that Helton’s violation of his duty to pay taxes was voluntary and intentional.”

As the Sixth Circuit discusses, the excuse from the taxpayer, that he was busy with work and occasionally depressed, was not enough to escape the finding that he intentionally violated his tax paying duty. It was not necessary for the court to conclude that his lifestyle spending was undertaken specifically to avoid paying taxes.

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.