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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bankruptcy and Farm Debt

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

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

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

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

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

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

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

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

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

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

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

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

Following Through on Promises

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

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

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

On to the case itself.

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

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

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

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

Constitutional Argument re Scope of Bankruptcy Court Jurisdiction

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

Interpretation of Agreement

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

Tenancy by the Entireties

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

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

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

Conclusion

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

Affluent Lifestyle plus Ignoring Tax Debts Equals No Discharge

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

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

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

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

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

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

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

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

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

Belair Woods – The Ghouls Continue

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

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

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

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

In a separate concurring opinion, Judge Morrison writes:

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

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

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

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

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

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

Bankruptcy code 362(a)(6) provides:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Eleventh Circuit described the dispute as follows:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Additionally, the bankruptcy court noted:

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

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

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

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