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

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

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

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

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

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

Additionally, the bankruptcy court noted:

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

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

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

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

Limited Ability to Offset Tax Refunds

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

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

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

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

Exempt Property Argument

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

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

Automatic Stay Argument

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

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

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

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

Lien Priority Litigation

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

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

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

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

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

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

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

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

Debtors Still Trying to Fight Against One Day Rule

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

New Circuit Precedent on Issue of Litigating Tax Merits in Bankruptcy

In Bush v. United States, 2019 U.S. App. LEXIS 28533 (7th Cir. 2019), the Seventh Circuit reversed the district court and held that a bankruptcy court can determine the amount of a debtor’s tax obligations even when the debtor is unlikely to pay them.  I wrote about the Bush case back in August of 2016, when the district court found that the bankruptcy court did not have jurisdiction to determine the debtors’ tax liability. We have also discussed this issue before here, here and here although perhaps not in the precise context presented by the Seventh Circuit.  Here, the court looks at the same Supreme Court precedent that we have frequently talked about in the context of the Tax Court’s jurisdiction.  For those who have not tired of our discussion of that issue or are new to the blog, you can find samples of that discussion here and here.

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So, what’s at issue and why might this decision be important? 

The bankruptcy code in section 505(a) gives the bankruptcy court authority (I am carefully avoiding the word jurisdiction at this point) to hear and decide the merits of a debtor’s tax liability.  The principle reason for this grant of authority derives from the need for a determination of the tax liability in order to know how to divvy up a debtor’s assets among the creditors.  If the debtor owes a huge tax debt, that has a significant impact on how the bankruptcy court distributes the debtor’s assets.  Normal tax litigation can take a long time. If the bankruptcy court did not have the authority to decide the tax issues, either the distribution of assets could wait interminably for the outcome of the tax litigation, or assets might leave the estate to wrong creditor.

The general purpose of section 505(a) has led to much discussion regarding when the bankruptcy should, or even could, exercise its authority.  If, as appears to be the case in Bush, the outcome of the decision has no bearing on the distribution of assets, many have questioned whether the bankruptcy court should, or could, exercise this authority.  This type of questioning of the bankruptcy court’s authority usually arises when the debtor seeks relief in a chapter 7 no asset or low asset case.  The argument against having the bankruptcy court exercise its authority to hear the tax merits of a case stems from the belief that this grant of authority only has meaning if the exercise of the authority has meaning.  In situations in which the debtor’s estate has no money to pay either the IRS or the other creditors, little point exists for the bankruptcy court to serve as the arbiter of the tax dispute – best to leave the forum for tax disputes with the “normal” channels for deciding these disputes, viz., the Tax Court, the district courts or the Court of Federal Claims.

With this background, looking at the facts in the Bush case provides a helpful context.  The IRS proposed a deficiency of about $100,000 against the Bushes and the 75% fraud penalty.  The Bushes agreed that they owed the tax but contested the application of the fraud penalty.  Instead, they argued that the 20% negligence penalty should apply.  On the date set for their Tax Court trial, the Bushes file a bankruptcy petition.  This triggered the automatic stay of B.C. 362(a)(8) which stops the commencement or continuation of Tax Court proceedings.  From the 7th Circuit opinion I gather that the IRS filed a motion to lift the automatic stay to allow the Tax Court case to move forward, but the bankruptcy judge denied this motion and instead scheduled a trial on the merits at the request of the Bushes.  The tax years at issue in this case are 2009-2011.  The Tax Court petition was filed on September 23, 2013 and the bankruptcy petition on September 30, 2014.  We are not talking about a speedy resolution in this case but the timing of the resolution may not matter too much, since the Bushes do not appear able to pay the liability whether it ends up in the neighborhood of $120,000 or $175,000.

The IRS argued before the bankruptcy court that B.C. 505 does not grant subject matter jurisdiction to the bankruptcy court to decide a case of this type and “only a potential effect on creditors’ distributions justifies a decision by a bankruptcy judge about any tax dispute.”  The Seventh Circuit characterizes the argument about jurisdiction as “unfortunate” while acknowledging that other circuits have used the jurisdictional characterization in discussing 505.  The Seventh Circuit observes “we do not see what 505 has to do with jurisdiction, a word it does not use.  Section 505 simply sets out a task for bankruptcy judges.”  It points out that the Supreme Court insists that judges “distinguish procedural and substantive rules from jurisdictional ones”, citing to the same Supreme Court precedent noted in the litigation over the Tax Court’s jurisdiction.  For an extensive discussion of this issue, see the recent motion filed by the Tax Clinic at the Legal Services Center of Harvard Law School.

The Seventh Circuit notes that most truly jurisdictional issues appear in Title 28 of the United States Code and quotes extensively from the Title 28 section 1334 provisions regarding bankruptcy.  The IRS argued that no waiver of sovereign immunity exists to allow merits litigation under B.C. 505 through 28 U.S.C. 1334; however, the Seventh Circuit pointed to the waiver of sovereign immunity in B.C. 106(a)(1) which “waives that defense for subjects within 505.”  The court then analyzes three potentially relevant sources of jurisdiction in 1334 – those “arising in” bankruptcy litigation, those “arising under” the Bankruptcy Code, and those “related to” the resolution of the bankruptcy proceeding. 

The court finds that that the tax dispute does not “arise in” bankruptcy but rather outside of bankruptcy.  It also finds that the tax dispute does not “arise under” the Bankruptcy Code since the tax merits dispute arises under the Tax Court.  The “related to” basis for jurisdiction, however, does form a basis for allowing the bankruptcy court to hear this case.  The court points out that an Article 1 Tax Court judge or an Article 1 Bankruptcy Court judge would decide the dispute and that decision would be subject to review by an Article III judge.  This presents no constitutional issues that might exist in a state tax issue.

The IRS did not argue that tax disputes never relate to bankruptcy but only that the tax dispute in this case did not relate to bankruptcy, since no money exists in the estate to make the dispute meaningful as it relates to the entitlements of other creditors. The IRS cited to In re FedPak Systems, Inc., 80 F.3d 207, 213-14 (7th Cir. 1996) where this court held that “related to” meant that the decision impacts property for distribution or allocation of property among creditors.  The Seventh Circuit states that rather than controlling the outcome of the “related to” jurisdiction, the FedPak decision needs refinement to make it clear that “related to” jurisdiction does not depend on how things look at the end of bankruptcy but rather at its beginning.  When the Bushes filed their 505 request in this case, just two months into their bankruptcy case, only three creditors had filed claims. 

The IRS argues that even though few claims existed at the time of the 505 request by the time the bankruptcy judge proposed to resolve the dispute “it seemed unlikely that the amount the Bushes owe in taxes and penalties would affect other creditors.”  The Seventh Circuit counters that taking the ex post view contradicts the norm that jurisdictional issues must be resolved ex ante.  It finds that looking at the issue at the proper time the 505 motion met the related to jurisdictional requirements because the outcome of the tax issue could have mattered if no other creditors filed claims.  The court points out that it shares the ex ante view of the appropriate time for testing as the nine other circuits that have addressed the issue.  So, the bankruptcy judge has subject matter jurisdiction to hear the tax dispute.

Even though the bankruptcy judge has the authority to hear the tax dispute, a question still exists of whether it should exercise that authority.  The Seventh Circuit analyzes the situation today and determines that no reason exists at the moment for the bankruptcy judge to hear the case rather than the Tax Court.  Therefore, the exercise of authority to hear the case “is no longer appropriate.”  The court then vacated the district court’s decision regarding jurisdiction and remanded the case with instructions for the bankruptcy judge to enter an order sending the tax dispute back over to the Tax Court, where some lucky judge will get to try a very stale penalty case.

The jurisdictional decision seems right but the somewhat tortured nature of the path to the decision, as well as the return of the case to the Tax Court, provides insight into the difficult nature of what to do in these cases.  Here, the Seventh Circuit spends little time describing when a bankruptcy judge should decide not to exercise the jurisdiction over the merits litigation that it has.  More guidance on that issue would be helpful, because individuals will continue to seek a merits decision in bankruptcy court due to the harsh application of the Flora rule and the current state of merits litigation in Collection Due Process cases. 

Section 505 offers a last chance for taxpayers to obtain a judicial ruling regarding the merits of their case when the opportunity for Tax Court has passed them by, and they lack enough money to fully pay the tax.  Here, the Bushes have the Tax Court option, both because of the type of liability at issue and their diligence in pursuing Tax Court litigation prior to filing bankruptcy.  Many taxpayers do not have the fallback to Tax Court but want a judicial review of the decision of the IRS.  Congress despaired of this situation during the debates leading up to the creation of the Board of Tax Appeals, the Tax Court’s predecessor.  With so many liabilities now assessed without deficiency proceedings, Congress needs to take a new look at the situation.

The Surprise Bill – Interest Due after Bankruptcy

The case of In re Widick, No. 10-40187 (Bankr. D. Neb 2019) provides a reminder that bankruptcy does not discharge all debts even when the debtor pays all of the tax for the year through the bankruptcy plan.  Mr. and Mrs. Widick completed a chapter 13 plan.  To obtain the plan and to complete the plan, they paid all of the income taxes for two years and all of the trust fund recovery penalties for two quarters.  I suspect that their bankruptcy attorney did not mention to them that paying all of the taxes does not keep the IRS from coming back after the bankruptcy case to collect the interest.  They brought this action to hold the IRS in contempt for violating the discharge injunction due to its efforts to collect from them after the bankruptcy court granted the discharge in this case.  With relative ease, the bankruptcy court delivered to them the sad news that the IRS could continue to collect from them after the discharge and the authority for the IRS actions went back for three decades in the controlling circuit case of Hanna v. United States (In re Hanna), 872 F.3d 829 (8th Cir. 1989).

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In bankruptcy creditors cannot generally collect post-petition interest from a debtor.  An exception to this rule exists if the creditor has a secured claim with enough equity to pay the interest or if the debtor is in chapter 11 where the creditor can receive interest after the plan confirmation (but not for the period from the petition to confirmation.)

Although bankruptcy generally serves as an interest free zone, interest still runs.  The difficult concept for debtors with tax debt comes where the IRS starts pursuing them after discharge to collect interest on a debt that they believe they have satisfied.  Whether the IRS can come after this debt post-discharge depends on whether the debt itself qualified as non-dischargeable debt.  In the case of the Widicks, it did.  Because the debt satisfied the exception to discharge in 523, the IRS could pursue collection of the interest after the granting of the discharge.

The Widicks owed income taxes that were recently incurred.  These income taxes received priority status under B.C. 507(a)(8)(A).  The unpaid TFRP liabilities also attained priority status under B.C. 507(a)(8)(C) and due to their nature have priority status no matter how old they were.  Because the income taxes and TFRP taxes had priority status, the debtors had to provide for payment in full of these taxes and all pre-petition interest in order to obtain confirmation of their plan.  The chapter 13 plan did not require, and could not require, the Widicks to pay the interest that ran on these taxes over the 5 year life of the plan.  Debtors might think that because the plan did not require payment of post-petition interest, they got a pass on this interest.  Because debtors might easily reach this conclusion, their lawyer must carefully advise them of the interest rules with respect to taxes.  Otherwise, they will become quite upset when the IRS offsets post-discharge refunds and takes other collection action.

A similar situation occurs in offers in compromise.  The standard language of the offer in compromise developed by the IRS requires that the debtor forego any refund for the year in which the IRS accepts the offer (and any pre-offer years.)  As with bankruptcy, the taxpayer’s representative must carefully explain to the individual obtaining the offer the consequence of this provision.  The taking of the refund might occur 12 months or more after the offer acceptance.  At that point the taxpayer can easily have forgotten the promise to forego the refund.  For this reason, putting a discussion of the refund taking in the letter closing out the offer provides a good way for the representative to prepare the taxpayer for the future and protect themselves from criticism and anger that occurs when the IRS takes the refund.

Here, the debtors’ chapter 13 attorney did not prepare his clients for the consequence of the post-discharge interest liability.  In its relatively short opinion the court points out that although the Hanna case cited above involved a chapter 7 debtor, case law existed with respect to chapter 11 and 13 cases in their district.  The law here is well settled even if it is surprising.  Clients may not like this aspect of the law, but if they know it’s coming, then they understand it’s part of the bargain of the discharge — just as the taking of the post-offer acceptance refund is part of the bargain of the offer in compromise.

Timely Filing Issues in Bankruptcy Court

Dixon v. IRS, No. 2:18-cv-00274 (N.D. Ind. July 24, 2019) presents the issue of whether filing a bankruptcy petition extends the time within which a taxpayer can file a claim for refund.  In re Long, No. 19-20186 (Bankr. E.D. Wis. July 29, 2019) raises the issue of whether a debtor in a bankruptcy case must accelerate the time for filing their income tax return because of filing bankruptcy.  The answer to both questions is no.  Details and explanation below.

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Charles Dixon filed a chapter 13 bankruptcy petition on September 2, 2010.  As with most chapter 13 cases, it took time before his bankruptcy case came to an end on July 22, 2016.  While his bankruptcy cases was pending Mr. Dixon filed an amended return for tax year 2012 on April 13, 2015.  The IRS notified him by Letter 105C, a statutory notice of claim disallowance, on January 21, 2016, that it would not allow his claim.  For some reason he filed another amended return for 2012 in June of 2016 and the IRS sent him a statutory notice of claim disallowance with respect to that claim on August 3, 2016. 

On July 26, 2018, Dixon filed a complaint alleging that the IRS improperly denied his first claim.  The IRS filed a motion to dismiss because of the filing of the complaint more than two years after the notice of claim disallowance.  Though the court couches the dismissal discussion in jurisdictional terms, readers of this blog know that the timing of filing of the complaint vis a vis the sending of the claim disallowance issue may not present a jurisdictional issue though the time frame for filing provided in IRC 6532(a)(1) does represent an important time frame that a taxpayer must meet or show reasons for the failure to meet the time frame.

The statute requires that the taxpayer file the refund suit within two years of the sending of the statutory notice of claim disallowance.  Here, Mr. Dixon filed suit more than two years after the notice.  To overcome this timing problem, Mr. Dixon argues that his bankruptcy case tolled the time for filing the refund suit.  In support of this argument he cites to IRC 6503(h).  This section provides a tolling of “the period of time in which the United States can collect a tax against a taxpayer/debtor.” But it does not mention tolling the time within which to bring a refund suit.  The bankruptcy court declined to extend the tolling provision to the refund situation.  Doing so would have created a shocking result.  The tolling statute that he cited in support of the timeliness of his claim seeks to give the IRS more time to collect a liability in situations in which the automatic stay of bankruptcy prevents it from collecting.  The statute has nothing to do with extending the time for a taxpayer to file bankruptcy.

Next he argued essentially that his second refund claim gave him more time; however, the second claim mirrored the first claim.  It did not raise new grounds for recovery.  The court found that a second claim could only extend the time within which to bring suit if the second claim raised new legal arguments.  Since it did not, the filing of the second claim here had no meaning.  (The IRS pointed out that even if the second claim had contained a second ground for recovery it would have done no good here because Mr. Dixon filed it after the statute of limitations for filing a refund claim.)  Although Mr. Dixon did not argue that the statute of limitations for filing his refund claim did not create a jurisdictional bar to filing a claim after that date, he presented no evidence that appeared in the opinion which would have allowed him to miss the due date.

As a result of making arguments on which he achieved little traction, the court grants the motion to dismiss filed by the IRS with relatively little discussion.  He does not appear to have made the argument that the time frame for filing a refund suit is not a jurisdictional time frame.  The facts available in the published opinion do not suggest that he would succeed in an equitable tolling argument.

The second case pits the taxpayer/debtor against the chapter 13 trustee rather than the IRS.  Here, the trustee argues that the taxpayer should have filed his return prior to the first meeting of creditors in his chapter 13 bankruptcy case.  The opinion parses the interpretation of a statute designed to require taxpayers to file their tax returns in order to obtain chapter 13 relief. 

Before the passage of the relevant statute in 2005, at almost every chapter 13 confirmation hearing day across the country, the IRS routinely sent attorneys who objected to the confirmation of a debtor’s plan because the debtor had unfiled returns which prevented the IRS from knowing whether, and how much, to claim against the estate.  Bankruptcy judges got tired of postponing hearings so that delinquent debtors could file these returns.  I made the objections in the 1980s and 1990s in the bankruptcy court in Richmond.  When we first started making them, the bankruptcy judge would give a stern lecture to the debtor about their criminal behavior in not filing returns.  It didn’t take too long before the judge realized that far more people failed to file their returns than he thought possible.  So, he stopped making the lectures but he still denied confirmation.  Stopping confirmation wastes the time of the court which must reschedule the hearing, prevents creditors from getting paid, costs the debtor’s attorney money to fix the plan and reappear and costs the trustee time and effort.  In 1994 when Congress appointed a bankruptcy commission to assist it in revising the bankruptcy laws to fix problems stemming from the Bankruptcy Code’s passage in 1978, the commissioners quickly identified this as a problem that needed to be fixed.  It took about eight years after the commission presented its findings before Congress got around to passing the correctively legislation but now anyone going into bankruptcy must be up to date on their return filing (the same basic rule that applies to anyone seeking an installment agreement or offer in compromise from the IRS). 

The Long case looks at the meaning of the statute requiring chapter 13 debtors to be current in their tax filing.  The bankruptcy case here was filed on January 8, 2019, during the filing season.  Usually the first meeting of creditors is scheduled within 20 to 40 days of the bankruptcy petition.  So, the debtor had more time to file their return according to the Internal Revenue Code than the date scheduled for the first meeting of creditors.  The issue before the court was whether the bankruptcy code accelerates the return filing date in this situation.  Here’s how the bankruptcy court framed the question at the outset of its opinion:

“Shortly after a debtor commences such a case, the United States trustee (or a designee) must “convene and preside at a meeting of creditors.” Id. §341(a); Fed. R. Bankr. P. 2003(a). By no later than “the day before the date on which the meeting of the creditors is first scheduled to be held”, the debtor must file with appropriate tax authorities the prepetition tax returns specified in 11 U.S.C. §1308(a), unless the chapter 13 trustee gives the debtor more time, see §1308(b). If the debtor does not file “all applicable Federal, State, and local tax returns as required by section 1308”, the court cannot confirm the debtor’s plan. Id.§1325(a)(9). The issue presented here is whether the prepetition tax returns specified in §1308(a) include returns that are not due to be filed with the appropriate tax authority before the date on which the meeting of creditors is first scheduled to be held.”

The bankruptcy court in Wisconsin was not working with a clean slate.  This issue, at least in that jurisdiction had been bubbling for quite a long time.  The court described the situation:

“This provision [Section 1308] may simply require the debtor to file, before the date on which the meeting of creditors is first scheduled to be held, all tax returns for the specified prepetition taxable periods that the debtor was otherwise required to file — i.e., that were due to be filed — before that date. But In re French, 354 B.R. 258 (Bankr. E.D. Wis. 2006), offers a competing construction: that §1308(a) requires “debtors who file for Chapter 13 protection . . . to have their return for the prior year filed by the date first scheduled for the meeting of creditors, even if the return is not yet delinquent under [applicable nonbankruptcy law].” Id. at 263.”

The opinion is lengthy and goes into some depth in seeking to find the meaning of Section 1308 and how it interacts with other provisions of the bankruptcy and tax codes.  The court expresses concern that following French really puts debtors filing early in the calendar year into a near impossible bind and allows the trustee to stop their bankruptcy cases by the simple act of refusing to extend the time of the first meeting of creditors.  After balancing the competing provisions, the court decides that the French case reaches the wrong conclusion and allows the debtor here to confirm a plan without filing the return not yet due under the tax code. 

I agree with this result as a logical reading of the code and the intent of the statute.  The statute seeks to require debtors to file past due returns.  The IRS or the debtor have a mechanism to add the debt for the 2018 year into the plan if they choose to do so.  Adding in the debt for the prepetition year after plan confirmation is a bit messy and expensive but denying confirmation to someone for not filing a return by the end of January also presents problems.  On balance the court reaches the logical result, but debtors who know they will owe taxes for the immediately past year do themselves no favors by failing to address the year in their plan.  Perhaps chapter 13 debtors should consider, as one of the factors in deciding the timing of filing a bankruptcy petition, postponing if possible to avoid filing at the very beginning of a calendar year.  If they can wait a few weeks or months before filing, they can avoid this problem.  Such a delay, however, is not always possible and taxes should not drive this timing.

Count Days BEFORE Filing for Bankruptcy

The case of Anthony Hugger v. Lawrence J. Warfield et al.; No. AZ-18-1003 (April 5, 2019) shows the danger of not carefully counting days before filing for bankruptcy if you seek to discharge taxes. Mr. Hugger filed a chapter 7 bankruptcy case and received his discharge in May of 2017 before coming to the realization that he had filed too early to obtain a discharge of his tax debts. After the epiphany in September of 2017, he requested that the bankruptcy court vacate his discharge and dismiss the chapter 7 case. Essentially, he requested a do over because it was understood that if the court granted his request he would file another chapter 7 case, but this one after the time passed to allow the tax debts to age into discharge status. The decision linked above is the 9th Circuit Bankruptcy Appellate Panel (BAP) affirming the decision of the bankruptcy court denying the request for vacature and dismissal.

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The bankruptcy court denied Mr. Hugger’s request because:

(1) Debtor lacked standing under § 727(d) and (e) to revoke his discharge, and the bankruptcy court could not use its § 105 equitable powers to circumvent the Bankruptcy Code (citing Law v. Siegel, 571 U.S. 415 (2014)); (2) Debtor had not established any grounds for relief under Civil Rule 60 because all of the relevant information was known before the bankruptcy case was filed, and Debtor had proffered no excuse why his or his counsel’s error had not been addressed earlier; (3) the cases cited to the court were distinguishable; and (4) the tax creditors would be harmed if the court were to grant the requested relief.

After the denial, he filed a request for a new trial and alleged that extraordinary circumstances existed. Specifically, he argued that:

(1) Debtor’s counsel had given him inaccurate or incomplete advice regarding the deadlines for filing; (2) no creditors had participated in the case before the motion to vacate discharge was filed; and (3) there would be no prejudice to creditors because the IRS and ADOR could continue to collect, while Debtor would be prejudiced by having to wait to file a new bankruptcy case.

It’s easy to believe that Mr. Hugger’s bankruptcy attorney may have failed to appreciate the need to count and therefore failed to alert him to the bad timing of the filing of the petition. It’s also possible that other issues caused him to file bankruptcy and that taxes did not drive the filing of his petition. The fact that no creditors participated probably results from the fact that he filed a no asset chapter 7 and creditors would have received notice not to bother filing a claim. Just because the creditors did not file a claim does not mean that the bankruptcy did not have an impact on their actions.

The BAP determined that it should review some of the bankruptcy court’s actions for abuse of discretion and other aspects of the case it would review de novo. With respect to abuse of discretion, the BAP determined that the decision of the bankruptcy court properly found that all of the facts were known by the debtor and his attorney at the time of the filing of the bankruptcy petition. This was not a case of fraud on the debtor or later discovered facts. The facts were there. Just because debtor and his attorney did not appreciate the importance of the facts does not form a basis for equitable relief.

The debtor argued that granting his request would not harm the creditors of the estate but the court did not agree:

… a chapter 7 debtor seeking to dismiss his case has the burden to show that doing so would not result in “legal prejudice” to creditors. Hickman v. Hana (In re Hickman), 384 B.R. 832, 841 (9th Cir. BAP 2008); Leach v. United States (In re Leach), 130 B.R. 855, 857 (9th Cir. BAP 1991) (citing Schroeder v. Int’l Airport Inn P’ship (In re Int’l Airport Inn P’ship), 517 F.2d 510, 512 (9th Cir. 1975)). Debtor contends that there would be no prejudice to the taxing authorities in permitting the relief requested because those creditors would be able to collect until such time as Debtor files a new chapter 7 case after enough time has elapsed for him to discharge the older taxes.5 Debtor’s argument ignores the fact that, as things stand, the taxing authorities would have much more time to collect than they would have had the bankruptcy court granted the requested relief. Debtor has not shown that the bankruptcy court abused its discretion in denying the motion.

The BAP found that the debtor had no arguments that established the bankruptcy court abused its discretion in denying him the relief he requested. He offered no good equitable reasons for revoking the discharge and dismissing the original case. Although the court did not fashion its discussion in this manner, the situation in this case reminds me of certain tax cases in which the debtors seek relief from penalties. If the court grants the relief, it essentially lets the attorney off the hook for malpractice. The same circumstances appear present here. If the court allowed Mr. Hugger a do-over, and if his attorney did drop the ball on noticing the dates the taxes would become dischargeable, the bankruptcy court would essentially be allowing Mr. Hugger’s attorney to avoid the malpractice claim that otherwise seems almost certain to follow from these facts. The fact that granting the relief would relieve the bankruptcy attorney from liability is not a reason to deny Mr. Hugger relief but neither is the bad advice a reason to grant the relief under these circumstances.

The case points to the critical importance of understanding tax transcripts and properly counting days in order to maximize the benefits of a bankruptcy filing. Since Mr. Hugger must now wait for years before he can file another chapter 7, the missed date means that it’s open season for the IRS and the state and local taxing authorities on his income and assets. Nothing prevents him from making an offer in compromise or otherwise trying to deal with his liability and the ability of the IRS to collect from him does not mean that it will succeed. Still, he lost the chance to rid himself of the tax liability and the loss has significance.