IRS Can File a Proof of Claim in Bankruptcy Court for the Full Amount of Tax Liability Even After an Accepted Offer in Compromise

Guest blogger Ted Afield today discusses the intersection of offers in compromise with bankruptcy. Professor Afield (with co-author Nancy Ryan) will be creating a chapter on Offers in Compromise for the next edition of Effectively Representing Your Client Before the IRS. Christine

In our clinic at GSU, we do a lot of collections work and routinely submit offers in compromise, which the IRS often accepts, on behalf of our clients. While our hope is always that the accepted offer will be a critical step that allows the taxpayer to get back in compliance with his or her tax obligations and get out from under the weight of a detrimental financial liability, unfortunately the accepted offer is sometimes not enough to prevent a taxpayer from continuing to be overwhelmed by other financial obligations. In situations like these, the taxpayer may in fact file bankruptcy during the 5-year compliance window for the offer in compromise. If this happens, the IRS potentially has a claim in the bankruptcy proceeding because the offer in compromise may have already been defaulted or may be defaulted in the future if the taxpayer fails to file tax returns and timely pay taxes. Accordingly, the IRS will file a proof of claim in the bankruptcy proceeding, which raises the question of should this proof of claim be for the full amount of the tax liability or for the compromised amount of the tax liability.

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This was the question recently taken up in a memorandum opinion by the Bankruptcy Court for the Southern District of Texas, Houston Division, in In Re: Curtis Cole, No: 18-35182 (May 29, 2019). In this case, Mr. Cole and the IRS had entered into a compromise of tax liabilities for 2003-2014 totaling over $100,000 for the much more manageable sum of $1,000. During the five-year monitoring period, Mr. Cole started off well and timely filed and paid his 2016 income tax. For 2017, however, Mr. Cole recognized that he would not be able to timely file a return, and he accordingly requested and was granted an extension. Mr. Cole did then file his 2017 return and pay his 2017 tax bill on October 15, 2018.

PT readers who do a lot of OIC work will immediately recognize the potential problem that Mr. Cole created for his offer because an extension of time to file is not an extension of the time to pay taxes, raising the possibility that the IRS would default Mr. Cole’s offer for failing to pay his 2017 taxes in a timely manner. Compounding the problem was that Mr. Cole had filed for Chapter 13 bankruptcy one month earlier, on September 15, 2018. As a result, the IRS filed a proof of claim in the bankruptcy proceeding for the full amount of the original tax liability that was compromised under exactly that theory (i.e., that Mr. Cole’s late payment of 2017 taxes caused his offer to default and thus caused the amount of the IRS’s claim to be the full amount of the tax liability).

Mr. Cole was not happy with this development and attempted to raise a couple of equitable arguments that did not have much of a leg to stand on. Mr. Cole’s first hope was that he would be simply forgiven his confusion over whether a filing extension also constituted a payment extension. This did not have much resonance in light of the fact that it is well established that filing extensions are not in fact payment extensions. Mr. Cole also attempted to argue that he effectively had rights under the Internal Revenue Manual by asserting that the IRS violated its own procedures when it did not offer him any opportunity to cure his late payment before declaring the offer to be in default. See I.R.M. 5.19.7.2.20, which states that in the event of a breach of the offer’s terms, the IRS should send the taxpayer a notice letter and provide an opportunity to cure before defaulting the offer. Again, this argument could not carry much weight in light of the well-established principle that the IRM does not give taxpayers any rights, and thus the IRS was not obligated to provide an opportunity to cure the default. Ghandour v. United States, 37 Fed. Cl. 121, 126 n.14 (1997).

Mr. Cole’s strongest argument was based on his reliance on a bankruptcy court opinion from the Eastern District of North Carolina that had ruled on a similar issue and had concluded that the proof of claim should be for the compromised amount rather than the full amount of the tax liability. In re Mead, No. 12-01222-8-JRL, 2013 WL 64758 (Bankr. E.D.N.C. Jan. 4, 2013). The Mead court found that the contractual language in Form 656 stating that the IRS may file a “tax claim” for the full amount of the tax liability if a taxpayer files for bankruptcy before the offer’s terms expire is ambiguous in regards to whether the “tax claim” refers to the full liability or the compromise amount. Accordingly, the Mead court held that the IRS violated the nondiscrimination rule of 11 U.S.C. § 525(a), on the grounds that it appeared that the IRS was trying to collect the full amount of the tax liability, rather than the compromised amount, solely because the taxpayer was in bankruptcy.

The Cole court, however, was not persuaded by its sister court in North Carolina and held that Mead was both distinguishable and simply incorrect.  Mead was distinguishable because, unlike in Cole, there was not an issue of whether the offer had been defaulted. However, even without that distinguishing characteristic, the Cole court noted that the outcome would be the same. In other words, regardless of whether the offer was in default, if the terms of the offer had not yet expired, the IRS would still need to file a proof of claim for the full amount of the tax liability in order to preserve its rights in case the taxpayer did subsequently default the offer. This is why the terms of the offer explicitly state in Section 7: “If I file for bankruptcy before the terms and conditions of the offer are met, I agree that the IRS may file a claim for the full amount of the tax liability, accrued penalties and interest, and that any claim the IRS files in the bankruptcy proceeding will be a tax claim.” I do not agree with the Mead court’s assertion that this language is ambiguous.

It’s not that the issue of whether the offer has been defaulted is irrelevant. Rather, that issue is simply premature at the moment when the IRS files its proof of claim. Even if the offer has unequivocally not yet been defaulted, the IRS must file a proof of claim for the full amount of the liability to protect its right to recover the full amount, should a default occur. So when can Mr. Cole attempt to make his likely to be very uphill arguments that he has not defaulted the offer? As the court notes, he does this when he submits his Chapter 13 plan, in which he will propose how to treat the IRS’s claim. If he believes he has not defaulted his offer, he can propose that the IRS only receive what it is owed if the offer is still in force. The IRS can then object if it believes that the offer is in default, and the issue can then be decided.

In comparing Cole and Mead, I think the Cole court likely has the better argument. The contractual language in Form 656 pretty unambiguously gives the IRS the right to file a claim for the full amount of the tax liability in a bankruptcy proceeding during the five-year monitoring period. That does not mean that the IRS will recover the full amount if the offer is not in default, but taxpayers should certainly expect such a claim to be filed and that they will have to litigate whether the offer is defaulted when they propose their bankruptcy plan.

Breland, Jr. v. Commissioner: Another Bankruptcy-Tax Trap for the Unwary Practitioner

Today we welcome first-time guest blogger Brad D. Jones. With editorial assistance from returning guest Ken Weil, in this post Brad evaluates the implications for bankruptcy debtors and practitioners of the Tax Court’s recent Breland decision. For a bankruptcy primer written for tax practitioners, see the bankruptcy chapter of Effectively Representing Your Client Before the IRS. Ken and Brad will be updating this chapter for the 8th edition of the book, expected to be published in December 2020. Several of Keith’s past PT posts also address the intersection of tax procedure and bankruptcy. Christine

If a tax is non-dischargeable, an understated IRS claim for that tax can have a devastating impact on an individual debtor’s financial well-being post-bankruptcy. This is because 11 U.S.C. § 523(a)(1)(A) of the Bankruptcy Code provides that non-dischargeable IRS claims can be collected by the IRS post-petition “whether or not a claim for such tax was filed or allowed.” If the IRS’s claim is understated, a person’s unpaid tax liabilities will generally be collectible by the IRS even if all of the individual’s available assets were used in the bankruptcy to pay other, lower-priority debts. As a result, an unfiled or undervalued IRS claim can lead the IRS to continue to pursue an individual for unpaid tax debt post-bankruptcy, even if the IRS did not pursue its claims in the bankruptcy case or allowed funds that should have gone to its claims to be paid to other creditors. The issue of how to fix a debtor’s tax liability and what needs to occur in the bankruptcy court to do so was at issue in Breland, Jr. v. Commissioner, 152 T.C. No. 9 (2019).

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Bankruptcy debtors generally have two main avenues to fix the amount of their tax liability for a given year: (1) file a motion for the bankruptcy court to determine the amount of their tax debt pursuant to 11 U.S.C. § 505; or (2) object to the IRS’s proof of claim. See Internal Revenue Service v. Taylor, (In re Taylor), 132 F.3d 256, 262 (5th Cir. 1998). In Breland,the Tax Court considered the effect of a resolved proof-of-claim objection on the ability of the IRS to pursue post-petition claims “regardless of whether a claim for the tax was filed or allowed,” as contemplated in § 523(a)(1)(A).

Breland involved a commercial-real-estate investor who allegedly owed a substantial sum to the IRS post-bankruptcy. The issue was whether the IRS could agree in the bankruptcy to a consent order setting the amount of its priority claim, allowing the debtor to pay a substantial sum to creditors subordinate to the IRS, and then later issue a notice of deficiency seeking up to $45 million more for the same tax years that it had compromised. The Tax Court held that it could, narrowly interpreting the bankruptcy court’s order as not addressing the total amount of the debtor’s federal tax liability. The Tax Court reached that result even though its interpretation conflicted with the interpretation of the bankruptcy court that entered the order. The Tax Court’s holding is surprising given that proof of claim objections are generally res judicata on the IRS and final orders resolving contested matters in bankruptcy are typically given broad preclusive effect. The Breland ruling forces bankruptcy practitioners to be particularly vigilant in addressing tax issues in the bankruptcy context.

Breland undercuts the ability of individual debtors to rely on proof of claim objections to fix the amount of their tax liabilities. In Breland, the debtor filed a Chapter 11 bankruptcy case and the IRS filed a proof of claim stating it was owed over $2 million in income tax for the years 2004 to 2008. The debtor filed an objection, stating in its entirety, that the “Debtor objects to the penalties assessed against him on the grounds that the Debtor had reasonable cause for not paying the taxes on time.” The parties entered into a consent order in which the IRS agreed to settle the debtor’s objection by agreeing to specific amounts for its priority tax debts with both sides agreeing that the disputed penalty portion was a general unsecured claim to be resolved after bankruptcy plan confirmation. After conducting discovery related to the disputed penalty portion, the IRS filed an amended proof of claim and asserted additional tax was due. The debtor objected on the grounds that the consent order fixed the debtor’s tax obligation. The bankruptcy court granted the objection and the IRS appealed. The district court remanded to the bankruptcy court for clarification as to the preclusive effect of the consent order. In response to the remand from the district court, the bankruptcy court ruled:

[T]he Court finds that the Consent Order . . . is the controlling document as to the extent of the Debtor’s tax obligation to the IRS. The Consent Order contains a clear statement of the total IRS claim amount and divides that amount into priority and general unsecured values. . . Moreover, by its terms, the Consent Order appears binding and complete. No specific limitation on the Consent Order’s effect is indicated in its terms. The IRS did not reserve the right to assert additional claims. Indeed, the Consent Order did not reserve any rights to the IRS, only to the Debtor. The purpose of the Consent Order is unclear if it was not meant to bind the IRS to its terms.

The IRS appealed, losing in the district court and stipulating to dismissal of its appeal to the 11th Circuit. In the midst of the proceedings in the bankruptcy and district courts, the IRS issued its notice of deficiency, triggering the filing of the debtor’s petition before the Tax Court.

Outside of bankruptcy, a consent order would normally be res judicata on the IRS’s attempt to collect additional amounts for the tax years set forth in the consent order. See United States v. Int’l Bldg. Co., 345 U.S. 502, 506 (1953) (consent order not binding on the United States for tax years subsequent to those years covered in the consent order). The consent order would also be binding if the tax in question were dischargeable. And Breland agreed that the consent order would be res judicata on the IRS if the “order had fixed petitioner’s total Federal tax liability for the subject tax years.”

Even though on remand the bankruptcy court had directly addressed the issue before the Tax Court and found its own order to be “the controlling document as to the extent of the Debtor’s tax obligation to the IRS,” the Tax Court interpreted the consent order narrowly. In the Tax Court’s view, the bankruptcy court’s order did not control for two reasons: First, the Tax Court believed res judicata did not apply because it believed that the consent order establishing the amount of the IRS’s claim and resolving an objection to plan confirmation is an inherently different proceeding than a proceeding to determine whether a particular liability is owed. The Tax Court noted that debtor’s proof of claim objection only challenged the penalties assessed, which the Court found undercut his argument that the consent order determined the total pre-petition tax liability. Second, in the Tax Court’s view, reading the consent order as a final determination of the debtor’s tax liabilities would have the effect of discharging otherwise non-dischargeable debts and contradict § 523(a)(1)(A). The Tax Court did not think res judicata applied because in its view the consent order was not “a final judgment on the merits of [the debtor’s] entire Federal tax debt for any given year.”

The Tax Court’s statement that a determination of an individual’s tax debt in bankruptcy is not the same cause of action as determining the tax debt generally is puzzling. The Court did not cite to any cases in its res judicata analysis that arose in the context of a settled or litigated proof of claim objection. The Tax Court’s view that the consent order was a different cause of action than a determination of tax liability is a more restrictive interpretation than is typically applied in a res judicata analysis. Generally, causes of action are the same for res judicata purposes if they arise “out of the same nucleus of operative fact.” In re Piper Aircraft Corp., 244 F.3d 1289 (11th Cir. 2001). In the context of a contested proof of claim, it is difficult to see how a dispute over the amount of the same tax, for the same years, and involving the same individual, can possibly not arise out of a common factual nucleus, which is precisely the reason that proof of claim objections generally are res judicata. See Hambrick v. Commissioner, 118 T.C. 348, 353 (2002) (recognizing that unlike proof of claim objections or a tax liability determination by the bankruptcy court, the mere confirmation of a Chapter 11 plan generally does not require a determination of the amount of a debtor’s non-dischargeable tax liability).

Similarly, the Tax Court’s consideration of the non-dischargeable nature of the debt also does not make much sense in the context of interpreting the scope of the bankruptcy court’s order regarding a proof of claim settlement. While unpaid non-dischargeable debts will generally survive whether the plan is confirmed or not, the purpose of a proof of claim objection is different. A claim objection is generally filed to determine the total amount owed, which does not turn on dischargeability (though a claim objection often establishes the facts from which dischargeability can easily be determined). In this case, the debtor conceded the non-dischargeability of the tax at issue. So in compromising the amount of the priority claim under the consent order, the IRS knew it was establishing the amount of the non-dischargeable portion of its claim. The bankruptcy court clearly understood this difference, which is why it interpreted its order as controlling for the amount of tax at issue.

Moreover, the Tax Court did not give any consideration to the way proofs of claims fit within the bankruptcy scheme as a whole. A basic underpinning of bankruptcy law is the absolute priority rule: the concept that higher priority claims (such as priority tax claims) must be paid in full before estate assets are used to pay lower priority claims. See Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 983 (2017) (recognizing that the “priority system has long been considered fundamental to the Bankruptcy Code’s operation”). Establishing the amount of priority tax claims and paying those claims before funds are lost paying lower priority debts is central to both the bankruptcy priority scheme and claims filing process – so much so that the Bankruptcy Code permits debtors to file a proof of claim on behalf of the IRS when doing so is necessary to determine the amount of the tax debt. 11 U.S.C. § 501(c); Taylor, 132 F.2d at 262 (suggesting the option of filing a claim for the IRS to fix the amount of the tax debt). The Tax Court’s decision to apply a restrictive reading of the consent order, at odds with the bankruptcy court’s own interpretation, frustrates these objectives of the Bankruptcy Code. It is also incompatible with the deference courts typically exercise in favor of orders entered by another court. See Colonial Auto Center v. Tomlin (In re Tomlin), 105 F.3d 933, 941 (4th Cir. 1997) (recognizing that the bankruptcy court is in the best position to interpret its own order and its interpretation warrants customary deference).

On May 7, 2019, the debtor filed a Motion to certify the Tax Court’s order to permit an immediate appeal and the Tax Court issued an order requiring the IRS to respond by June 10, 2019. Regardless of the outcome of any appeal, Breland is instructive for practitioners with bankruptcy clients facing tax debts. The Tax Court made much of the fact that neither the plan nor the consent order referenced the bankruptcy court’s authority under 11 U.S.C. § 505 to determine the amount of a debtor’s tax liability. It would be advisable for practitioners to seek to include language either in the Chapter 11, 12, or 13 plan or in orders resolving the IRS claims that specifically reference Bankruptcy Code § 505 and state that the plan or the order constitutes a determination of the amount of the total tax due for the years at issue. Similarly, the Tax Court in Breland also appeared troubled that the debtor’s proof of claim objection only stated that the objection was to the amount of the penalties. If a debtor is going to file an objection to the IRS’s proof of claim anyway, it may be helpful to include an objection to any amounts in excess of those asserted in the IRS proof of claim with a reference to 11 U.S.C. § 505.

Update: coincidentally, on the date this post was published the Tax Court issued a memorandum opinion holding that the Brelands had overstated their long-term capital loss by nearly a million dollars. Christine

Seeking Attorney’s Fees for Violation of Automatic Stay

What does a court do when the statute requires exhaustion of administrative remedies before a grant of attorney’s fees and the administrative agency (here the IRS) guides people to perform an impossible act in order to seek to exhaust administrative remedies?  That was the issue facing the bankruptcy court in Langston v. Internal Revenue Service, Case No. 17-10236-B-13 (Bankr. E.D. Cal. 2019).  In the end, the court denied the request for attorney’s fees because of precedent in the 9th Circuit but the courts are split on the issue and the IRS is about a decade behind in updating its guidance to the public on how to make an administrative request to fix a problem it creates by violating the automatic stay. Outdated language referencing the non-existent “Chief, Local Insolvency Unit” role remains in the current version of the CFR.

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Mr. Langston is a retired federal employee who also owed federal taxes.  I don’t think he is the only retired federal employee with this issue, but the government especially wants individuals to whom it is paying a pension to pay their taxes.  So, it has a program for taking from their pension payments to satisfy the outstanding tax debt.  The program is a perfectly legitimate method for the IRS to collect past due taxes except when used while the automatic stay comes into effect.  That’s what caused the problem here.

Mr. Langston and his wife filed a Chapter 13 bankruptcy case in January 2017.  The bankruptcy court notified the IRS within two weeks of the filing and the IRS filed a proof of claim one week thereafter.  So, it is indisputable that the IRS knew about the automatic stay.  Normal procedures would have had it input a code into its computer system almost immediately after learning of the case.  Here, it is not the IRS specifically that took the action violating the stay.  The agency taking from his pension and sending the money to the IRS was the Office of Personnel Management (OPM).  It could well be that the debt offset indicator arrived at the OPM before the bankruptcy case and there was a delay in that office in taking action.  It is also possible that there was a delay at the IRS getting information about the stay to OPM or a delay at OPM in putting the stay into its system.  The bankruptcy court does not go into the details of how the problem occurred and it really does not matter in the resolution of the case, but it should matter to the IRS and OPM so that a system exists to immediately notify OPM of the stay and for OPM to immediately put the stay into its system. 

For undescribed reasons, OPM sent to Mr. Langston a letter he received in early April saying that it would withhold a part of his pension to satisfy the outstanding federal tax debt. OPM withheld almost $400 a month for four months starting in April 2017.  The Langstons’ bankruptcy lawyer filed an adversary proceeding in May 2017 after informally trying to convince the IRS to stop taking the money.  Their representative did not seek to formally stop the taking of the pension funds prior to bringing the suit.  The IRS eventually gave back all of the money taken by OPM.  In responding to the complaint which undoubtedly included a request for monetary damages, the IRS would have pointed out that the Langstons did not first try to resolve the problem administratively.  Apparently, in doing so the IRS informed the Langstons that they were supposed to send a request to the “Chief, Local Insolvency Unit” of their district.

A few reorganizations ago, there existed in every IRS district (also a thing of the past) an insolvency unit that handled bankruptcy cases and a few other related proceedings.  Most of the IRS bankruptcy function was centralized some time ago, and local offices no longer had someone with the title “Chief, Local Insolvency Unit.”  Of course, if you weren’t following the staffing flows of the IRS, you would have no easy way of knowing this and that was the problem the Langstons faced in trying to make their administrative request for relief.  Here’s what the court said about it:

Then, Langstons’ counsel tried without success to find the right “Chief, Local Insolvency Unit” to receive an administrative claim. Many web searches and even formal discovery was met with no identified “Chief, Local Insolvency Unit.” Exasperated, Langstons’ counsel sent the administrative claim addressed to “Chief, Local Insolvency Unit” to every IRS office located within this district. The IRS admitted in discovery that to their knowledge no employee retains the title of “Chief Local Insolvency Unit” after the IRS reorganized in 2010. The IRS instead referred debtors’ counsel to a listing of “Collection Advisory Groups.” The IRS did respond after receiving debtor’s administrative claim noting they were referring it to the “Local Insolvency Unit.” But the IRS did not name a “Chief” of that unit. And so, it goes.

The Langstons could not show they had actual damages from the taking of $400 of his pension for four months.  Of course, they did incur attorney’s fees as their attorney tried to get the IRS to stop taking their money.  So, they sought attorney’s fees even though they were not entitled to damages.  The IRS fought the payment of attorney’s fees stating:

… [the] court does not yet have subject matter jurisdiction to decide the attorney’s fees issue because the debtors filed this adversary proceeding before filing an administrative claim with the IRS. They reason that their waiver of sovereign immunity under § 106(a)(1) for attorney’s fees claims stemming from automatic stay violations is conditioned upon a debtor’s compliance with 26 U.S.C. §§ 7430 and 7433 and the applicable regulations before filing suit. Counsel for the United States noted in oral argument that the Plaintiffs have now complied with the exhaustion requirement because they filed the administrative claim, albeit at the wrong time and that more than six months have passed with no action by the IRS. 26 C.F.R 301-7433-2(d)(ii).

The debtors must have wondered, “Wait a minute, how could we file an administrative claim prior to filing suit when your instructions told us to file the claim with someone who does not exist?”  Seems like a reasonable question to ask.

The IRS responded with two arguments.  First, it argued

“all that is required to satisfy the plain language of the regulation is that a writing be sent to ‘Chief, Local Insolvency Unit’,” the actual existence of an individual with that title being immaterial for compliance. 

[Keep that in mind because this is not the only place where the title in the regulations or other IRS guidance does not match the actual lineup at the IRS. Of course, the IRS did not say where the taxpayers should mail this letter and that could become an issue in a future case.]

Second, the IRS argued that the debtors’ reliance on Hunsaker v. United States, 902 F.3d 963, 968 (9th Cir. 2018) was misplaced.  Les blogged the district court opinion in Hunsaker here and the bankruptcy court opinion here.  We did not blog the 9th Circuit’s opinion in Hunsaker, in which it reversed the district court and determined that the bankruptcy code did waive sovereign immunity to obtain damages for emotional distress.  The IRS argued that the Langstons’ reliance on the 9th Circuit opinion was misplaced because Hunsaker did not address the situation where the only issue involved attorney’s fees.  It determined that there was a waiver for emotional damages, but here that issue does not exist.

The bankruptcy court looked at the litigation on this issue around the country and found that courts are split over the sovereign immunity argument.  Focusing on 9th Circuit jurisprudence, it found a 1992 opinion, Conforte v. United States, 979 F.2d 1375, 1377 (9th Cir. 1992) (almost all cases involving Conforte are worth reading if you enjoy cases with lurid details) holding that debtors must exhaust administrative remedies in order to receive attorney’s fees.  So, on the legal aspect of the IRS argument, the court finds that the IRS is correct in the precedent controlling it.

Then the court addressed the factual issue of whether the debtors did try to exhaust administrative remedies despite the barriers imposed by the IRS.  It stated:

In none of the cases previously discussed have the courts examined this issue raised by Plaintiffs — that complying with the statute is impossible. The courts either found that the taxpayer made no attempt (see Swensen v. United States (In re Swensen), 438 B.R. 195, 198 (Bankr. N.D. Iowa 2010); In re Rae v. United States, 436 B.R. 266, 275 (Bankr. D. Conn. 2010); Kight v. Dep’t of Treasury/IRS (In re Kight), 460 B.R. 555, 566 (Bankr. M.D. Fla. 2011)), or found that the taxpayer’s attempt was deficient for a number of reasons (see Klauer v. United States (In re Klauer), 23 Fla. L. Weekly Fed. D 153, at *11-14 (M.D. Fla. 2007); Don Johnson Motors, Inc. v. United States, 532 F. Supp. 2d 844, 883 (S.D. Tex. 2007); McIver v. United States, 650 F. Supp. 2d 587, 593 (N.D. Tex. 2009); Barcelos v. United States (In re Barcelos), 576 B.R. 854, 857-58 (Bankr. E.D. Cal. 2017); Galvez v. IRS, 448 F. App’x 880, 886 (11th Cir. 2011); Kuhl v. United States, 467 F.3d 145, 148 (2d Cir. 2006); In re Lowthorp, 332 B.R. 656, 659-61 (Bankr. M.D. Fla. 2005)), but no court addressed whether compliance was possible because the tax-payer was required to send the documents to a person that did not exist, nor was that argument ever raised.

Because the debtors’ original and amended complaint did not allege that they exhausted their administrative remedies, the court ultimately concludes that it cannot award attorney’s fees.  But it does not stop there.  Before dismissing the case without prejudice, it finds that

Plaintiff actually did send such a notice but after the lawsuit was filed. The IRS now admits Plaintiffs have complied and could proceed with another action for attorney’s fees.

I do not know if that means we should stay tuned for the second suit for attorney’s fees or that the Langstons can get fees if the IRS does not adequately resolve the matter.  In any event, it’s clear that the law here is not clear.  It’s also clear that the IRS paints itself into a corner when it asks people to do the impossible. 

Bankruptcy Decisions Impacting Taxes in 2018

We provided a year in review look at the Collection Due Process cases decided in 2018 on which we wrote. Here is a similar year in review for bankruptcy cases involving tax issues. We wrote 18 posts on bankruptcy issues involving a wide range of issues. For the most part 2018 was not a year of groundbreaking jurisprudence in the intersection of bankruptcy and taxes but cases continue to clarify certain areas not previously addressed or to supplement prior decisional law. Because it is possible to litigate the merits of a tax liability in bankruptcy as well as to eliminate the liability completely under the right circumstances, it is not possible to fully discuss tax procedure without examining the law and the case in the bankruptcy area.

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  • What is the effect of BC 523(a)(7) on the fraud penalty and how does bankruptcy impact the statute of limitations on collection?

In the case of United States v. Joel No. 3:13-cv-01102 (W.D. Ky. Oct. 18, 2018) the taxpayer committed fraud on the bankruptcy court. His bankruptcy case was reopened once the fraud was uncovered. At issue in this case is the impact of his bankruptcy case on the statute of limitations for collection.

https://procedurallytaxing.com/effect-of-a-revoked-discharge-on-the-suspension-of-the-collection-statute-of-limitations/

  • Interplay between the Federal Tax Lien and the Homestead exemption.

The bankruptcy trustee tries to use the federal tax lien to his advantage to bring property into the estate. The bankruptcy court holds that the trustee cannot step into the shoes of the IRS for the purpose of reaching property that he could not otherwise reach.

https://procedurallytaxing.com/the-federal-tax-lien-and-the-homestead-exemption/

  • Excluding pension plan from property of the estate.

Even though the Supreme Court ruled a couple of decades ago that pension plans are not included in property of the estate under BC 541, the issue of what is a pension plan remains and was addressed in this case. Here, the court holds that the taxpayers retirement plan did not qualify under ERISA and therefore the assets in the retirement account came into the bankruptcy estate for the creditors to use to satisfy their claims.

https://procedurallytaxing.com/bankruptcy-court-declines-to-exclude-retirement-plan-from-estate/

  • Tolling the Period for the IRS to obtain priority status for its claim

If the taxpayer files a prior bankruptcy case or submits an offer in compromise, the act can extend the period in which the IRS can file its claim as a priority claim. A pair of cases discuss how actions taken prior to bankruptcy can extend the statute. In the Clothier case the Assistant United States Attorney arguing the case initially, failed to fully apprise the bankruptcy court of the scope of the statute extension available which caused a motion for reconsideration and a revised opinion from the court once it understood the reach of the statute.

https://procedurallytaxing.com/suspending-the-priority-claim-period-and-an-update-on-clothier-v-irs/

https://procedurallytaxing.com/bankruptcy-court-limits-prior-supreme-court-decision-on-equitable-tolling/

  • Proper treatment of the EITC as source of funds for trustee vs taxpayer

Bankruptcy trustees regularly seek a chapter 13 debtors tax refund during the time the case is pending. The Seventh Circuit holds that the trustee does not have a right to a refund caused by the EITC if the taxpayer can show that the amount received by the taxpayer is needed for necessary expenses. Here there was evidence that the money the debtor received through the EITC tax refund allowed her to pay necessary expenses. Under these circumstances, the court did not order the debtor to pay over to the trustee the amount of the refund related to the EITC.

https://procedurallytaxing.com/proper-treatment-of-earned-income-tax-credit-in-calculating-disposable-income/

  • Who owns the refund in consolidated return cases

When some but not all members of a consolidated group go into bankruptcy the issue arises of who is entitled to refunds of the consolidated group and whether the refunds become property of the estate.

https://procedurallytaxing.com/who-owns-a-refund-consolidated-returns-and-bankruptcy-add-wrinkles-to-refund-dispute/

  • When can the bankruptcy court clawback money paid to the IRS by a fraudster

Cases regularly arise in which a party perpetrating a fraud pays taxes on the money gained by the fraud with the money fraudulent acquired. A circuit split exists on whether the bankruptcy court can clawback the money paid for the taxes in order to use it to repay the parties who lost it due to the fraudulent scheme.

https://procedurallytaxing.com/another-clawback-of-money-paid-to-the-irs/

  • The application of the voluntary payment rule in bankruptcy cases

The IRS allows taxpayers to designate the liability to which their payment will be posted if they make a voluntary payment. If the IRS levies to obtain money or otherwise obtains it involuntarily, it does not allow the taxpayer to designate how the payment will be applied. How does a bankruptcy payment fit into this scheme?

https://procedurallytaxing.com/bankruptcy-and-the-voluntary-payment-rule/

  • What happens when the IRS wrongly tells the taxpayer a debt was discharged by a bankruptcy case

Following bankruptcy many taxpayers have not spoken to their bankruptcy lawyer in a long time and rely upon the IRS determination regarding discharge. Sometimes the IRS person to whom they speak may give them wrong advice. What then?

https://procedurallytaxing.com/detrimental-reliance-on-the-irs/

  • Filing the notice of federal tax lien during the automatic stay

The stay prohibits collection action including filing the NFTL. In this case the IRS asked the bankruptcy court to lift the stay to allow it to file the NFTL and the bankruptcy court agreed to do so.

https://procedurallytaxing.com/filing-the-notice-of-federal-tax-lien-during-the-automatic-stay/

  • Must the IRS affirmatively obtain permission of the bankruptcy court before pursing post discharge collection from a taxpayer.

The IRS makes a discharge determination in each bankruptcy case in which it is listed as a creditor. When it makes the decision that a debt is excepted from discharge, it sends the case back into the collection stream. It does not seek a ruling from the bankruptcy court before doing so. One bankruptcy court challenged this practice. If the IRS must seek a ruling from the bankruptcy court in every case in which it makes a discharge determination and determines that the bankruptcy case did not discharge the taxes, the bankruptcy courts will see a definite rise in the cases on their dockets since it is common for some taxes to pass through bankruptcy without being discharged.

https://procedurallytaxing.com/does-irs-bear-the-responsibility-to-affirmatively-obtain-a-ruling-from-the-bankruptcy-court-before-pursuing-collection-after-discharge/

  • Can a taxpayer obtain a discharge on a late filed tax return

There is a serious circuit split on the meaning on the language at the end of BC 523(a) regarding late filed tax returns. These cases continue to bubble up although the pace has slowed and the tide has turned against the per se one day late rule adopted by three circuits. 2018 did not produce any groundbreaking decisional law in this area but an opinion from the 9th Circuit continued to provide a basis for court opinions on the subject of late returns.

https://procedurallytaxing.com/mr-smith-continues-to-suffer-from-his-failure-to-file-and-other-updates-on-late-filed-returns/

  • Validity of IRS claims in bankruptcy

A pair of cases examines how and when to attack IRS claims in bankruptcy. One deals with who is authorized to file the claim while the other deals with the amount of the claim.

https://procedurallytaxing.com/irs-claims-in-bankruptcy/

  • Priority claim status of unpaid individual mandate tax (penalty)

Several liabilities imposed by the IRC carry the label tax but walk like a penalty and talk like a penalty. Bankruptcy courts have determined that several such liabilities cannot result in priority status claims. It recently applied the same logic to the liability imposed by the individual mandate of the ACA.

https://procedurallytaxing.com/priority-status-of-individual-mandate-tax-obligation/

  • Dischargeability of the first time homebuyer credit

In an issue similar to the priority provision for the individual mandate, a bankruptcy court addresses the dischargeability of the credit. The similarity between to two situations is the need for the bankruptcy court to examine what type of debt is really present and whether the debt created when someone does not fulfill their obligation under the homebuyer credit provisions is tax debt or some other type of debt.

https://procedurallytaxing.com/dischargeability-of-the-first-time-homebuyer-recapture-liability/

  • Cases raising the issue of excepting a liability from discharge due to the fraud exception

Taxpayers who fraudulently evade their liability cannot obtain a discharge. A pair of cases are discussed.

https://procedurallytaxing.com/bankruptcy-cases-involving-evasion-of-payment-and-classification-of-the-failure-to-file-penalty/

  • Who can avoid the federal tax lien in a bankruptcy case

A debtor tries to avoid the federal tax lien and fails in a situation in which the trustee would have succeeded.

https://procedurallytaxing.com/avoiding-the-federal-tax-lien-securing-penalties-in-a-bankruptcy-case/

 

Ninth Circuit Affirms Earlier Decisions Denying Debtor Right to Alter IRS Lien after Bankruptcy

On November 7, 2017, I posted on the case of In re Nomillini in which the debtor sought to limit the secured claim of the IRS based on the confirmation of his chapter 13 plan. The Ninth Circuit, in an unpublished opinion dated December 18, 2018, denied the debtor’s motion to cut off the rights of the IRS lien in debtor’s property. Here, the debtor’s plan did not seek to limit the rights of the IRS as a secured creditor. The court relied on the normal rule that a lien against a debtor passes through the bankruptcy unaltered absent a specific attack on the lien as a part of the bankruptcy proceeding.

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The Ninth Circuit stated the general rule as follows:

For a debtor to avoid a creditor’s lien or otherwise modify the creditor’s in rem rights, the debtor’s confirmed plan must do so explicitly and provide the creditor with adequate notice that its interests may be impacted. Id. at 873. Any ambiguity in the plan will be interpreted against the debtor. Id. at 867.

Mr. Nomillini did not mention the IRS lien in his chapter 13 plan. He gave no notice to the IRS during his bankruptcy proceeding that he sought to reduce or eliminate its lien on his property. He sold his home. He entered into an agreement with the IRS that its lien would attach to the proceeds. The sale of the home brought a greater price than anticipated by the IRS when it filed its original lien. Based on the sale price, the IRS amended its claim to increase the amount of its lien claim to match the proceeds. Mr. Nomillini sought to limit the IRS lien claim to the amount of the original claim. He then brought an action seeking to avoid the IRS lien to the extent that it exceeded the original claim. The lower courts dismissed the case and the 9th Circuit affirmed.

Lien claims not only pass through bankruptcy unimpacted (absent a specific challenge) but the amount of a lien claim can change during or after a bankruptcy as the value of the property increases or decreases. When the IRS filed its original claim in this case, it had to value its lien claim and claim any portion not covered by equity in Mr. Nomillini’s property as an unsecured claim. Here, the value of the secured property turned out to be low either because the IRS made a wrong determination at the outset or because the property continued to increase in value. In either event the debtor does not receive a windfall because of the low value in the initial claim.

Once the property was sold, the value of the property was set and the IRS amended its claim up to the amount of the sales proceeds. The Ninth Circuit joins the lower courts in determining that the IRS has the right to do this. Had the property sold for less than the amount of the lien claim that the IRS made, the value of the lien claim would have decreased rather than increased. For this reason creditors often seek to protect themselves from a downward movement of value in secured property by seeking adequate protection. The IRS does not do this often because of the time involved to seek adequate protection and, in cases in which its lien is secured by real property, because of the difficulty in proving that the property will decrease in value.

The case resolves the issue in a manner consistent with existing law. The lesson here is that the value of a lien claim is not fixed at the time of filing bankruptcy.

Effect of a Revoked Discharge on the Suspension of the Collection Statute of Limitations

On June 22, 2016, I wrote a post about the case of Bush v. United States in which the Tax Division of the Department of Justice argued that B.C. 523(a)(7) did not limit the exception to discharge with respect to the fraud penalty to a fraud penalty arising within three years of the date of the bankruptcy petition. In the Bush case the court ruled against the government and followed the precedent of three circuit court decisions from the early 1990s. After those three decisions the IRS had decided to abandon the argument that B.C. 523(a)(7) limited the exception to discharge to fraud penalty assessments arising within three years of the petition. I speculated in that post that maybe the government had changed its position though it was possible that the case merely reflected the arguments of an Assistant United States Attorney, similar to the situation in a recent post, who made a logical argument unaware of the history of the issue and the position of the government.

In the recently decided case of United States v. Joel No. 3:13-cv-01102 (W.D. Ky. Oct. 18, 2018) the taxpayer made the argument that the government lost in Bush and in the earlier cases. The government goes back to arguing that the circuit court cases were correctly decided, which suggests either that the Bush case was argued by a “rogue” government attorney or that the government has returned to the position it adopted following the three circuit losses in the early 1990s. The court ruled against the taxpayer and spent a little time parsing the confusing language of the statute. The Joel case concerns a post-bankruptcy effort by the IRS to reduce its assessment to judgment and to foreclose its lien on property held by an alleged nominee/alter ego. Most of the opinion focuses on the discharge of the underlying taxes and the effect of the prior bankruptcy case on the statute of limitations on collection.

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Depending on the impact of the prior bankruptcy, the statute could have expired prior to the filing of suit by the government. The court goes through a lengthy analysis in determining that the prior bankruptcy suspended the statute of limitations for a sufficient period of time to make the filing of the suit timely. Anyone interested in the interplay of the filing of a bankruptcy petition on the statute suspension for collection may find the case instructive. What makes this case somewhat unique and causes the taxpayer to argue about the fraud penalty is that the bankruptcy court granted Mr. Joel a discharge in his bankruptcy case and later revoked the discharge when his fraud came to light.

The fraud penalty was a minor point in the case, though because of the dollar amounts at issue the taxpayer may not have thought of it as minor. The tax years at issue are 1991, 1992 and 1993. Mr. Joel filed his first bankruptcy on November 8, 2001. He filed a chapter 7 petition and the court granted a discharge on February 7, 2002. The timing of the discharge reflects a normal time period of about three months for a debtor to obtain a discharge in a chapter 7 case with no objections. At the time of the discharge, the IRS would have written off the fraud penalty assessments as discharged pursuant to B.C. 523(a)(7) and made no further effort to collect those assessments because the discharge injunction of B.C. 524 bars creditors from collection against discharged debts.

After the grant of the discharge, the trustee became aware that Mr. Joel might not be a routine bankruptcy case. On January 29, 2003, the trustee brought an adversary proceeding in Mr. Joel’s bankruptcy case seeking to revoke the discharge because the debtor failed to list assets in the bankruptcy schedules and failed to surrender estate assets to the trustee. Additionally, on January 4, 2005, the IRS indicted Mr. Joel for IRC 7201 evasion of payment of his 1991-1993 taxes. In 2007, Mr. Joel pled guilty to evasion of payment and subsequent to that plea, the bankruptcy court ruled that he committed perjury in the filing of the bankruptcy schedules and revoked his discharge. This is where the position of the parties with respect to the discharge arguments gets somewhat reversed.

The IRS argues that the statute of limitations on collection should be suspended from the time of the bankruptcy filing until the time of the discharge revocation. Prior to the discharge, the IRS was prohibited from collecting the fraud assessment because of the automatic stay of B.C. 362(a). After the discharge, the IRS was prohibited from collecting because B.C. 523(a)(7) caused it to abate the assessment. It wasn’t until after the bankruptcy court revoked the discharge on June 20, 2007, that the IRS could reverse the abatement of any discharged taxes and penalties and begin to try to collect the liabilities again.

The debtor, in a quasi role reversal, argues that the fraud penalties were not discharged because of the language of 523(a)(7). Because the statute did not require the discharge of the taxes, the IRS had the ability to collect the taxes after the initial discharge lifted the automatic stay. So, the statute of limitations suspension lifted at the time of the initial discharge in 2002 and not the revocation in 2007. Because it lifted five years earlier, it had run by the time the IRS brought the suit.

The court looked carefully at the language of 523(a)(7) which provides:

A discharge under 727… of this title does not discharge an individual debtor from any debt-

(7) to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty –

(A) relating to a tax of a kind not specified in paragraph (1) of this subsection; or

(B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition….

The debtor first argued that (A) and (B) were conjunctive conditions and not disjunctive, such that a penalty must meet both conditions. The fraud penalty cannot meet the first condition because it relates to taxes on which the taxpayer has committed fraud, which are excepted from discharge under B.C. 523(a)(1)(C). It would make logical sense that the fraud penalty should be excepted from discharge. In many instances the IRS does not impose the fraud penalty until long after three years from the due date of the return because the IRS must amass evidence prior to imposing this penalty. The fraud penalty also represents the type of penalty that policy would dictate that the debtor should continue to owe. The legislative history of the statute implies that Congress intended the fraud penalty to continue.

The debtor’s problem here is the same one faced by the government when it litigated the meaning of this provision almost three decades ago. Subsections (A) and (B) are joined by the word “or.” The word “or” places (A) and (B) in a disjunctive and not conjunctive posture. Therefore, if either the condition of (A) or the condition of (B) applies, the provision discharges the fraud penalty. Subsection (B) refers to transactions occurring before three years before the petition date. The fraud penalty relates back to the due date of the return. Those due dates here occurred in the early 1990s, long before the filing of the bankruptcy petition.

Since the condition of (B) is met, the fraud penalty is discharged. The IRS correctly abated the fraud penalty when the bankruptcy court entered the discharge and the IRS receives the benefit of the period between the initial discharge and the revocation in calculating the statute suspension.

While this is not a huge issue, Congress should consider fixing B.C. 523(a)(7) to except from discharge the fraud penalty. Allowing the discharge of this penalty is not good policy. In most instances, I suspect the IRS will struggle to collect the fraud penalty because the individual who committed the fraud will have run through most or all of their assets before the IRS collection personnel arrive on the scene; however, cases exist in which the individual who committed fraud still has assets and the bankruptcy discharge should not protect those assets from collection.

 

The Federal Tax Lien and the Homestead Exemption

The case of In re Selander, No. 16-43505 (Bankr. W.D. Wash. Oct. 19, 2018) pits the bankruptcy trustee against the IRS. The trustee attempts to use a provision in Chapter 7 to take from property secured by the federal tax lien in order to pay his fees and other administrative costs. The IRS argues that when its lien attaches to property claimed by the debtor as a homestead, the provision allowing the trustee to use an asset secured by the federal tax lien does not apply. The case allows for an explanation of B.C. 724(b), in which Congress allows the use of money that would otherwise come to the government because of its secured position to pay unsecured priority creditors, and the interplay between the federal tax lien and the homestead exemption. The bankruptcy court here gets the law right and does a good job of explaining it.

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Mr. Selander filed a Chapter 7 petition on August 22, 2016. The Umpqua Bank filed a claim for over $5 million and the IRS filed one for over $700,000. The bank had liens against the debtor that predated the IRS’s federal tax lien. The debtor owned a ½ interest as a tenant in common of a home in the Seattle area. Other assets may have existed, but the house occupied the attention of the court.

The trustee of the bankruptcy estate found a buyer for the house for a gross sales price of $825,000. After paying off the mortgage, closing costs and the other owner, about $200,000 came to the bankruptcy estate. Washington is one of the states that allows debtors to choose between the federal bankruptcy exemptions in B.C. 522, or its own state-level exemptions, including a pretty generous homestead exemption of $125,000. The debtor elected to receive that amount as his homestead exemption.

The homestead exemption seeks to allow debtors something to get going after bankruptcy as part of their fresh start. While some states provide generous homestead exemptions and other states provide very little, the exemption in all states comes to the debtor subject to the federal tax lien. So, debtors owing federal taxes do not get the benefit of the homestead exemption that the state might intend since the state homestead law lacks the ability to pass property to the debtor in a way that overrides federal law. The operation of the federal tax lien vis-à-vis the homestead exemption has frustrated many debtors and provides one of many reasons to pay down federal tax debt prior to bankruptcy rather than to pay ordinary creditors.

The trustee ordinarily cannot use the homestead amount to pay his fees or to pay the claims of creditors of the estate. B.C. 522 carves the homestead amount out of the estate and gives it to the debtor as property exempt from the estate.

B.C. 724(b) allows the trustee to take an amount that would ordinarily go to the IRS because of the federal tax lien and use that amount to pay unsecured creditors of the bankruptcy estate entitled to priority status. The trustee is one of the creditors entitled to priority status. In the B.C. 724 analysis of Mr. Selander’s bankruptcy estate, nothing would go to the IRS because of the higher priority lien of Umpqua. That higher priority lien and the value of the assets in the estate prevents the IRS from having a secured claim against the estate. Without a secured claim held by the IRS, the trustee could not use B.C. 724(b) to carve out money to pay priority claimants.

Even though the IRS could not take from the estate, it stood to receive the homestead amount. The trustee argued that the payment of the homestead amount should allow the B.C. 724(b) carve out to occur even though the basis for the payment occurred from money not a part of the bankruptcy estate.

The court rejects the trustee’s argument, citing to relevant case law and finding:

There is no conflict between § 724(b) and § 522(k) because those two sections speak to different kinds of property. Section 724(b) involves property of the estate where the IRS holds a valid lien. In this scenario, Congress has made the decision that the bankruptcy trustee may subordinate the secured tax claim to pay administrative expenses. What § 724(b) does not address is the property a debtor removes from the estate by exemption, but still subject to a continuing lien of the IRS. This property is not covered by the plain language of § 724(b), which provides that it only applies to property ‘in which the estate has an interest….’ Exemptions remove property, or a certain value of that property, from the estate. Alsberg v. Robertson (In re Alsberg), 68 F.3d 312, 315 (9th Cir. 1995). Debtor’s Homestead Exemption removed the value of $125,000 from the estate but such exemption was powerless to eliminate the interest of the IRS in those funds claimed with the exemption.

The court noted that in the absence of the federal tax lien, the trustee’s attempt here would be a naked effort to take exempt funds to pay his fees, and that B.C. 522(k) prohibits that action. The bankruptcy court found that by claiming the homestead exemption, the debtor removed the property from both the estate and the application of B.C. 724(b).   It further found that the IRS need not bring a separate action to seize the money in the debtor’s bank account, but that the trustee should remit the $125,000 to the IRS. This victory by the IRS may benefit the debtor if the taxes were excepted from discharge. If the taxes would have been discharged by the bankruptcy, the debtor loses as well as the trustee since the debtor’s homestead exemption turns out to provide him with no benefit. Prior to filing bankruptcy, debtors should check the impact of a federal tax lien if they hope that bankruptcy will allow them to take certain assets with them. Mr. Selander’s case leaves him with a bankruptcy discharge but no major asset to take with him as he leaves bankruptcy.

 

Bankruptcy Court Declines to Exclude Retirement Plan from Estate

Congratulations to Keith Fogg on his new grandchild, Samuel! And now, back to tax procedure. Christine  

The case of In re Xiao, No. 13-51186 (Bankr. D. Conn 2018) presents the unusual situation of a bankruptcy court analyzing whether the pension plan of debtor’s corporation met the qualifications required by the Internal Revenue Code for such a plan. Here, it was not the IRS attacking the validity of the pension plan, though it might have if it had noticed. Rather, the bankruptcy trustee brought the action seeking a determination that the plan did not qualify in order to bring the money in the pension plan into the bankruptcy estate. Because the plan held over $400,000 in assets, it provided a rich target for creditors of the estate. Of course, the trustee also has a financial incentive to bring assets into the estate since the more assets the estate contains the larger the fee received by the trustee. Regardless of the financial incentive, bringing the asset into the estate for use to pay the unsecured creditors also fulfills the trustee’s obligation to the estate.

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As a general rule B.C. 541(c)(2) excludes a debtor’s pension plan from the bankruptcy estate. The Supreme Court confirmed this reading of the statute a quarter of a century ago in Patterson v. Shumate, 504 U.S. 753 (1992). The exclusion from the bankruptcy estate does not cover everything labeled as a pension plan. Excluded plans must meet certain criteria. Even if not excluded by BC 541(c)(2), funds could be exempted from the estate under B.C. 522. Few cases exist in which trustees have successfully attacked a plan to bring its assets into the bankruptcy estate. The trustee’s success in this case demonstrates the possibilities of such an action and also the perils to someone who fails to follow all of the necessary formalities for maintaining a proper plan. Even if you believe that the IRS has so few people looking at these plans that the chances of an IRS audit remain slim, the Xiao case shows another way in which failure to properly maintain a pension plan can create problems.

The court here spends several pages recounting the inappropriate manner in which the pension plan of debtor’s corporation was established and administered. The details of the administration of this plan suggested many lapses in following the necessary formalities to properly maintain a plan. The trustee hired an expert to examine plan activity and to testify concerning plan failures. In effect, the expert hired by the trustee acted like a revenue agent performing an audit of the plan. He explained in great detail the plan’s failures. The trustee charges the estate for the cost of the expert and the cost of the litigation attacking the plan. In essence, the plan assets will pay for the cost of the attack. The debtor’s creditors do not mind because even though these costs reduce the funds available from the plan, the trustee still brings into the estate money not otherwise available. The loser here is the debtor who sees his entire pension plan used to fund the attack on the plan and to pay creditors who would not otherwise have had the opportunity to get paid from this asset.

Debtor also hired an expert who testified about the plan in order to prove it was appropriately administered. Debtor himself testified on this point as well. The court did not find the debtor credible and did not find his expert persuasive.

After a detailed examination of the plan, the court found that it did not operate in a manner that allowed the debtor to exclude or exempt this asset. The concluding paragraph of the opinion provides the best overview of the court’s reasoning:

…the Plan failures at issue in this case do not merely constitute technical defaults, but instead are operational failures that ‘are substantial violations of the core qualification requirements for a retirement’ plan as set forth in the IRC Section 401(a)(2). … it appears that LXEng [debtor’s corporation] operated the Plan in order to solely benefit Mr. Xiao and his then spouse, Ms. Chen. According to the Treasury Regulations, a plan cannot act as a subterfuge for the distribution of profits to the owners of the employer. 26 C.F.R 1.401-1(b)(3). It appears to have been so here.

The opinion does not explain how the trustee came to the conclusion that the debtor’s plan did not meet muster. Because I have seen few of these cases over the years, I do not think that many trustees key in on this issue and perhaps the taxpayer’s failure to follow plan formalities represents a rare aberration. I suspect that there may be a number of plans of small businesses with problems that could be attacked by a trustee if the business owner seeks bankruptcy relief and tries to shelter assets in a pension plan. The former employees of the business that this plan did not properly cover could have had claims against the bankruptcy estate. Such employees may have provided the trustee a roadmap to unlocking the assets in the plan. While I am just speculating that one of the employees the plan sought to stiff provided critical information about the inadequacies of the plan, this serves as yet another reminder why employers should keep employees happy and not overtly antagonize them.

The court stresses that it tests qualification of the plan as of the date of the filing of the bankruptcy petition. For any small business where the owner is headed for bankruptcy, the Xiao case should serve as a significant wake-up call regarding the proper administration of a pension plan. The debtor here loses an asset that the creditors could not have reached had the plan been properly administered. Conversely, the case also serves as a reminder to attorneys for creditors that they should pay attention to pension plans in the case of small businesses to look for improper administration of the plan as a way to pull the asset into the bankruptcy estate that might otherwise have few assets for the unsecured creditors. Hiring an expert to do the analysis of the plan and pursuing the litigation to get information about the plan serve as barriers where the plan assets are not significant and information about plan administration does not suggest problems worth pursuing.