Rare Discharge in Bankruptcy for Taxpayers with a Return Filed After an SFR Assessment

We welcome back guest blogger Ken Weil. Ken is one of the top national experts on the intersection of personal bankruptcy and taxation, and today we are fortunate to publish his analysis of an unusual loss for the government on the issue of dischargeability following a substitute for return assessment. Keith covered a previous case on the issue here. Christine

In Golden v. United States (In re Golden), Bankr. E.D. Cal. Adv. Proc. No. 21‑2012, Docket No. 60 (Golden), the taxpayer‑debtors Nicole Golden and Stephen Alter (the Taxpayers) argued successfully that their return was an honest and reasonable attempt to satisfy the requirements of the tax law.  The bankruptcy court discharged their tax obligation even though the Taxpayers had filed their return after the IRS initiated the substitute‑for‑return process, issued a notice of deficiency (NOD), and assessed tax based on the NOD.  This note calls that type of an assessment an “SFR assessment.”

As far as the author knows, Golden marked only the second time a court using a subjective‑test analysis discharged tax due on a return filed after an SFR assessment (and was not reversed on appeal).  Golden also extended the IRS’s streak of unsuccessfully arguing that the tax due on a document filed after an SFR assessment is per se nondischargeable.

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1. Applicable Law

In the First, Fifth, and Tenth Circuits, the rule is that tax due on a late‑filed return is always nondischargeable, even if the return were filed only one‑day late.  McCoy v. Miss. Tax Comm’n (In re McCoy), 666 F.3d 924 (5th Cir. 2012); Mallo v. IRS (In re Mallo), 774 F.3d 1313 (10th Cir. 2014); and Fahey v. Internal Revenue Service, 779 F.3d  1 (1st Cir. 2015).  The one‑day-late rule has been discussed extensively in Procedurally Taxing.  See K. Fogg, Debtors Still Trying to Fight Against One Day Rule (October 24, 2019), which cites prior discussions.  In shortened form, these three circuits reason that the language in 11 U.S.C. §_523(a)(*) requires that, for a document to be considered a valid return, it must satisfy all applicable nonbankruptcy law requirements, including applicable filing requirements and timely filing is an applicable filing requirement.  This note focuses on Golden and not the propriety of the one‑day‑late rule.

Outside of those three circuits, to determine whether a document filed late will be considered a valid return, the IRS and the other circuits follow the Beard test, which is a four‑part test.  Beard v. Comm’r, 82 T.C. 766, 775‑778 (1984), aff’d, 793 F.2d 139 (6th Cir. 1986).  The Ninth Circuit uses the Beard test.  Smith v. United States Internal Revenue Serv. (In re Smith), 828 F.3d 1094, 1096 (9th Cir. 2016), and United States v. Hatton (In re Hatton), 220 F.3d 1057, 1060-1061 (9th Cir. 2000).  As Golden arose within the Ninth Circuit, it will have no impact on those courts bound by the one‑day‑late rule.

Under the four‑part Beard test, for a late‑filed document to be considered a valid return

  • there must be sufficient data to calculate the tax liability;
  • the document must purport to be a return;
  • there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and
  • the taxpayer must execute the return under penalty of perjury.

The most contentious part of the Beard test is whether the taxpayer made an honest and reasonable attempt to satisfy the requirements of the tax law.  That was the key question in Golden.

The Eighth Circuit stands alone in using an objective test to determine whether the taxpayer made an honest and reasonable attempt to satisfy the tax law.  Colsen v. United States (In re Colsen), 446 F.3d 836 (8th Cir. 2006).  Under the objective test, the inquiry into the validity of the document at issue is limited to the four corners of the document.  The IRS accepts that an objective test is used in the Eighth Circuit.  IRM 5.9.17.8.1(3) (12-09-2016).  The other “non-one-day‑late circuits” use a subjective test, and the Golden court used a subjective test.  Golden p.19 (“this court looks to the totality of circumstances”).

2. Factual Background

The tax year at issue in Golden was 2008.  The Taxpayers extended the return’s due date to October 15, 2009.

With the onset of the Great Recession in 2008, the Taxpayers experienced financial difficulties, including loss of a rental property through foreclosure.  In 2010, Golden took over operation of the jointly owned business from Alter.  Golden took an additional, unspecified amount of time to take over the tax responsibilities. 

The financial difficulties led to marital difficulties.  In February 2010, Golden separated from Alter.  At that time, the Taxpayers’ children were aged four and six.

On March 8, 2011, the Taxpayers filed their 2009 tax return.  On March 10, 2011, the Taxpayers’ accountant completed the 2008 return and the Taxpayers signed the return.  This was approximately 15 months after the extended due date for the 2008 return.  Thereafter, the Taxpayers held off filing the 2008 return in hopes of putting together the money to pay off the taxes and to understand the IRS’s position better.

On March 14, 2011, the IRS issued its NOD for 2008.  The NOD asserted a deficiency of $276,506.  The document signed by the Taxpayers asserted a liability of approximately $23,000.  The difference in the two amounts appears to have been primarily expenses incurred in running the Taxpayers’ business that were not accounted for in the NOD.

The Taxpayers did not respond to the NOD, and, on July 28, 2011, the IRS assessed the tax due as reported in the NOD.  From issuance of the NOD to assessment, 136 days elapsed.  On August 10, 2011, the Taxpayers filed a document that they asserted was their 2008 return.  From issuance of the NOD to the filing of the document that purported to be the return, 149 days elapsed.  From assessment to filing, 13 days elapsed.  From the extended due date to filing, approximately one year and ten months elapsed.

On February 11, 2013, the IRS reduced the assessed tax to the $23,000 number reported as due by the Taxpayers.

On April 30, 2014, the Taxpayers filed for relief under Chapter 13 of the Bankruptcy Code.  This was approximately two years and eight months after the Taxpayers filed the document purporting to be their 2008 return.  This was approximately four years and six months after the extended due date of the 2008 return.

The Taxpayers successfully completed their Chapter 13 plan.  They full paid their secured and priority tax claims of over $58,000 and made a small distribution to their unsecured creditors.

3.  Briggs, Sr.

Prior to Golden, the only case known to the author that discharged tax reported on a document filed after the SFR assessment was Briggs, Sr. v. United States (In re Briggs, Sr.), 511 B.R. 707 (Bankr. N.D. Ga. 2014), aff’d, Briggs, Sr. v. United States (In re Briggs, Sr.), N.D. GA. No. 15-2427‑MHC  (June 7, 2017) (“District Court Briggs, Sr.).  In that case, Mr. Briggs thought his business partner had filed his return.  Mr. Briggs had signed the return and sent it back to his business partner, as was his annual custom.  The business partner did not file the return, and an IRS SFR designation ensued.  The IRS mailed the NOD to the business partner’s address and not Mr. Briggs’s address.  Upon learning of the nonfiling and SFR assessment, Mr. Briggs filed a document purporting to be his return, and it was found to be a valid return. 

The United States argued in Briggs, Sr. that any document filed after the SFR assessment is per se not a return under §_523(a)(*).  Yet, in its appeal brief to the district court, the United States conceded that no appellate court had adopted the per se rule.  District Court Briggs, Sr. at p.8.  The District Court Briggs, Sr. opinion is now almost five years old.  In the ensuing five years, the author is unaware of any appellate court that has adopted the per se rule, i.e., an appellate court outside of the one-day-late circuits and the Eighth Circuit.

4. Facts used by the Court to find for the Taxpayers

At Golden p.20‑21, the Court explained why it thought the Taxpayers had made an honest and reasonable attempt to comply with the tax law. 

  • The Taxpayers did not “belatedly” accept responsibility for filing a return, and they did not “attempt to present inaccurate or fabricated information.”
  • Taxpayers “provided solid and accurate information” to the IRS.  Taxpayers used the “assistance of a tax professional” to present accurate information.
  • Taxpayers did not try to “walk away” from the debt.  They spent five years in “bankruptcy purgatory” in order to obtain a discharge.
  • The Taxpayers’ “corrective actions were not merely filing a ‘me too’” 2008 return that “parroted the assessed tax” with a goal of two years later filing for bankruptcy and asserting the tax debt should be discharged.
  • The IRS presented “no identifiable bad faith reason for the failure to file” the 2008 return sooner.
  • Although “beset” with financial and marital problems, the Taxpayers acted properly to substantially pay their tax obligations.

Without discussion, the Court rejected the per se rule.  Golden at p.3 (where the government argument is set forth) and p.19 (where the Court makes clear that the Hatton rule applies; the Court looked at the totality of circumstances to determine whether the Taxpayers acted honestly and reasonably in the filing of their return).

5. Lagniappes

Golden will be a tough case for the IRS to win on appeal.  Ninth Circuit case law is clear that a subjective test applies so de novo review is unlikely.  The government will need to prove clear error.  See District Court, Briggs, Sr. at p.4 (burden is on the government to show that the bankruptcy court’s findings were clearly erroneous).  The United States might question, even under a “totality of the circumstances” test, how much weight should be given to actions taken after the document is filed, e.g., completing a Chapter 13 plan.  Regardless, sufficient facts exist to support the Court’s holding.  For example, the Court found that “the personal and financial maelstrom is the reason for Plaintiff‑Debtor stumbling with respect to the 2008 federal tax return.”  Golden at p.21.  Kudos to the Taxpayers’ attorney for taking on this battle and winning.

In Golden, the IRS again argued for a per se rule.  Even though such a rule would make life easier for the IRS, the IRS should put that argument to bed.  It has been singularly unsuccessful.  Golden notwithstanding, the IRS still has a de facto per se rule.  It is very difficult for a taxpayer to prove that a document filed after the SFR assessment was an honest and reasonable attempt to comply with the tax law.

One other note, if you represent a client with a non‑filed return and a NOD has been issued and the 90‑day period has not run, strongly consider filing a Tax Court petition.  Section_523(a)(*) of the Bankruptcy Code provides that a return includes “a written stipulation to a judgment or final order entered by a nonbankruptcy tribunal.”  The Tax Court filing and subsequent final order will keep the bankruptcy‑discharge option open, and, perhaps, prevent an expensive discharge litigation.

Can Bankruptcy Trustee Be Held Liable for Trust Fund Recovery Penalty of Responsible Officer?

In In re Big Apple Energy, LLC, No. 8-18-75807 (Bankr. EDNY 2022), the owner of a business that failed to pay the taxes withheld from employees over to the IRS sought an order that the bankruptcy trustee was personally liable for the interest and penalties arising from the failure.  In rejecting this claim, the bankruptcy court found that the trustee could not be held liable for unpaid taxes for which no claim was filed against the estate.  The holding does not mean that a bankruptcy trustee could never have liability for the failure to pay trust fund taxes, but the court does not hold the trustee liable for taxes that arose before he came on the scene and where he fully paid the claim filed by the government entities.

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The debtor initially filed a chapter 11 bankruptcy petition in 2018 but, as often happens, the case was converted to a chapter 7 later that year, at which time a trustee was appointed.  While operating as a chapter 11 the debtor failed to pay over the taxes withheld from its employees.  This failure would have served as an unmistakable statement that the debtor needed to convert to a liquidation.  When the bankruptcy court became aware of the failure, it ordered the owner to segregate money to pay the taxes and hold it in a special account.  When the conversion occurred, the owner turned the segregated account over to the trustee.  The IRS filed claims against the estate for the withheld taxes, as did the state.  Time marched on between the time the taxes were due and when they were ultimately paid.  This caused the accrual of interest and penalties due to the late payment.

In subsequent litigation between the estate and the owner, the parties entered a stipulation identifying the segregated funds and authorized the trustee to pay the IRS and state claims for the unpaid withholding taxes.  Unfortunately, the amount turned over to the trustee in the segregated funds covered only the unpaid tax and not the penalties which accumulated rapidly on the liability.  In a subsequent hearing the owner sought an order that the trustee pay the interest and penalties as well.  The trustee countered that neither the IRS nor the state had amended their claims to add on these amounts.  So, the trustee requested an order allowing him to pay the tax claims as filed.  The court granted this request.

Meanwhile, the IRS ramped up collection on the penalties against the owner while still not amending its claim.  The owner sought reconsideration of the distribution order, arguing:

that the Distribution Motion neglected to mention that the Trustee failed to timely pay the IRS Claims after Ferreira turned over the Segregated Funds. The Trustee’s inaction, Ferreira alleges, resulted in over $54,000 in penalties and interest being “assessed against the Big Apple Estate.” Ferreira argues that because the December 16 Order states the IRS and NYS Claims will be paid “in full and final satisfaction,” the Trustee signaled his intention to also pay the accrued IRS penalties and interest. This language, Ferreira submits, requires the Trustee to pay all interest and penalties that have been and may be assessed on the IRS Claims and NYS Claim. Therefore, Ferreira urges the Court to reconsider the December 16 Order pursuant to Federal Rule of Civil Procedure 59(e) and amend the December 16 Order to require the Trustee to also pay the penalties and interest that have been asserted by the IRS against Ferreira personally, and any that may be asserted in the future against Ferreira by the IRS and NYS for unpaid withholding taxes.

The trustee responded to this argument by pointing out that the order defined claims by referring to the specific claims filed against the estate.  He paid those claims after receiving the court’s permission.  The trustee further argued that the penalties and interest assessed personally against the owner differ, even though they have the same root cause, from the claims against the estate.  The trustee’s obligation is to pay debts of the estate and not collateral debts of the former owner of the company in bankruptcy.  The trustee also argued that the debts resulted from the owner’s failure to pay the taxes while operating the company during the chapter 11 phase of the bankruptcy and that it was the obligation of the owner to pay those taxes as they became due.

The owner replied to the trustee’s response by citing to drafts of the stipulation agreement under which he turned over the money designated for the payment of the taxes.  These drafts were exchanged during a mediation process.  The bankruptcy court found that it could not look at the drafts created during the mediation process because of Rule 408 of the Federal Rules of Evidence, which governs statements made during settlement and mediation discussions.  The bankruptcy court deemed these drafts inadmissible because of Rule 408 and also noted that the owner did not submit them during the process leading up to the distribution order.  In denying the motion for reconsideration, the court stated:

The Court agrees that the Trustee is neither obligated nor authorized to pay the personal penalties imposed on Ferreira from outstanding tax obligations when there are no claims filed against Debtors for such amounts. The Trustee is neither obligated nor authorized to pay claims that are not filed against Debtors’ estates. See generally 11 U.S.C. §§ 704(a)(2); 704(a)(5). Therefore, the Court does not find that there was “mistake” warranting Ferreira relief from the December 16 Order under Rule 60(b)(1).

This leaves the former owner of the business, Mr. Ferreira, holding the bag personally for a fair amount of penalty and interest resulting from the late payment of the taxes withheld from the employees.  Ultimately, the penalties and interest did stem from Mr. Ferreira’s failure to timely pay over the taxes as he was obligated to do as the person who controlled the company during the chapter 11 phase of the bankruptcy case when it operated as a debtor in possession.  The case demonstrates a danger to someone operating as a debtor in possession who does not keep current with the taxes because once the case is converted to a chapter 7 the finances of the company are no longer in their control which can result in significant delays in payment in addition to payment of an amount less than the former owner needed paid in order to avoid personal liability.  So, Mr. Ferreira not only has lost everything he invested in the business but comes out of the business bankruptcy with his own personal liability to the taxing authorities.

The court did not lay out when Mr. Ferreira was assessed the trust fund recovery penalty.  Persons hit with this penalty do receive a break on interest because it does not start running until the assessment against them.  Similarly, the penalties referred to, I believe, are penalties for failure to pay the trust fund liability which would also have run from the date of assessment.  The opinion does not contain enough detail for me to tell if the IRS claim included penalties and interest to a specific date.  Creditors generally lose the ability to claim interest for prepetition debts in a bankruptcy case though they have the ability to claim interest in postpetition debts such as this.  I don’t know if the IRS did claim some postpetition interest or if its claim merely included the unpaid tax.

The case highlights the importance of control.  Mr. Ferreira had control during the chapter 11 and lost it as the case converted to chapter 7.  His decision not to have the company pay the taxes while he had control ultimately leads to him being left holding the bag.  A potentially important lesson for others taking a troubled entity into chapter 11 bankruptcy and making decisions about who to pay and when to shut down.

General Discharge Denial in Chapter 7 Based on Taxes

I have written before on many occasions about taxpayers who sought a discharge of their tax debts through chapter 7 bankruptcy.  For individuals filing chapter 7, the basic discharge provisions exist in BC 727, but I have always previously discussed the exceptions to discharge in BC 523(a)(1) and (7).  In the case of Kresock v. United States, 128 AFTR 2d 2021-6995 (BAP 9th Cir.)(unpublished), the bankruptcy appellate panel sustains the decision of the bankruptcy court denying Mr. Kresock a discharge based on BC 727.  To get a discharge of taxes based on BC 727 the individual’s behavior must rise to the level that the court feels no need to get to exceptions to discharge because the general provisions denying discharge prevent the debtor from writing off the debt.  Maybe this happens more often than I think but I don’t ever remember seeing a BC 727 discharge denial where the focus of the denial was on tax debt.

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BC 727(a)(3) provides that a debtor is not entitled to a chapter 7 discharge if he

has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, records, and papers, from which the debtor’s financial condition or business transactions might be ascertain, unless such act or failure to act was justified under all of the circumstances of the case.

BC 727 has other provisions that could deny a debtor a discharge but (a)(3) relates to Mr. Kresock’s case and potentially to other similar cases with major tax issues.  If the bankruptcy court denies a debtor’s discharge under BC 727, then no need exists to examine the exceptions to discharge.  That’s what happens in this case but in a case in which the debtor does survive the general denial of discharge, something that does not happen with great frequency, then the exceptions to discharge apply and some have specific application to taxes.

BC 523(a)(1)(A) excepts from discharge any tax debt entitled to priority under BC 507(a)(8) which basically covers income taxes where the return due date falls within three years of the filing of the bankruptcy petition, income taxes assessed with 240 days of the bankruptcy petition, income taxes not yet assessed but assessable (unless the statute is open because of non-filing or fraud), taxes based on non-payment of money held in trust (e.g., trust fund recovery penalty for responsible officers) and employment and excise taxes due within the past three years.  This covers a lot of taxes but certainly not all.  Older income, employment (non-trust fund) and excise taxes are not described here.

BC 523(a)(1)(B) excepts from discharge taxes for which the taxpayer has not filed a return and taxes where the taxpayer late files a return within two years of the bankruptcy petition.

BC 523(a)(3) excepts from discharge taxes which the debtor tried to avoid by filing a fraudulent return or by concealing income and assets to avoid payment.

BC 523(a)(7) excepts from discharge penalties on taxes to the extent the penalty arose within three years of the filing of the bankruptcy petition.

One reason I may not have seen a BC 727 case heavily basing the decision on taxes is that to deny a discharge under BC 727 the taxing authority must affirmatively act within a specified period of time to bring the discharge issue before the court.  For exceptions to discharge, the IRS does not need to do anything during the bankruptcy case if one or more of the exceptions apply.  Discharge fights under BC 523 typically play out after the bankruptcy case when the IRS starts collecting again and the debtor thinks the tax or penalty the IRS seeks to collect after bankruptcy was discharged.  The debtor then brings an action that the IRS has violated the discharge injunction and the parties fight it out, but the IRS did not need to do anything affirmatively.

Mr. Kresock is a cardiologist who appears to believe that normal rules do not apply to him.  The court finds that Mr. Kresock failed to keep or maintain financial records, falsified a court order and made false oaths in connection with his bankruptcy case.  On that basis the BAP sustains the decision of the bankruptcy court.  The court provides lots of details regarding his behavior in support of its conclusion, including this paragraph about his girlfriend:

Ms. Janine Smith is Dr. Kresock’s girlfriend. Since 2009, she has lived with Dr. Kresock and worked at CVC. Ms. Smith is not paid a salary from CVC, but Dr. Kresock pays all of her expenses, including the mortgage interest payments (not disclosed) on four homes titled in her name. For at least six years prior to his bankruptcy, from 2010 to 2015, Dr. Kresock gave Ms. Smith annual gifts of $100,000 and had his CPA prepare gift tax returns to reflect these gifts.

As the IRS and other creditors tried to gather information from him, Mr. Kresock failed to respond to the creditors or to the court orders.  He had filed returns for several years prior to bankruptcy reporting that he had no taxable income.  The IRS questioned this, considering he purchased numerous homes, vehicles, boats, and other personal property listed in his schedules.  From the information it could gather, the IRS determined that he owed $2,293,059.32.  The court recounts other actions of Mr. Kresock, which included altering the purchase date of a Hummer, altering an order entered in a criminal case regarding his obligations, and misrepresentations in his bankruptcy schedules including false statements about the amount of gifts he had given prior to bankruptcy.

The U.S. Trustee filed the complaint seeking to deny his discharge which is consistent with my not having seen the IRS do this before.  The trustee moved for summary judgment.  In his response, Mr. Kresock denied some of the trustee’s allegations in the motion but admitted:

that he “was a highly educated professional who engaged in complex transactions involving millions of dollars of assets,” that given “his education and business history, [he] had the sophistication and forethought to maintain proper documentation of his financial affairs,” and that “to complete its audit, the IRS was required to subpoena third parties in order to obtain financial information in an attempt to recreate [his] financial records.” Dr. Kresock admitted that the “IRS reviewed well over 10,000 documents in its audit…including bank statements, cancelled checks, and deposit slips subpoenaed from the several banks in which CVC, Dr. Kresock, and Ms. Smith did business.”

In sustaining the granting of the summary judgement motion the BAP found that the trustee had proven Mr. Kresock’s failure to keep business records and his false statements under oath.  The trustee also proved that he falsified a court order as well as the bill of sale of the Hummer.  Because of the proof, the court sustained the summary judgment determination.

Because the IRS generally does not engage at the stage of seeking a BC 727 discharge, few cases exist using taxes as one of the bases for a general discharge denial.  Mr. Kresock’s case shows that if your behavior is bad enough, the failure to properly file taxes or to respond to questions from the IRS can play a major role in denying a discharge.  The same facts would also support an exception to discharge under 523(a)(1)(C) but thanks to the work of the U.S. Trustee the IRS will not have to defend its decision to except Mr. Kresock’s taxes from discharge since he is denied a general discharge and doesn’t get to the stage of having the exceptions apply.

A New Twist on What Constitutes a Tax Return

In Sienega v. Cal. Franchise Tax Bd. (In re Sienega), No. 20-60047, 2021 U.S. App. LEXIS 35875 (9th Cir. Dec. 6, 2021), the taxpayer/debtor raised a novel argument regarding a document the debtor sought to have the court treat as a tax return.  In this case the debtor argued that the bankruptcy court should treat his audit report from the IRS, which he faxed to the California Franchise Tax Board, as his tax return for the state so that he could discharge his state tax liabilities.  The Ninth Circuit, like the Bankruptcy Appellate Panel and the bankruptcy court before it, declined the invitation.

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At issue in Mr. Sienega’s case is his ability to discharge certain taxes.  He failed to file state income tax returns with California for 1990-92 and 1996.  The Ninth Circuit says he went to Tax Court to contest his federal taxes for those years.  Here is a link to the Tax Court docket for the only case filed by Mr. Sienega in that Court.  Of course, it’s not possible to see any of the documents filed in his case, but the docket sheet indicates that he reached an agreement with the IRS to resolve the case.  While the Ninth Circuit describes the resolution of the Tax Court case by saying “the [Court] ruled that Sienega was also liable for accuracy-related penalties of approximately $9,688,” it appears that he agreed to this result. 

As part of his agreement to resolve the Tax Court case, the IRS created a Form 4549-A, a typical form it uses for reflecting adjustments to a tax year.  The Tax Court docket information indicates he was represented in his Tax Court case by Cindy L. Ho and Amanda F. Vassigh.  The Ninth Circuit states that his attorney notified the state of California of the adjustments via fax.  Most, if not all, states impose a requirement on taxpayers to notify the state following a resolution with the IRS.  It’s not clear from the opinion if the attorney who notified the state knew that he had never filed state income tax returns for those years. 

The fax cover sheet transmitting Form 4549-A stated:

Pursuant to California State law, Mr. and Mrs. Sienega hereby notify the Franchise Tax Board that the Internal Revenue Service has made recent adjustments to their [year] federal tax return, which they concede. Following please find a copy of the IRS’ adjustments, including a computation of how the changes were made.

California’s Franchise Tax Board (FTB) issued to him a notice of proposed assessment which indicated that it had no record of a return from him for any of the years.  The letter offered him the opportunity to appeal if he disagreed with the proposed assessment.  In response to the letter, he did not file the missing returns or file a protest.  The proposed assessments became final by operation of law in October 2009.

He did not file bankruptcy until five years later.  He initially filed a chapter 13 petition but it was converted to a chapter 7 case.  The FTB filed an adversary proceeding seeking a ruling that the taxes were excepted from discharge.  That’s when Mr. Sienega put forth the novel argument that faxing the IRS audit adjustment document met his state filing requirement.

The 9th Circuit noted that the California taxing scheme did not have a parallel to IRC 6020(a) which allows an agreement to serve as a return.  It noted that the closest California statute:

does not authorize the FTB to prepare or execute a return. Therefore, under the plain words of the relevant statutes, the return exception contained in § 523(a)’s hanging paragraph does not apply. And it is undisputed that the FTB did not prepare or execute returns for Sienega. Rather, it issued notices of proposed assessment and advised that it had no record of any returns being filed for the relevant years.

Frequent and long term readers of the blog will recognize the phrase “hanging paragraph” in 523(a) as the paragraph that set off the one-day rule controversy discussed here (and in many linked posts).  All of the one-day rule cases of which I am aware involve the taxpayer actually filing a return rather than sending an audit report in its place.

The 9th Circuit then discusses its precedent regarding what is a return, including its adoption of the test set out in Beard v. Commissioner, 82 T.C. 766 (1984) and its application to cases under 523(a)(1)(B) in In re Hatton, 220 F.3d 1057, 1060-61 (9th Cir. 2000) and In re Smith, 828 F.3d 1094, 1096 (9th Cir. 2016).  The 9th Circuit determines that the fax of the IRS adjustment document fails the Beard test as well as a related test for what is a return under California law in the case of In re Appeals of R. & Sonja J. Tonsberg, 1985 WL 15812, at*2 (Cal. St. Bd. Eq. Apr. 9, 1985).  Aside from the fact that the faxed documents don’t purport to be a return, they were not submitted under penalties of perjury, they did not contain enough information to allow the FTB to compute the tax liability, and the fax is not an honest and reasonable attempt to satisfy the requirements of the law.

The only thing surprising about the opinion’s discussion of whether the fax is a return is that the court gave it as much ink as it did.  The case provides some relief from the run of the mill case where a taxpayer makes a logical argument that forces us to think about the limits of the law.  This case stands so far out of the boundaries of what might be considered a return that it requires little effort for the court, or for us, to consider that the faxed material might constitute a return.

Even though the fax is not a return and does not meet the Beard test or the penalties of perjury test, does the debtor have a point that this document gave the FTB the information it needed in order to make an assessment against him and start collecting?  The fax seemed to work for this purpose and the FTB had five years to try to collect from him before he filed bankruptcy.  Should bankruptcy court be hung up on formalities or look at the practical effect of his communication, which was to give the FTB information on which it could make an assessment, to effectively consent to the assessment, and to wait well past the period in 523(a)(1)(B) before seeking to discharge the liability?

It’s certainly understandable that the FTB would not want to start down the slippery slope of allowing most anything to trigger the running of the time period to discharge a tax liability, but at the same time, if the goal of the statute was to put the taxing authority on notice and give the taxing authority adequate time to collect before allowing a discharge, Mr. Sienega seems to have satisfied that goal.  By not discussing the issue in this way and pursuing the formalities of the Beard test, perhaps the court is saying equities and action notice do not matter in this situation and the narrow path to discharge lies through adherence to narrowly prescribed rules of what one must due to set up a liability to meet the test of 523(a)(1)(B).

The Train Tracks

My three-year old grandson Sam is enamored with trains and train tracks.  He loves to lay out the tracks and run Thomas and Thomas’ friends along the tracks.  Unfortunately for Sam, his 14-month old sister has now learned to walk.  She wants to do whatever Sam is doing, which includes playing with the train tracks.  One day recently Sam threw his body across a stack of train tracks in order to protect them from the clutches of his sister.  His tactic might work if his only goal is to keep her from the tracks; however, if he also has a goal of playing with the train tracks, this tactic will not work.  As I read the case of Chow v. Lee, Adv. Proc. No. 20-4036 (Bankr. E.D. Tex. 2021), I was reminded of Sam and the train tracks.  Let me explain why.

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The Impasse

Mr. Lee had a profitable business fixing the LCD monitor (front cover) of iPhones when Apple, without notice to Mr. Lee, according to his testimony, changed the landscape and caused repairs of its phones to move to China, essentially throwing him into bankruptcy because of his business losses.  Mr. Lee’s wife had a good job as director of financial analysis as an employee.  Mr. Lee decided to file a chapter 7 bankruptcy petition to deal with his financial problems; however, his wife did not join him.  Somewhat like the decision to file a joint tax return, married couples have the choice to file an individual or joint bankruptcy. 

Mr. Lee brought into the bankruptcy a pile of business losses.  He and his wife filed a post-petition tax return on which they claimed the losses.  In doing so, they reduced the taxable income on the return to zero, resulting in a refund of about $26,000.  The bankruptcy trustee sought the refund for the estate, arguing that the refund was the result of the business losses which were an asset of the estate.  Mr. Lee agreed that the losses did belong to the estate but pointed out that the refund resulted entirely from his wife’s withholding because following the loss of the business he decided to go to divinity school and during the year at issue he had no income.

The bankruptcy court analyzed the varying interest in the refund and determined that:

the Debtor and his spouse did not have authority to use the net operating losses, which are the Debtor’s pre-bankruptcy tax attributes, in their 2018 Tax Return.  Those attributes belonged to the Debtor’s bankruptcy estate. Although it is not clear how the trustee can use the Debtor’s pre-bankruptcy tax attributes, the Court will require the Debtor and his non-filing spouse to take whatever steps are necessary, if requested by the Chapter 7 trustee in writing with 14 days of entry of this Memorandum Opinion and Order, to return the net operating losses to the estate by amending their 2018 Tax Return.

So now, the trustee, like Sam, has smothered the loss carryforward and can prevent the Lees from obtaining the benefit of this tax attribute, but what will she receive for taking this position?  Mr. Lee has no income in the year at issue and based on my reading of the case is unlikely to have much income in the near future.  Will the trustee assert her right to prevent the use of the loss to shelter a non-debtor’s income from tax or can the parties negotiate an agreement mutually beneficial to each?  Somewhat similar to the position of the trustee, the Lees also have an interest in reaching an agreement since they cannot enjoy the benefit of the loss to reduce their overall taxes without such an agreement.  A good case for a negotiation exercise in law school.  Maybe someday I will talk to Sam about the case, but I don’t think it will do much good yet.

The Family

The tax refund issue was only one part of Mr. Lee’s bankruptcy case.  The other part also reminded me of my family and of many families.  Mr. Lee and his wife have small children.  As his business grew and his wife’s job responsibilities took her away from the home, they looked for a way to take care of their children and other responsibilities around the house.  They convinced Mr. Lee’s parents to sell their business and move to Texas to provide child care.  My daughter has not yet convinced me to do this, but my wife provides significant childcare for our grandchildren as do many grandparents, bringing Mr. Lee’s bankruptcy case closer to home than just the example with Sam.

Initially, the parents lived in Mr. Lee’s house, but as his family grew, space became a premium.  Mr. Lee and his wife assisted his parents, who no longer had outside income, in buying a house nearby and in buying a car to transport them back and forth to the Lees’ house and elsewhere.  The trustee sought to bring the value of the house and the car into the estate as transfers from Mr. Lee that defeated creditors.  The court works through the necessary analysis regarding each of the transfers before determining that these two assets should not be brought back into the estate.  I was a little surprised that in the analysis the court did not explicitly talk about the value of the services provided by Mr. Lee’s parents who not only provided childcare, but seemed like they also provided meal preparation and lawn maintenance, etc.  I suspect this value was in the judge’s mind as she thought about this family situation but she did not need to use it in reaching her conclusion.

The case provides lessons not only about negotiation but also blended families.  I think the judge got it right, but the opinion, like any opinion, tells the story as written by the deciding judge who wants you conclude they got it right.  When you have informal assistance going from one generation to another, with reciprocal services coming back, the formalities of property law, fraudulent transfer and other concepts designed to sort out assets in a bankruptcy case sometimes meet up with real life situations in which a family seeks not to defraud its creditors but to make life work.  I don’t fault the trustee for raising questions about the transfer of property from someone who ends up owing creditors.  Here, it forced the judge to look at the goal of the transfers and the timing of the transfers in deciding they were not done to defeat creditors but to preserve the best interest of the family.  Here, and in other cases, this can be a close question as the court and the trustee try to determine the motive and timing behind transfers of wealth from one family unit to another.

Discharging Student Loan Debt

The Department of Education (DOE) recently lost a motion for reconsideration of a bankruptcy court decision involving the discharge of student loan debt.  The case is almost a purely bankruptcy matter having no real tax aspect to it, but because the bankruptcy court talks about what will happen to the debt upon its forgiveness, viz., taxable income under IRC 61, the case got picked up in the tax press and caught my eye.  If you have ever been curious about why students can almost never get rid of student loan debt, you may find this rare case in which a former student succeeds in getting past the exception to discharge interesting.  If you are looking to learn something about taxes or tax procedure, read no further.

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In Wheat v. Great Lakes Higher Education Corp, No. 18-03041 (M.D. Ala. 2022) the bankruptcy court issues an opinion explaining its earlier opinion granting Ms. Wheat a discharge.  DOE brought this motion for reconsideration because it felt that the bankruptcy court had failed to follow the applicable precedent for determining if a debtor could discharge student loan debt under the exception to discharge provided in B.C. 523(a)(8).  In the end, the bankruptcy court sustains its prior decision and provides more explanation for the reasons behind its decision.  This outcome happens frequently, as discussed in an earlier blog post on motions for reconsideration and presents a real hazard for parties who file this particular motion.  In effect, the bankruptcy court has received and taken the opportunity to write a reply to DOE’s opening brief on appeal.

The court outlines what it should consider in such a motion:

A motion to reconsider, alter, or amend a judgment, if filed within 14 days of the judgment, is governed by Federal Rule of Bankruptcy Procedure 9023, which incorporates Rule 59 of the Federal Rules of Civil Procedure. To warrant reconsideration, a motion must establish one of the following applies:

1. An intervening change in the law,

2. Consideration of newly discovered evidence, or

3. To correct clear error or prevent manifest injustice.

With this test in mind, the court explores its earlier decision and the concerns raised by DOE, which in this case plays the role of Inspector Jobert made famous in Les Miserables.

Ms. Wheat had filed a chapter 7 bankruptcy and received a discharge under B.C. 727.  That discharge rids her of her pre-petition debts; however, certain pre-petition debts are excepted from the discharge.  The excepted debts are described in B.C. 523, which applies to almost all individual bankruptcy cases.  Most often on this blog we discuss the exception in B.C. 523(a)(1) which excepts certain pre-petition tax debts or B.C. 523(a)(7) which excepts certain penalties, but there are 18 subparagraphs under 523(a) and individual debtors must consider all of them in calculating the impact of their discharge.

Debtors seeking to discharge student loan debt must meet the requirements to overcome the statutory exception to discharge for student loan debts.  The case of In re Brunner, 46 B.R. 752 (S.D.N.Y. 1985), aff’d, 831 F.2d 395 (2d Cir.1987) (per curiam) is the leading case here and the 11th Circuit adopted the Brunner test in In re Cox, 338 F.3d 1238 (11th Cir. 2003).

Under the Brunner test, a debtor must prove, by a preponderance of the evidence, the following components:

(1) That the debtor cannot maintain, based on current income and expenses, a “minimal” standard of living for herself and her dependents if forced to repay the loans,

(2) That additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans, and

(3) That the debtor has made good faith efforts to repay the loans.

The bankruptcy court recounts the financial and family circumstances of Ms. Wheat.  As a single mom with three children, ages 8-12, including one with special medical needs and as a daughter whose mom had significant medical needs, Ms. Wheat faces significant challenges.  Those challenges cause the calculation for her repayment amount on the student loan to be $0 at the time of the bankruptcy case.  DOE has concerns because many individuals with student loans have financial hardship, yet it wants to argue under the second prong of the test that the borrower will not necessarily face these hardships throughout the entire life of the repayment period.  Children grow up, people get better jobs, circumstances change, and DOE did not feel the bankruptcy court recognized these possibilities in applying the Brunner test.

DOE wants the bankruptcy court to apply the “certainty of hopelessness” standard some courts have adopted, essentially putting the burden on the debtor to show that there is no hope their finances will improve during the life of the repayment.  An example of someone who could meet this standard would be someone with an irreversible medical condition that kept them from working for the rest of their life.  The bankruptcy court responds that DOE’s interpretation of the rule would “swallow the rule” and make it essentially impossible for any debtor to meet the second prong of the Brunner test.  I think the court accurately describes DOE’s interpretation, which is why it is so hard to discharge student debt and why DOE has concerns about the Wheat case.  The court finds, however, that Ms. Wheat’s dire financial situation is likely to continue for so long that the realistic chances she will have the ability to repay the loan are minimal.

In its original decision the bankruptcy court referred to the tax debt that can replace the student loan debt upon forgiveness if the forgiveness triggers cancellation of debt income.  It hypothesizes that she could possibly discharge the debt after 25 years using the Income Driven Repayment Plan adopted during the Obama years.  The court points out that its discussion of her forgiveness under this plan and the possible tax consequences flowing from it did not form the exclusive basis for its decision.  It merely acknowledged the size of her potential tax bill if she paid nothing further on the loan and discharged it at the conclusion of the 25-year period.

Finally, the court addressed DOE’s argument that the discharge exception should apply in all but the most severe circumstances.  It finds this policy-based argument to go too far and spends more time detailing her dire financial circumstances, her family circumstances, and her work ethic.  It also explains why her circumstances will likely persist for a significant portion of the repayment period.  The court rejects DOE’s argument that Ms. Wheat’s children should start helping her pay the student loan when they reach the age of majority.

The test for discharging student loan debt applied here suggests a loosening of the rules, though not a major one.  Ms. Wheat is clearly struggling.  If you read cases applying the Brunner test, you understand why discharging student loan debt is so difficult.  The fact that DOE fights so hard in this case further brings that point home.  While her tax debt, if she ultimately has one, will create another debt excepted from discharge, B.C. 523(a)(1) allows the discharge of the tax debt once it ages out after three years.  The student loan provision for discharge has no similar mechanism for aging out the debt, requiring student loan borrowers to continue paying, or at least being billed for, the debt forever unless they qualify for the 10 and 25-year relief provisions passed during the Obama administration.  That’s why there is so much pressure being brought to bear on the current administration to provide relief from student debt.  Because of issues of fairness and equity, providing blanket relief will be difficult.

Diving Beneath the Surface of In re Webb

We welcome back Ken Weil to help us parse a technical bankruptcy issue impacting taxes.  Ken has his own practice in Seattle that focuses on representing individuals with tax debt and resolving that debt through administrative action with the IRS or through bankruptcy. He has written a book on his specialty area, Weil, Taxes and Bankruptcy, (CCH IntelliConnect Service Online Only) (3d ed. 2014). He is one of the top experts at the crossroads of personal bankruptcy and taxes. We are fortunate to have him back with us again. Keith

In Webb v. Internal Revenue Service (In re Webb), Bankr. N.D. W.Va. Adv. Proc. No 21-00014 (November 8, 2021), a Chapter 13 debtor brought an adversary proceeding to hold the IRS in contempt for an improper setoff of a tax refund against a tax debt.  On the IRS’s Rule 12(b)(6) motion to dismiss, the court held for the IRS. 

The court stated that “[a]n order of contempt is a serious reprimand and is appropriate only in the case of a deliberate violation in the face of succinct directions to the contrary.”  Id. at p.3.  Because the debtor’s Chapter 13 plan did not explicitly prevent tax setoffs, the court found that the high standard necessary to hold the IRS in contempt was not met.  In note 2, the court stated that it “need not discuss the legality of the IRS’s actions because the Debtor only alleges the [IRS’s] actions constituted contempt of the confirmation order.”

Because contempt was the only issue before him, Judge Bissett decided the case without diving into the more complicated issues lurking beneath the surface.  What makes this case blog-worthy are the issues that would or could have been before the court if the case had been presented differently.  In particular, because of the IRS’s implicit election to treat its 2019 tax debt to Ms. Webb as a prepetition debt, there are multiple opportunities to discuss an analytical tool that I call deemed versus defined, which I first learned from Professor Harvey Dale almost 40 years ago.

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   1.   Factual background.

          In November 2019, Marie Webb (the Debtor) filed a Chapter 13 petition.  In her schedules, she listed taxes owed for 2013 and 2018.  In April 2020, the IRS filed its proof of claim, which it amended subsequently.  It listed the 2013 tax owed as an unsecured general claim, i.e., nonpriority claim.  It listed the 2018 tax owed as an unsecured priority claim.  In addition to the taxes scheduled by the Debtor, the IRS’s proof of claim listed the 2019 tax year as an unsecured priority claim and estimated the tax due. 

          In her Chapter 13 plan, the Debtor agreed to pay the 2019 tax debt as a priority obligation.  Corrective Order Confirming Chapter 13 Plan, Webb Docket No. 45, p.5, ¶ 10 (February 19, 2021) (Corrective Order).  The Debtor’s Chapter 13 plan left all property the Debtor acquired postpetition in the bankruptcy estate.  Corrective Order p.8, ¶ 10.

          In March 2021, the IRS set off the Debtor’s 2020 tax refund (IRS’s debt) against the 2019 tax obligation (IRS’s claim). In the Bankruptcy Code, setoffs are viewed from the creditor’s perspective.  Thus, the IRS’s refund owed is the debt, and the taxpayer’s unpaid tax obligation is the claim.  The Tax Code and 11 U.S.C. § 553 use the word “offset.”  I use “setoff” when used as a noun or adjective and “set off” when used as a verb. The Debtor objected to the setoff by filing an adversary proceeding seeking to hold the IRS in contempt.

     2.   Applicable law and its application in Webb.

          This paragraph discusses the law that would have been applicable if some of the underlying issues had been raised and argued by the parties.

          a.   I.R.C. §§ 1398-1399. 

          Tax Code §§ 1398 and 1399 provide rules for when a debtor’s tax year in the year of filing can be bifurcated.  The only time an individual’s tax year can be bifurcated is in an asset, Chapter 7 case. Assuming a calendar year-end, if the tax year of filing is bifurcated, a prepetition tax year runs from January 1 to the day before the petition is filed.  A second, postpetition year runs from the day of filing to December 31. See I.R.C. § 1398(d) (rules for taxable years of individual debtors); I.R.C. § 1399 (“Except in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a case under title 11 ….”); and Hall v. United States, 566 U.S. 506, 516 (2012) (Chapter 13 postpetition taxes are not incurred by the estate; they are a liability of the debtor).

          The Debtor filed for bankruptcy in November 2019.  This means the 2019 tax year ended after the bankruptcy filing and was a postpetition tax year.  The IRS’s proof of claim treated 2019 as a prepetition tax year.

          b.   11 U.S.C. § 1305.

          This paragraph discusses the things we know and do not know about 11 U.S.C. § 1305, and it looks at Webb through a § 1305 lens.

               i.   What we know about § 1305.

          Under 11 U.S.C. § 1305, a governmental unit can elect to file a proof of claim for taxes that [first] become payable while the case is pending.  11 U.S.C. §§ 1305(a)(1) and 1322(b)(6); and see Joye v. Franchise Tax Board Cal. (In re Joye), 578 F.3d 1070, 1075-1077 (9th Cir. 2009) (payable means first becomes payable); and In re DeVries, Bankr. D. Id. No. 13-41591 (April 28, 2015), 2015-1 USTC ¶ 50,287 (only governmental entity may file § 1305 claim).  Internal Revenue Manual guidance is found at IRM 5.9.10.9.2 (08-07-2018).

          Beyond the proof of claim, no special form is needed for a governmental unit to elect § 1305.  The IRM states that IRS personnel should file a proof of claim and add to the proof of claim language stating that the proof of claim is being filed under the authority of § 1305.  IRM 5.9.10.9.2(6) (08-07-2018).  The IRS’s proofs of claim in Webb did not have this language. 

          If the governmental unit so elects and the proof of claim is accepted as filed, the governmental unit’s postpetition claim is treated as if it were a prepetition claim.  In other words, a postpetition claim is deemed to be a prepetition claim.  Beyond this point, the applicable law is murky.

               ii.  The confusing world of § 1305.

          The election to use § 1305 raises a number of confusing issues.

                     I.  Are § 1305 claims entitled to priority?

          The argument that § 1305 claims do not receive priority is based on 11 U.S.C. § 507(a)(8), which has no provision for priority treatment of a deemed prepetition claim under § 1305.  In re Jagours, 236 B.R. 616, 619-620 (Bankr. E.D. Tex. 1999) (postpetition claim treated as filed prepetition but not entitled to priority because such a claim does not fit within the language of § 507(a)(8)(i)).  Cases that allow priority rely on § 1305(b), which states that a § 1305 claim shall be allowed or disallowed the same as if such claim had arisen prepetition.  In re Jagours, 236 B.R. at 616 n.3.  The IRM straddles the fence.  Compare IRM 5.9.10.9.2(8) (08-07-2018) (benefit of filing § 1305 claim is that “Service will be paid as a priority creditor”), with IRM 5.9.10.9.2(9) (08-07-2018) (risk of filing § 1305 claim is that “§ 1305 claims may not be accorded priority status”).

                     II.  Is a § 1305 claim dischargeable?

          In dicta, Jagours stated that § 1305 claims are not dischargeable.  In re Jagours, 236 B.R. at 620 (“rights of the creditor to collect are not impaired by the Chapter 13 plan”).  The IRM appears to disagree.  IRM 5.9.10.9.2(9) (08-27-08) (“Once provided for in the plan, the tax liability may be dischargeable.”)

                     III. Is postpetition interest paid on § 1305 claims? 

          Assuming funds are insufficient to pay interest to unsecured creditors, postpetition interest will not run on a discharged § 1305 claim, regardless of whether the § 1305 claim is paid-in-full.  If the § 1305 claim is not discharged or if it is deemed a postpetition claim, postpetition interest will continue to run.  See Ward v. Bd. of Equalization of Cal. (In re Artisan Woodworkers), 204 F.3d 888 (9th Cir. 2000) (postpetition interest payable on nondischargeable tax debt fully paid through a Chapter 12 plan).

                     IV.  Are penalties paid on § 1305 claims?

          In Webb, what happens to the failure-to-pay penalty (assuming the Debtor filed her 2019 return timely)?  If a prepetition claim, during the bankruptcy, the penalty does not accrue.  I.R.C. § 6658.  If a prepetition claim, the portion of the penalty that accrued prepetition is dischargeable in the bankruptcy, regardless of age.  See 11 U.S.C. § 1328(a)(2) (by omission from the listed exceptions, all penalties discharged regardless of age; this rule is one of the last vestiges of the old Chapter 13 superdischarge that disappeared with the 2005 revisions to the Bankruptcy Code).  If a postpetition claim, the penalty accrues.  

               iii. Webb and § 1305.

          With its proofs of claim in Webb, the IRS implicitly filed a § 1305 claim and took the position that it was entitled to priority.  The Debtor agreed to that treatment.  If the plan is completed, the tax would be paid-in-full.  At that point, only the payment of interest would turn on the dischargeability issue. 

          If postpetition interest and penalties are not paid, this is a sweet deal for the Debtor, as a postpetition tax is paid interest-free over the life of the plan.

          c.   11 U.S.C. §§ 541, 1306, and 1327(b).

          Bankruptcy Code §§ 541 and 1306 tell us what property is included in the bankruptcy estate.  Section 541 broadly defines bankruptcy estate property.  Section 1306(a)(1) provides that property of the estate includes all property that the Chapter 13 “debtor acquires after the commencement of the case but before the case is closed, dismissed or converted ….”  Upon plan confirmation, all property of the estate vests in the debtor.  11 U.S.C. § 1327(b).  Section 1327(b) does not override § 1306.  In re Shay, 553 B.R. 412, 417-418 (Bankr. W.D. Wash. 2016) (Lynch J.).  A priori, it applies to prepetition property that is returned to the debtor upon confirmation.

          The Debtor’s Chapter 13 plan included all property acquired postpetition in her bankruptcy estate, which means it included any potential tax refund in her bankruptcy estate. Whether the refund could even be estate property is also debatable.  Because the right to overpayment arose before the IRS made its setoff, it was most likely estate property.  Copley v. United States, 959 F.3d 118, 122-123 (4th Cir. 2020).  West Virginia is in the Fourth Circuit.  Otherwise, under I.R.C. § 6402(a), a “debtor is generally only entitled to a tax refund to the extent that her overpayment exceeds her unpaid tax liability.”  IRS v. Luongo (In re Luongo), 259 F.3d 323, 335 (5th Cir. 2001); and United States v. Gould (In re Gould), 401 B.R. 415, 424-425 (B.A.P. 9th Cir. 2009) (citing Luongo with approval), aff’d, Gould v. United States (In re Gould), 603 F.3d 1100 (9th Cir. 2010) (adopting BAP opinion).

          d.   11 U.S.C. §§ 327(a), 362(a)(3), (b)(26), and (c)(1).

          The automatic stay protects the debtor from collection action by creditors while a bankruptcy case is pending and before discharge is entered.  In particular, the creditor may not act to obtain possession of estate property.  11 U.S.C. § 362(a)(3).  An exception is that a governmental unit may set off postpetition a prepetition debt (a tax refund) against a prepetition claim (a debtor’s unpaid tax debt).  11 U.S.C. § 362(b)(26).  Here, the 2020 tax refund is a postpetition debt.

          The Debtor’s plan kept all property in the bankruptcy estate, and § 362(a)(3) stayed collection as to that property.  The automatic stay remained in place as long as the property remained bankruptcy estate property.  11 U.S.C. § 362(c)(1); and see also 11 U.S.C. § 362(c)(2) (if property had been returned to debtor, stay would have remained in place until the case was closed, dismissed, or the debtor received a discharge.)

          Judge Bissett stated correctly that the Debtor’s plan failed to address explicitly whether the setoff of a postpetition tax refund was permissible.  Consistent with § 1306, the plan did state that all property acquired postpetition would be property of the bankruptcy estate.  It also provided that the Debtor could keep the first $1,500 of any tax refund and the remainder should be sent to the Chapter 13 trustee.  Corrective Order p.2, ¶ 3.

          Pursuant to 11 U.S.C. § 1327(a), all creditors, including the IRS were bound by the terms of the plan, and the Debtor’s complaint so alleged.  Webb v. Internal Revenue Service (In re Webb), Bankr. N.D. W.Va.Adv. Proc. No. 21-00014, Docket No. 1, Complaint ¶ 23 (June 21, 2021).

          e.   Setoffs, mutuality of obligation, and deemed versus defined.

          This paragraph discusses when setoffs are allowed in bankruptcy and the concept of mutuality of obligation.  It then applies the analytical tool of deemed versus defined to ask whether mutuality of obligation existed when the IRS made its setoff in Webb. For a thorough analysis of setoffs and taxes, see K. Fogg, “The Role of Offset in the Collection of Federal Taxes,” added to SSRN on February 26, 2021 and forthcoming in the Florida Tax Review.

               i. Setoffs and mutuality of obligation.

          As a general rule, the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose” prepetition against a claim of the debtor that arose prepetition. One exception is the improvement-in-position test that a bankruptcy trustee can use to claw back into the bankruptcy estate setoffs made in the 90-day prepetition period. 11 U.S.C. § 553(b).11 U.S.C. § 553(a).

          Valid setoffs require a mutual debt, i.e., mutuality of obligation.  The debt and claim must be between the same persons.  Because a bankruptcy filing creates a new entity, i.e., the postpetition debtor, the mutual debt requirement may be flunked while a bankruptcy case is active.  For example, a setoff of a postpetition debt (IRS refund owed to the debtor in bankruptcy) against a prepetition claim owed by the prepetition debtor (IRS’s right to unpaid tax) is not a mutual debt.  After a bankruptcy case closes, this issue disappears.  There is no longer an existing bankruptcy case to force a division between events arising pre and postpetition.

               ii.  Did mutuality of obligation exist in Webb?

          The combination of the IRS’s implicit § 1305 election and its setoff of the 2020 refund against the 2019 claim also puts the deemed versus defined concept in play.  If the IRS’s 2019 tax claim is treated as defined, mutuality of obligation exists because the IRS set off a postpetition obligation against a postpetition claim.  This must be how the IRS viewed the world.  Yet, as long as the Debtor has rights in the overpayment, see n.3, supra, this setoff would violate the automatic stay.  11 U.S.C. §§ 1306 and 362(c)(1).  If the 2019 tax refund is treated as deemed, i.e., prepetition treatment under the Debtor’s Chapter 13 plan, mutuality of obligation does not exist.  The IRS set off its postpetition debt against its prepetition claim.   

     3.   Conclusion.

          Judge Bissett is a wise man.  He found the straight-forward answer to the issue at hand.  He wisely and successfully avoided the difficult issues that were lurking beneath the surface. See Webb at n.2 (“the court need not discuss the legality of the IRS’s actions”).

          In lieu of filing an adversary proceeding alleging contempt and depending on the legal analysis one thinks is correct, the Debtor might have sued the IRS for (i) turnover under 11 U.S.C. § 542(b) for failing to pay the tax refund to the bankruptcy estate, (ii) violation of the automatic stay for exercising control over estate property, or (iii) making a setoff without mutuality of obligation.

2021 Year in Review – Cases

Despite the ability to access most courts only remotely for much if not all of the year, 2021 still produced a number of important tax procedure decisions.  Perhaps judges could produce more opinions because they did not need to travel or to hold lengthy in-person trials.  This post shows that not all cases are Graev cases.

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Supreme Court matters

The Supreme Court handed down a unanimous opinion in CIC Services.  The Court holds that the Anti-Injunction Act does not bar a suit challenging an IRS notice that requires a non-taxpayer to provide information even though the failure to provide the information could result in a penalty.  Posts can be found  here, here, here and here.

The Supreme Court rejected the request for certiorari in Organic Cannabis v. Commissioner seeking a determination that the time period for filing a petition in Tax Court in a deficiency case is a claims processing period rather than a jurisdictional one but granted certiorari in Boechler v. Commissioner regarding the same issue but in the collection due process context.  The Boechler case will be argued before the Supreme Court on January 12, 2022.

Circuit Court matters

Coffey v. Commissioner, –F.3d – (8th Cir. 2021)  – in a case that fractured the Tax Court about as badly as it can be fractured, the Eighth Circuit, after initially projecting harmony and uniformity in its decision, fractured as well, reversing its initial decision which overturned the Tax Court’s fully reviewed opinion.  This action briefly reopened the door on the question of adequate filing of a return for purposes of triggering the statute of limitations, before reinstating the original holding through a new opinion by the panel. That new panel opinion can be found here. 

Taxpayers claimed that they were residents of the US Virgin Islands in 2003 and 2004 and filed returns with the Virgin Islands tax authority.  That taxing authority has a symbiotic relationship with the IRS and sent to the IRS some of the documents it received.  The IRS took the documents it received and concluded that M/M Coffey should have filed a US tax return.  Based on that conclusion, it sent the Coffeys a notice of deficiency.  The Coffeys argued that the notice of deficiency was sent beyond the statute of limitations on assessment since their filing with the US Virgin Islands tax authority also served as a filing with the IRS, starting the normal assessment statute.  The government argued that because the Coffeys did not file a return with the US, no statute of limitations on assessment existed.  After only eight years, the Tax Court sided with the Coffeys.  A mere three years later, the Eighth Circuit reversed in a unanimous three judge panel. 

On February 10, 2021, the Eighth Circuit granted a panel rehearing but denied a rehearing en banc.  Disagreements with the outcome of a circuit court usually result in a request for a rehearing en banc rather than a rehearing with the very panel that entered the decision.  So, this is a bit of an unusual twist in a case with many twists. After the vacating of the original opinion, the same panel issued a new opinion with some minor differences.

The result of the Eighth Circuit’s decision allows the IRS to come in many years later to challenge residence of individuals claiming Virgin Islands residence.  If the Coffeys had succeeded in this case, the procedural issue would have turned into a substantive victory, since the IRS would not have been able to make an assessment against them for the years at issue.

Gregory v. Commissioner, — F.3d – (3rd Cir. 2020) – This case was decided at the very end of 2020 so it is included here as it came out during last year’s end of year review and also because it is a case argued on appeal by the Tax Clinic at Harvard so including it provides another opportunity to showcase the work of the students.  The issue before the Third Circuit was whether the taxpayers’ use of Forms 2848 Power of Attorney and 4868 Request for Extension of Time constituted “clear and concise notice” of a change of address to the IRS pursuant to Treasury Regulation §301.6212-2.  Although filed as a non-precedential opinion, the outcome is a clear example of how the IRS cannot simply ignore the actual knowledge it has of a taxpayer’s address when issuing a Statutory Notice of Deficiency pursuant to I.R.C. §6212(b)(1), even if that taxpayer failed to follow the IRS’ prescribed procedures for changing their address. 

An odd ending to this case occurred when the Third Circuit returned it to the Tax Court.  Rather than simply entering an opinion for the taxpayers, the Court issued an order restoring the case to the general docket.  That order made no sense because the Gregorys unquestionably filed their Tax Court petition late.  This required the filing of a motion to have the court make a determination that the notice of deficiency was invalid, which it eventually did with no opposition from an equally confused government counsel.

In Patrick’s Payroll Services, Inc., v. Commissioner, No. 20-1772 (6th Cir. 2021), the Sixth Circuit upheld the decision of the Tax Court denying the taxpayer the opportunity to litigate the merits of the underlying tax because of a prior opportunity to discuss settlement with Appeals.  Guest blogger Chaim Gordon wrote about this case after the Tax Court’s decision and while the case was pending before the Sixth Circuit.  Chaim pointed out some of the novel arguments the taxpayer was making.  Unfortunately for the taxpayer, the Sixth Circuit was not buying what they were selling.

The 11th Circuit upheld the decision of the Tax Court in Sleeth v. Commissioner, — F.3d — 2021 WL 1049815 (11th Cir. 2021), holding that Ms. Sleeth was not an innocent spouse.  The Sleeth case continues the run of unsuccessful taxpayer appeals of innocent spouse cases following the major structural changes to the law in 1998. The Tax Court found three positive factors and only one negative factor applying the tests of Rev. Proc. 2013-34.  Yet, despite the multitude of factors favoring relief in each case, the Tax Court found that the negative knowledge factor required denial of relief.  This case follows the decision in the Jacobsen case from 2020 in which the Tax Court denied relief to someone with four positive factors for relief and only knowledge as a negative factor.  The pattern developing in these cases suggests that the Tax Court views the knowledge factor as a super factor, despite changes in IRS guidance no longer describing it as such.  Only economic hardship seems capable of overcoming a negative determination on knowledge.  In this post, Carl Smith discussed the Seventh Circuit’s decision in the Jacobsen case.  Both cases were argued on appeal by the Tax Clinic at Harvard.  The clinic also filed an amicus brief in the case of Jones v. Commissioner, TC Memo 2019-139, set to be argued soon before the 9th Circuit.

Lindsay v. U.S. is the latest case to apply the principle that United States v. Boyle essentially stands for the position that taxpayers have a nondelegable duty to be aware of tax deadlines. An agent’s incompetence or willful misconduct will not excuse the taxpayer from delinquency penalties.  Lindsay was incarcerated and executed a POA to Bertelson, an attorney, to manage his affairs, including filing his tax returns.  The attorney assured Lindsay he was doing so for the years 2012-15; instead he failed to file the returns and for good measure embezzled hundreds of thousands of dollars. The actions resulted in Lindsay receiving $705,414.61 in actual damages and $1 million in punitive damages.  Lindsay eventually filed his tax returns and paid over $425,000 in delinquency penalties. He filed a claim for refund; IRS rejected and he filed a suit in district court. The district court, contrary to the magistrate’s recommendation, granted the government’s motion to dismiss, citing Boyle as precluding a claim for relief. Following a timely appeal, the Fifth Circuit affirmed. In so doing, it applied Boyle to Lindsay’s somewhat sympathetic circumstances.

Tax Court

In Ramey v Commissioner, 156 T.C. No. 1 (2021), the Tax Court determined in a precedential opinion that when the IRS issues a notice of decision rather than a notice of determination and the taxpayer has filed the collection due process (CDP) request late, the Court lacks jurisdiction to hear the case.  The taxpayer, a lawyer, represented himself and pegged his arguments to last known address rather than jurisdiction.  Nonetheless, the decision expands the Court’s narrow view of jurisdiction to another setting without addressing the Supreme Court precedent on jurisdiction and its impact on the timing of the filing of documents.

Galloway v Commissioner, TC Memo 2021-24: This case holds that a taxpayer cannot use the CDP process to rehash a previously rejected offer in compromise (OIC).  Mr. Galloway actually submitted two OICs that the IRS rejected.  As an aside, from the description of the OICs in the Court’s opinion, the rejections seemed appropriate strictly from an asset perspective, since he did not want to include the value of a car he owned but allowed his daughter to use. 

The case of Mason v. Commissioner, T.C.M. 2021-64 shows at least one benefit of submitting an offer in compromise (OIC) through a request for a collection due process (CDP) hearing.  As part of his lessons from the Tax Court series, Bryan Camp has written an excellent post both on the case and the history of offers. 

Friendship Creative Printers v. Commissioner, TC Memo 2021-19: This case holds that the taxpayer could raise the merits of delinquency penalties by the backhanded method of challenging the application of payments.  Taxpayer failed to pay employment taxes over an extended period of time and failed to file the necessary returns but at some point made payments on the earliest periods.  In the CDP hearing, taxpayer argued satisfaction of the earliest periods and eventually provided an analysis showing payments equal to the tax paid.

The Court treated this as a challenge to the merits of the delinquency penalties imposed.  Unfortunately, the taxpayer did not designate its payments, which meant that the payments it made were not applied in the manner it expected and argued in the CDP hearing.  Taxpayer also looked at the transcripts without appreciating the impact of accruals not reflected in the assessed portion of the transcript but accruing nonetheless.

Reynolds v. Commissioner, TC Memo 2021-10: This case holds that the IRS can collect on restitution based assessments even when the taxpayer has an agreement with the Department of Justice to make payments on the restitution award.  Taxpayer’s prosecution resulted in a significant restitution order. He agreed to pay DOJ $100 a month or 10% of his income.  At the time of the CDP case he was not working and did not appear to have many prospects for future employment. Citing Carpenter v. Commissioner, 152 T.C. 202 (2019), the Tax Court said that the IRS did have the right to pursue collection from him.  Obviously that right, at least with respect to levy, is tempered by the requirement in IRC 6343 not to levy when it would place someone in financial hardship, but no blanket prohibition existed to stop the IRS from collecting and therefore to stop it from making a CDP determination in support of lien or levy. The case is a good one to read for anyone dealing with a restitution based assessment to show the interplay between DOJ and IRS in the collection of this type of assessment, as well as to show the limitations of restitution based assessments compared to “regular” assessments.

BM Construction v. Commissioner, TC Memo 2021-13: This case involves, inter alia, a business owned by a single individual and the mailing of the CDP notice to the business owner rather than the business.  The Tax Court finds that sending the CDP notice to the individual rather than the business does not create a problem here, since the sole owner of the business would receive the notice were it addressed to the business rather than to him personally.

Shitrit v. Commissioner, T.C. Memo 2021-63, points out the limitations on raising issues other than the revocation of the passport when coming into the Tax Court under the jurisdiction of the passport provision.  Petitioner here tries to persuade the Tax Court to order the issuance of a refund but gets rebuffed due to the Court’s view of the scope of its jurisdiction in this type of case.

The case of Garcia v. Commissioner, 157 T.C. No. 1 (2021) provides clarity and guidance on the Tax Court’s jurisdiction in passport cases as the Court issues a precedential opinion to make clear some of the things that can and cannot happen in a contest regarding the certification of passport revocation.  I did not find the decision surprising.  The Court’s passport jurisdiction is quite limited.  Petitioners will generally be disappointed in the scope of relief available through this new type of Tax Court jurisdiction. 

Other Courts

In Mendu v. United States, No. 1:17-cv-00738 (Ct. Fd. Claims April 7, 2021) the Court of Federal Claims held that FBAR penalties are not taxes for purposes of applying the Flora rule.  In arguing for the imposition of the Flora rule, the taxpayer, in a twist of sides, sought to have the court require that the individual against whom the penalties were imposed fully pay the penalties before being allowed to challenge the penalties in court.  The FBAR penalties are not imposed under title 26 of the United States Code, which most of us shorthand into the Internal Revenue Code, but rather are imposed under Title 31 as part of the Bank Secrecy Act.

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