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 Outdated language referencing the non-existent “Chief, Local Insolvency Unit” role remains in the current version of the CFR.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.

 

Suspending the Priority Claim Period and an Update on Clothier v. IRS

On August 17, 2018, I wrote about the bankruptcy case of Clothier v. IRS which held that a debtor’s prior bankruptcy did not suspend the time period for the IRS to retain priority status. I will come back to that case in a postscript to this post. Clothier involved the issue of whether a taxpayer’s prior bankruptcy case tolled the time for the IRS to claim priority status. The case of Tenholder v. United States, No. 3-17-cv-01310 (S.D. Ill. 2018) looks at the same issue but examines a different basis for tolling – a Collection Due Process (CDP) request. The district court, affirming the decision of the bankruptcy court, concludes that taxpayers’ CDP request did toll the time period for claiming priority status.

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Debtors filed a chapter 7 petition on December 30, 2015. At issue in this discharge litigation is tax year 2011. Debtors requested an extension of time to file their 2011 return making the return due date October 15, 2012. That extended due date falls more than three years before the date of their bankruptcy petition. As such, the priority claim provision of BC 507(a)(8)(A)(i) did not apply nor did the other two rules that allow the IRS to file a priority claim for assessments within 240 days of the bankruptcy petition and for taxes not yet assessed but still assessable. So, the IRS sought to hold open the three years from the extended due date for filing by resorting to the flush language added to the end of 507(a)(8) in the 2005 legislative changes.

That language provides:

An otherwise applicable time period specified in this paragraph shall be suspended for any period during which a governmental unit is prohibited under applicable nonbankruptcy law from collecting a tax as a result of a request by the debtor for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior case under this title or during which collection was precluded by the existence of 1 or more confirmed plans under this title, plus 90 days.

Applying this language suspends the three year period for 207 days in the debtors’ case because that was the time between their CDP request on July 22, 2013, and the end of the CDP hearing on February 14, 2014. In addition to the 207 days, the flush language also tacks on an additional 90 days. Adding 297 days to the end of the period three years from the extended due date of October 15, 2015, yields a date of August 7, 2016. Since debtors filed their bankruptcy petition prior to August 7, 2016 the IRS filed its claim for 2011 as a priority claim. Based on its claim of priority status for 2011, the IRS argued that the debt was excepted from discharge by BC 523(a)(1)(A).

Debtors disagreed with the application of the flush language because the language of the paragraph says taxes for “which a governmental unit is prohibited under applicable non-bankruptcy law from collecting a tax.” Debtors acknowledge that the IRS could not levy while their CDP case was pending but argued that the IRS could offset or could bring a collection suit while the CDP case was pending and, since it was not totally prohibited from collecting, the flush language does not apply to suspend the priority period.

Debtors were not the first to make this argument. At least three prior cases addressed the same issue but the district court did its own analysis of the provision. It found IRC 6330, the CDP provision, was a non-bankruptcy law prohibiting collection. The court disagreed with debtors’ argument that the language provided a clear statement requiring broad prohibition of any type of collection and agreed with the argument of the IRS that the statute does not say all collection and it clearly covers the collection prevented by a CDP hearing. In holding for the IRS the court found the language of the statute ambiguous but the legislative history clear in its intent to cover the CDP situation. As a result it found that debtors filed within the period during which the IRS could claim priority status. This decision aligns with the prior decisions interpreting the language of this paragraph.

The harsh result here points to the care that a debtor must take in choosing the timing of a bankruptcy petition where discharge of a tax for a specific year serves as the goal of the filing of the bankruptcy petition. Had the debtor realized the impact of the filing of the CDP request, and assuming no other factors drove the timing of the filing of the petition, the debtor could have realized the discharge of this tax debt by simply waiting a little longer to file.

This brings us back to the Clothier case which raised a similar issue of timing but did not discuss the flush language of 507(a)(8) added in 2005. As I mentioned in the earlier post about Clothier, the Court’s decision essentially overturned the Supreme Court’s decision in Young v. United States, 519 U.S. 347 (1997).

Following the post, I received an email from Ken Weil in Seattle who specializes in bankruptcy and tax matters citing me to the hanging paragraph at the end of 507(a)(8). Ken’s cite to this part of 507 is perfect because in this hanging paragraph Congress codified the decision in the Young case. I am getting too rusty on bankruptcy and should have questioned in my post why the government did not vigorously argue this language.

Coincidentally, I had a conversation with someone familiar with the case who informed me that the case was argued by an assistant United States Attorney rather than a Department of Justice Tax Division attorney. The AUSA would not be as familiar with tax issues in bankruptcy and did not cite the court to the hanging paragraph. So, the judge missed it as well.

We have not yet confirmed that the IRS appealed the Clothier decision. I expect that it will and that the outcome of the decision will change. We will see.

 

 

Proper Treatment of Earned Income tax Credit in Calculating Disposable Income

In Marshall v. Blake, 885 F.3d 1065 (7th Cir. 2018) the Seventh Circuit accepted a certified appeal from the bankruptcy court and ruled that taxpayer’s earned income credit refund (EIC) could be prorated over the year. Both the procedure for certification of bankruptcy appeals and the method for calculating disposable income provide useful procedural information.

Before discussing the issues raised in the opinion, I would like to point out a related issue that bothers me in offer in compromise (OIC) submissions. The IRS pre-printed OIC contract permits the IRS to retain the debtor’s refund for the year in which the IRS accepts the OIC. This includes the EIC refund. In many cases, even if the IRS allowed taxpayers to keep their refunds and added the prorated amount to a taxpayer’s monthly income, monthly expenses will still exceed projected income.  The EIC refund seeks to lift the taxpayer out of poverty. It is not a refund of funds withheld. Taking the refund hurts the children of the taxpayer as much as or more than the taxpayer. Many families rely on the EIC to purchase everyday items, as indicated by a recent Federal Reserve analysis. The analysis tracked retail sales following the 2017 congressionally mandated delay in tax refunds for EIC claimants. It noted that retail sales were much lower than previous years during the period in which refunds are typically issued, but peaked once the EIC was finally released. For a more detailed analysis, see Elaine Maag’s recent blog post. I think the IRS should not require offset of the taxpayer’s refund generated by EIC where the debtor’s schedules show allowable expenses in excess of income but should allow a refund recoupment bypass as cryptically described in IRM 5.19.7.2.21.  Allowing the taxpayer to retain future refunds under these circumstances, makes economic sense because of the purpose of the credit. Taking the EIC portion of a taxpayer’s refund where the schedules demonstrate its need to meet basic living expenses just seems wrong. The Seventh Circuit shows a better way.

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The trustee in the chapter 13 bankruptcy case seeks to have debtor turn over her entire refund each year to fund the plan. The debtor, a low-income wage earner, single mom living in subsidized housing with three dependent children, argues that the court should allow her to retain the portion of her refund attributable to the earned income tax credit allocating a portion of the credit each month to offset her reasonably necessary expenses. Her annual income of $30,000 falls well below the median income for a family of four in Illinois. In her schedules she included a pro rata share of her anticipated EIC. Doing this and subtracting payroll deductions and allowable expenses created for her the ability to pay $120 a month toward her chapter 13 plan.

The chapter 13 plan explicitly laid out her proposed use of the refund each year attributable to the EIC. The trustee filed a motion to dismiss the case for failing to correctly list her income and expenses. The trustee argued that the court should not confirm the plan because it failed to commit all of the debtor’s projected disposable income since it called for her to retain a portion of her annual refund. The debtor argued that the EIC should not count as income under the bankruptcy code. The bankruptcy court allowed the debtor to confirm a plan with a prorated version of annual income that would have her offset expenses throughout the year in a manner that would have her keep most or all of the EIC portion of the refund.

The court noted in its confirmation order that the debtor sought to purchase beds and furniture for her two 19 year old sons who had previously slept on air mattresses. The plan also proposed purchasing dressers for their bedroom which they previously did not have. These types of purchases created “a pretty skinny budget overall.”

The trustee moved for a direct appeal to the circuit court. The debtor objected. The normal path to the circuit court would involve a stop at the district court or a bankruptcy appellate panel; however, a direct appeal can occur in certain circumstances and the majority of the panel at the 7th Circuit citing 28 USC 158(d)(2)(A)(i) agreed that certification to the circuit “was appropriate because there is no controlling decision from the Supreme Court or the Seventh Circuit as to whether tax credits are disposable income under the Bankruptcy Code.”

Although the parties had argued in the bankruptcy court about whether to characterize the EIC credits as income, the circuit court recast the issue by focusing on the language of the bankruptcy statute. It looked at BC 1325(b)(1) which defines disposable income and BC 101 which defines “current monthly income.” It found that current monthly income includes the monthly income from all sources that the debtor receives “without regard to whether such income is taxable income.” The Seventh Circuit also looked at case law in reaching the conclusion that “Congress intended for the [EIC] to be included in the calculation of income.”

More importantly, however, the court found that just because current monthly income includes the EIC refund received by the debtor, that does not mean that the debtor must pay the entire refund to the trustee because the real issue in this case involves how the EIC works when calculating projected disposable income. The court noted that several bankruptcy courts in its circuit used the same calculus used by the bankruptcy court and allowed debtors to prorate future expense on which the debtor would spend the refund as long as such expenses met the reasonably necessary test.

The Seventh Circuit found that the holding here fits with the Supreme Court’s interpretation of projected disposable income. In Hamilton v. Lanning, 560 U.S. 50 (2010) the Court adopted a forward-looking approach to the question. It provided several reasons for approaching this issue with flexibility. It looked to the ordinary meaning of projected. The Supreme Court found that the mechanical approach adopted by the trustee in that case clashed with the provisions of BC 1325 and would produce senseless results in cases in which the debtor’s income during the six month lookback period was “substantially lower or higher than the debtor’s disposable income during the plan period.” Here, the bankruptcy court’s flexible approach aligned with the approach used by the Supreme Court.

The trustee argued that prorating the annual refund to a monthly amount artificially inflated the debtor’s income; however, the Seventh Circuit found that nothing in the bankruptcy code requires that current monthly income “is limited to income that is received on a monthly basis.” Rather, the bankruptcy code defines current monthly income as “the average monthly income from all sources that the debtor receives’ during the six-month lookback period.” The court describes the trustee’s objection to the plan as one driven by the fact that it allows the debtor to deduct reasonable expenses which reduces the amount that the debtor could use to fund plan payments.

The Seventh Circuit also found that allowing confirmation of this plan meets the good faith requirement of BC 1325(a)(3), that it meets the feasibility requirement in 1325(a)(6), and that it promotes the purposes of chapter 13. The dissenting opinion on the circuit court did not object to the holding on the merits but expressed concern that the case did not meet the criteria for direct appeal from the bankruptcy court.

The opinion avoids rigid treatment of the EIC just because it comes once a year. Though the court did not mention this, the EIC was available throughout the year prior to 2010 when Congress discontinued that option apparently because of the low uptake on the monthly option and the higher cost to employers. The impact allows debtors to project the true cost of their expense on an annual basis rather than treating the once a year payment as some sort of special payment that does not relate to the annual expenses. I would like to see the IRS adopt this approach in the treatment of OICs which have very similar considerations.