Lien Priority Litigation

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

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

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

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

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

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

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

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

Debtors Still Trying to Fight Against One Day Rule

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

New Circuit Precedent on Issue of Litigating Tax Merits in Bankruptcy

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

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

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

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

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

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

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

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

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

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

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

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

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

The Surprise Bill – Interest Due after Bankruptcy

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

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

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

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

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

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

Timely Filing Issues in Bankruptcy Court

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Count Days BEFORE Filing for Bankruptcy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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