Tracing Social Security Payments          

Social security funds provide a safety net for recipients and generally receive protected status from creditors.  The case of In re Weber, 130 AFTR2d 2022-5161 (Bankr. M.D. Fla. 2022) examines what happens to social security payments when the taxpayer uses them to pay federal income taxes and then receives a refund partially based on the social security payments.  The bankruptcy court allowed Mr. Weber to shield the portion of his tax refund which represented the return of his social security payments citing to 42 USC 407.  The decision speaks to the power of the exemption of social security funds from private creditors.


Mr. Weber filed a chapter 7 bankruptcy petition in February of 2022.  At issue is his 2021 income tax refund which the trustee seeks to claim as an asset for the benefit of the general unsecured creditors of the bankruptcy estate.  Mr. Weber argues that a substantial portion of the refund resulted from his decision to have money withheld from his monthly social security payments to pay federal taxes.  He overestimated what his federal tax obligation for 2021 would be for reasons not explained in the opinion.  Mr. Weber’s position is that just because he had a portion of his social security payment used to pay an anticipated federal tax liability did not change the character of the funds to such a degree that they lost the protection afforded to social security payments.

You might ask why Mr. Weber had any taxes withheld from his social security payments.  The opinion indicates that he had a part time job as an employee.  The income from that job in 2021 was only $378.00 per month.  Based on that level of income, he would not have triggered any of his social security payments to become taxable, and he could have used wage withholding from the job to cover any taxes from his employment.  The facts suggest that his decision to withhold from his social security in 2022 was unnecessary.  We are not given information about prior years when his wages could have been higher and could have come from work as an independent contractor rather than an employee.  Higher income could have triggered tax on a portion of his social security payments making the withholding of a portion of the payment logical.  If he worked as an independent contractor, he might have found it simpler to have some of this social security payments withheld than to make quarterly estimated tax payments.  We just don’t have enough information to evaluate his thought process in having the withholding.  We do know that he overwithheld from his social security payments and that a significant portion of his 2021 refund resulted specifically from that withholding.

The trustee argued that once Mr. Weber’s social security payment went to the IRS as withholding for payment of taxes it lost its character as a protected social security payment and transformed into simply a tax payment the refund of which the trustee could reach for the benefit of the estate.  The trustee’s position is supported by the decision of the bankruptcy court in In re Crutch, 565 B.R. 36 [119 AFTR 2d 2017-1428] (Bankr. E.D.N.Y. 2017).

The bankruptcy court in Mr. Weber’s case stated:

Under 42 U.S.C. § 407, social security benefits are not subject to execution, levy, attachment, garnishment, or other legal process, and no other provision of law may limit or modify the exemption from execution except by express reference to the statute.

It acknowledged the Crutch decision but cited to another bankruptcy court decision, In re Spolarich, 2009 WL 10267351 (Bankr. N.D. Ind. Sept. 30, 2009), which it found more persuasive.  The court in Spolarich found the protection for Social Security payments exceptionally expansive and only subject to modification by express statute.  It determined that when a social security recipient uses a portion of that payment for tax withholding, the individual’s consent to the use of those funds extends only to the payment of tax liabilities and not to the payment of other claims stating:

[B]y the clear language of 26 U.S.C. §§ 3402(p)(1), the election to withhold [funds from social security payments] benefits only the Internal Revenue Service, and does not constitute a general waiver of the protections of § 407(a) with respect to Social Security benefits vis-à-vis other entities.

The bankruptcy court in Mr. Weber’s case agreed with the analysis in Spolarich and allowed him to exempt that portion of his 2021 tax refund traceable to the withholding of his social security payments.

We have discussed tracing of payments exempt from IRS levy in several posts.  This post written by Les discusses the issue and links to earlier post which also discussed the character of a protected payment once moved to an unprotected source. The issue of tracing arises in many contexts.  While the language of the social security statute may be particularly strong, the analysis here may be useful in other settings.  The policy issue of when a protected payment loses its special status is one worth considering.  If the Weber court got it right should the language of 42 USC 407 serve as a model for other statutes in which taxpayers receive payments protected from levies?  Can Weber assist taxpayers trying to fend off a levy to their bank account find assistance from the approach here?

Court Awards Damages When IRS Tried To Collect Following Discharge: Pandemic No Excuse

McAuliffe v United States involves IRS mistakenly sending collection letters following a bankruptcy discharge. Following bankruptcy, IRS opens itself up to damages claims if an IRS employee willfully violates the effect of a discharge or an automatic stay.

McAuliffe concludes that the pandemic does not excuse the IRS from failing to update its records; nor does the automatic nature of the collection process, which arguably severed the actions from any one misbehaving IRS employee. While the opinion finds the IRS actions willful, it notes that unlike with other misbehaving private creditors who fail to respect a discharge, the court has little discretion over the amount of damages it can award.


In McAuliffe the husband and wife were co-debtors in a Chapter 13 case they filed in 2016. The IRS asserted a claim for $13,624.58 relating to tax years 2010 and 2011, of which $7,230.78 was secured. Prior to the bankruptcy, the taxpayers had entered into an installment agreement, but as per the Chapter 13 case, they terminated the agreement and paid the debts through their repayment plan. The taxpayers/debtors received a discharge on September 24, 2019. As an unsecured creditor, the IRS received a 22% distribution on the $6,393.80 unsecured portion of the claim.

Things went awry after the discharge. On February 5 and March 4, 2020, the IRS sent the McAuliffes two demand letters seeking to collect the liabilities from the discharged 2010 and 2011 tax years. On March 20, 2020, Mr. McAuliffe, a bankruptcy attorney, sent the IRS a letter addressed to the IRS’s Cincinnati Service Center advising the IRS of the discharge. On August 15, 2020, the McAuliffes received another IRS collection letter, leading to their filing a motion to reopen the bankruptcy case.

The IRS did eventually acknowledge McAuliffe’s March 2020 letter, with a September 29, 2020 letter stating it would need sixty days to review the liability. Despite the letter stating that IRS needed to review the account, on September 28, 2020, IRS actually abated the assessment.

In addition to the liabilities that were covered by the discharge, the McAuliffes also owed on their 2018 tax year. The taxpayers asserted that the IRS’s mistaken belief that the McAuliffes still owed for the discharged years led to a delay in setting up an installment agreement for the 2018 liability, which led the IRS to issue a soft notice of intent to levy, threatening to seize state tax refunds.

What led to the delay in updating its account to reflect the discharge and the six-month delay in responding to McAuliffe’s March 2020 letter? IRS blamed the combination of COVID and McAuliffe sending the correspondence to the Cincinnati Service Center rather than a bankruptcy specialist.

All of this factual background leads to the main issues in the case: whether the IRS is liable for damages and if so, how much?

Is IRS Liable for Damages?

In light of the IRS actions, the debtors reopened the bankruptcy case, and sought damages under Section 7433(e) for the IRS’s mistakes. That case was stayed pending a possible administrative resolution. The IRS and the McAuliffes failed to resolve the matter within six months, teeing the matter up for the bankruptcy court.

To find a violation of 7433(e) a debtor must show by clear and convincing evidence that the IRS “had knowledge [actual or constructive] of the discharge and willfully violated it by continuing with the activity complained of.”  IRS raised a number of arguments in support of its position that the actions were not willful.

First, IRS argued that the court needed to find that a specific employee willfully violated the discharge order, rather than the entity as a whole.  Moreover, IRS, in arguing that there was no willful violation, cited to cases where courts concluded that clerical errors alone were insufficient to justify finding damages:

The IRS’s attempts to characterize the actions here as “inadvertent” in light of these cases is unpersuasive. While the IRS here failed for nearly twelve months to enter the discharge in its systems, the debtors on their own behalf called and mailed multiple notices to correct the issue. The IRS instead disregarded these warnings and continued direct attempts to collect the discharged debts.

The opinion also rejected the IRS’s attempt to deflect blame by pointing to the taxpayer’s failure to contact an IRS bankruptcy specialist rather than the IRS office that issued the collection letters:

It contravenes common sense to require a debtor who receives a notice from Cincinnati to direct a response to a Richmond office involved in the bankruptcy claim filed four years prior rather than responding directly to the office from which he received the communications.

The IRS then argued that its automatic collection notices should not be viewed as collection action, a contention the court rejected:

The IRS contends that these letters were non-threatening and should not be seen as an attempt to collect. This court disagrees. The letters state a monthly payment due immediately and threaten default if no payment is made. Further, none of the letters included a disclaimer that they are not an attempt to collect. This surely gives the appearance of an attempt to collect, whether sent to a layperson or a well-experienced bankruptcy attorney and his spouse. The court agrees with the Plaintiff that these letters serve no purpose other than to collect discharged personal liabilities.

IRS also argued that the automatic nature of the notices removed them from any one IRS employee, and thus should insulate the agency from sanctions designed to punish the agency for its employee’s misconduct:

The IRS is a federal agency within the executive branch and serves an extremely important mission. If employees and automated systems in the Cincinnati office are disconnected from the interactions of other offices, the resulting shortcomings should not be attributed to the affected Plaintiff, but to the agency responsible.

As to COVID, the court was sympathetic, but noted that there was plenty of time following the discharge and before the pandemic hit for IRS to get the taxpayers’ account fixed:

While COVID-19 is having a significant impact on all levels of the federal government, it does not excuse repeated attempts to collect on a Plaintiff doing everything possible to correct any miscommunications. At the time when the serious impacts of the COVID-19 pandemic reached the United States in March 2020, the Plaintiff was nearly six months post-discharge and the IRS still had not properly applied the discharge order to the couple’s federal tax accounts. Further, the IRS had already mailed the first two automated notices.

While perhaps one mistaken notice might not have led to a finding of liability, the repeated notices that lasted almost a year after discharge, combined with multiple taxpayer attempts to halt the collection action, led the court to conclude that the IRS’s actions were willful.

What Damages?

McAuliffe sought court costs and legal fees and damages relating to the unlawful collection attempts. The court noted that Section 7433 is the exclusive remedy for IRS failure to respect a discharge order, unlike that for other creditors, where the bankruptcy code provides more discretion. Under 7433(e), courts generally look to actual pecuniary damages, plus costs and possibly legal fees, but the awarding of fees under Section 7433 is controlled by Section 7430. (Note that Saltzman and Book, IRS Practice & Procedure, courtesy of Keith, has an extensive discussion of damages relating to wrongful collection).

As to legal fees, Mr. McAuliffe represented his wife in the proceeding, and did not charge her for the representation. He had previously been a party to the reopened bankruptcy case, but as the opinion notes, he dismissed himself as a party on the eve of the evidentiary hearing. He likely did so due to McPherson v US, unfavorable Fourth Circuit precedent under Section 7430, which bars recovery of legal fees for pro se litigants.

Instead, Mr. McAuliffe argued that he should be compensated because after his dismissal his representation of his wife resulted in lost business opportunities due to the time spent representing his wife. He also sought to distinguish the precedent that barred recovery from pro se litigants because following his dismissal he was technically no longer a pro se litigant.

The court found the lost opportunity argument too speculative, and in so doing noted that unlike cases more liberally awarding of fees purely under the bankruptcy code, its hands were tied:

The court realizes the annoyance and outright inconvenience that the Plaintiff and her husband may have suffered as a result of the IRS’s disregard for the discharge order (whether intentional or inadvertent), but any discretion which it would otherwise be afforded by the Bankruptcy Code is severely limited by relevant Tax Code provisions herein referenced.

As to his attempt to distinguish the adverse legal fee precedent, the court did not bite:

Put simply, McPherson is binding precedent in this circuit. While McAuliffe argues that the opinion applies only where an attorney seeks compensation for pro se representation, this conflation is misplaced. This court does not read the statute to apply solely to pro se representation, but applies it more broadly to the situation where the challenger seeks recovery of legal fees and no out of pocket legal expenses are incurred. Assuming for purposes of this analysis that the IRS’s position was not substantially justified, the Plaintiff nevertheless did not pay any out-of-pocket costs which would allow recovery of legal fees under 26 U.S.C. § 7430 and the precedent established in this circuit by McPherson.

As to other damages, McAuliffe argued that they felt pressure from the IRS’s issuance of notice of intent to levy relating to another year’s tax liability, leading them to accept the first offer on the sale of their house for an amount $15,000 less than its market value. The sale of the house occurred in 2021, a year after the IRS abated the assessment and unwound its mistaken failure to reflect the discharge. While it is likely that the IRS errors on the discharged debt may have led to a delay in a later year installment agreement, “the home sale a full year after the abatement is too distant in time and nature to attribute any possible damages to the discharge violation.”

The court did award the McAuliffe’s damages relating to interest and delinquency penalties on their 2018 liability. Despite 2018 not being before the court, the opinion notes that the mistake to respect the discharge of 2010 and 2011 liabilities led the IRS to be “uncooperative with the couple and unwilling to enter into any such agreement until approximately nineteen months after the original request was made. For eight months beyond the initial request (and more than a year past the discharge order) this uncooperativeness was attributable, in part or in whole, to the mistaken belief that the debtors still owed debts from 2010 and 2011.”

IRS argued that he 2018 debt was outside the court’s jurisdiction and subject to the Anti-Injunction Act.  The court disagreed, noting that it was not restraining the assessment or collection of the 2018 liability but finding that “any interest and missed payment penalties accrued from the initial March 2020 notice letter until the IRS’ eventual acceptance of the couple’s settlement offer are actual pecuniary damages that resulted from the IRS’s violation of the discharge order.”  The delay, according to the court, resulted in about an additional $500 in interest and delinquency penalties, which the court awarded to McAuliffe.


The McAuliffe opinion is interesting on a number of levels. The opinion discounts the government’s excuses for its mistakes. The court expects the multiple IRS offices involved with the case to communicate with each other. The court squarely rejects the IRS attempt to lean on the automated nature of the collection process to avoid liability, and it holds the IRS responsible for its delay when the taxpayers tried in good faith to inform the IRS that its actions were mistaken. While COVID complicates the question of fault, there were enough IRS mistakes prior to the pandemic to justify a finding of liability.

At the end of the day, McAuliffe walked away with not much in damages, and I suspect that case was brought mostly for the denied recovery of legal fees. While maybe it will not make the McAuliffes content, the opinion reflects judicial disapproval of the IRS and a shared frustration that the IRS should have done better.

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

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

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

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


1. Applicable Law

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

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

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

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

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

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

2. Factual Background

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

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

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

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

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

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

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

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

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

3.  Briggs, Sr.

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

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

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

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

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

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

5. Lagniappes

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

General Discharge Denial in Chapter 7 Based on Taxes

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A New Twist on What Constitutes a Tax Return

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


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

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

The fax cover sheet transmitting Form 4549-A stated:

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

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

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

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

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

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

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

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

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

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

The Train Tracks

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


The Impasse

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

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

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

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

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

The Family

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

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

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

Discharging Student Loan Debt

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


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

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

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

1. An intervening change in the law,

2. Consideration of newly discovered evidence, or

3. To correct clear error or prevent manifest injustice.

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

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

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

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

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

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

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

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

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

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

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

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