General Discharge Denial in Chapter 7 Based on Taxes

March 21, 2022 by Leave a Comment

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  In the case of Kresock v. United States, 128 AFTR 2d 2021-6995 (BAP 9th Cir.)(unpublished), the bankruptcy appellate panel sustains the decision of the bankruptcy court denying Mr.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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Filed Under: Bankruptcy, Fraud

Attorneys Behaving Badly

February 3, 2022 by Leave a Comment

A Tax Court press release noting suspensions and disbarment came out on the heels of the 9th Circuit sustaining the conviction of a former IRS Chief Counsel attorney for tax evasion.  Like a moth drawn to a candle, I could not resist reading about these situations.  The criminal case raises a statute of limitations issue while the cases in the press release provide pretty standard fare for discipline received.  Aside from closely following the criminal case of former Tax Court Judge Kroupa and occasionally reporting on Tax Court disciplinary matters, here, here and here, we leave these types of discussions to Jack Townsend and his excellent Federal Tax Crimes Blog which focuses on this area of the law and brings his expertise to bear.  He blogged the Orrock case on January 27, 2022 for anyone wanting his take on the case.

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In United States v. Orrock, D.C. No. 2:16-cr-00111-JAD-DJA-1 (9th Cir. 2022) the taxpayer concealed the sale of real property he controlled.  He did not report the sale on his personal return and belatedly disclosed the sale in the return of a partnership where he significantly underreported the amount of the sale.  From reading the Ninth Circuit opinion, the case looks like a rare prosecution of a single transaction.  Most tax evasion cases involve a pattern ,not because it’s necessary for the IRS to establish a pattern, but because establishing a pattern knocks out the defense of the mistaken treatment of a single item or a single year.  Because of the background of the defendant, a single event or single year case becomes easier to sell.

I don’t teach criminal tax but in the clinic I do spend a few minutes on criminal tax provisions each semester because inevitably some client has done something that could give rise to criminal tax prosecution.  The students, and possibly the client, have concerns which we must take seriously, but I also explain to the students the types of factors that go into the consideration of which taxpayers to prosecute among the many people the IRS could choose.  I let them know that the IRS would very much like to prosecute Harvard lawyers because that brings good publicity but would not be as interested in low income taxpayers both because the sentencing guidelines will generally not produce much of a sentence and the appearance of prosecuting individuals who are struggling economically.

The basis for Mr. Orrock’s appeal of his conviction rests on an argument that the IRS took too long to bring the case and not that the IRS failed to prove the offense.  I thought that the timing issue he raises was settled and Jack’s post indicates that he did as well.  The specific issue is the date from which the statute of limitations to bring the prosecution runs.  Mr. Orrock argues that it runs from the date of the filing of the fraudulent return.  He is certainly right that it runs from that date and based on that date the IRS brought its case against him too late.  The problem, however, is that the date to bring a prosecution of this type also runs from the date of each affirmative act of evasion and he committed an affirmative act of evasion after filing the return and that act restarted the statute of limitations.

On the civil side, the act of evasion in filing the return would create an unlimited statute of limitations to assess so you don’t get into the issue of subsequent affirmative actions.  On the civil side, subsequent acts of contrition, like filing an amended return properly reporting the tax liability, don’t restart the statute of limitations as the Supreme Court explained in Badaracco v. Commissioner, 464 U.S. 386, 394 (1984).  The Orrock case highlights the fact that once you start with a fraudulent return things can go very bad.  While in the criminal context the fraudulent return does not create the same unlimited statute of limitations for criminal prosecution that the fraudulent return creates for civil assessment, it’s still possible to create a long period for the criminal prosecution statute of limitations to run because subsequent affirmative acts often take place.

The Tax Court’s January 24, 2022 press release describes the suspension of two attorneys and the disbarment of a third.  In each case the attorney’s problem arises not from actions taken in a case before the Tax Court but from collateral disciplinary action stemming from action taken by their state bar.  The Tax Court attaches the relevant order it issues with respect to each individual.  The orders set out the path that led to the action by the Tax Court.  If you are the subject to disciplinary action by the state bar or the bar of another court, you have a duty to notify the Tax Court within 30 days.

I don’t know how many people in this situation actually report the disciplinary action to the Tax Court within that period though I suspect that’s a small number, and I don’t know how the Tax Court finds these cases, but I do know from reading enough of these orders over the years that the Tax Court takes it seriously.  Read the press release if you want the more details on the cases.  When the Tax Court’s action simply follows as a collateral matter, the lurid details require going further down the chain.  If it weren’t tax filing season, I would expect a comment from Bob Kamman providing those details in the near future on any of the cases with especially interesting fact situations. 

Filed Under: Criminal Penalties, Fraud, Tax Court

Nominees

July 30, 2021 by Leave a Comment

Several years ago I wrote a post providing a general explanation of nominee liens in discussing two decisions.  Christine wrote an excellent post on a case that had an income tax twist to the nominee situation, but she also expanded my discussion of the nominee lien doctrine.  The case of United States v. Simones, No. 1:20-cv-0079 (D. N.M. 2021) provides a look at nominee lien cases from the perspective of the nominee rather than the person creating the purported nominee situation.  The Simones case is short, yet it still provides an important point for those the IRS tags as nominees.

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Nominee liens occur when the IRS believes that a taxpayer has transferred property to a third person(s) in an effort to prevent the IRS from collecting the tax from the transferred property.  The person allegedly holding the property for the taxpayer is the nominee.  A nominee case will exist because a revenue officer assigned to the taxpayer’s account believes the taxpayer has transferred the property but retained an ownership interest.  The revenue officer will prepare a case and send it to Chief Counsel for approval before being allowed to file the nominee lien.  Some cases provide a clear picture of nominee status, such as when a taxpayer transfers property but continues to reside there, pay the mortgage, utilities, etc., and some will be much less clear.

The opinion is quite brief and does not provide background information concerning the tax debt or the creation of the nominee situation.  The information presented does not allow a reader to draw conclusions regarding the likely or appropriate final outcome here.  It explains that the taxpayer owes $276,283.56 and that the IRS asserts that the taxpayer fraudulently transferred property to the Ancient of Days Trust.  The case involves an effort by the nominees to extract themselves from a suit brought by the IRS.  The IRS sued to reduce the liability to judgment against the taxpayer and the trust; to obtain a judgment that the trust holds title to property as a nominee of the taxpayer which property is encumbered by the federal tax lien; and to set aside the conveyances of property from the taxpayer to the defendants as a fraudulent conveyance.

When the IRS brings a suit of this type it almost always has a count seeking to reduce the liability to judgment.  Doing so takes little additional effort and provides the IRS with much more time to collect the tax liabilities.  See the discussion of the benefits to the IRS of obtaining a judgment here.  This part of the case does not involve the nominees except to the extent that the IRS seeks a judgment against the trust.

The second reason the IRS brings this suit is to set aside the record title of the property showing that the trust is the record owner.  This is a natural part of any nominee suit.

The third part of the suit seeks to set aside the conveyance of property to the nominees and to the trust.  Two of the three nominees challenge the suit against them, arguing that the court lacks subject matter jurisdiction and that the IRS lacks authority to assert claims against them.  The court disposes of their argument in two sentences:

[F]ederal district courts have original jurisdiction over “any civil action arising under any Act of Congress providing for internal revenue,” 28 U.S.C. § 1340, as well as “all civil actions, suits or proceedings commenced by the United States,” 28 U.S.C. § 1345. Moreover, this court has jurisdiction to issue orders and render judgments “as may be necessary or appropriate for the enforcement of the internal revenue laws.” 26 U.S.C. § 7402(a).

It does not take the court much effort to let the nominees know that the IRS does indeed have a right to bring an action against them.  That does not mean that it will win and prove that they are nominees of the taxpayer, but that on the basic issue of the authority of the IRS to initiate the action there is little to discuss or debate.

The opinion does not discuss it, but prior to the filing of this suit, the IRS almost certainly filed nominee liens against the individuals it has named as nominees in the suit.  It did this to tie up the property while it works to clean up the title so it can be sold for the highest price.  The nominee lien, unlike the regular federal tax lien, will list the specific property covered by the nominee lien and will not attach to all of the property owned by the nominees.  Nonetheless, it will cause the nominees to have to explain the lien to anyone from whom they seek to borrow.  They will also need to explain the existence of the suit itself.  Serving as a nominee for someone seeking to make a fraudulent transfer does not come without downsides.  Frequently, the friends or relatives who agree to serve as a nominee fail to appreciate the potential costs of that action.

Lavar Taylor has discussed in prior posts, two of which are found here and here, the inability of nominees to avail themselves of collection due process.  This means that unless an individual targeted by the IRS as a nominee can convince the IRS informally that they are not nominees, they face the likelihood of being named in a suit such as this and forced to litigate in order to prove they are not serving as nominees.  They have no formal path to an administrative decision.  Because all nominee liens require approval by Chief Counsel, alleged nominees with a good legal argument seeking to avoid getting caught up in litigation might seek a conference with the attorney in Chief Counsel’s office who approved the nominee lien in an effort to convince that person that nominee status does not exist and to provide information that the revenue officer making the nominee referral to Chief Counsel may have failed to provide.

Filed Under: Collection Due Process, Federal Courts - Jurisdiction, Fraud, Lien

Imposing the Fraud Penalty after Prosecution While Satisfying IRC 6751(b)

July 23, 2020 by 3 Comments

In Minemyer v. Commissioner, T.C. Memo 2020-99 the Tax Court determined that the IRS failed to prove it made a timely approval of the fraud penalty and determined that the IRS could not assess the penalty in this case.  Because Mr. Minemyer had the fraud penalty imposed after a successful prosecution of him for tax evasion under IRC 7201, I found the application of IRC 6751(b) here produced a surprising result, though I cannot say the decision is incorrect and sympathize with any effort to parse through the language of this statute.  The Tax Court seeks to enforce a bright line rule even though the circumstances of this case which follows a criminal conviction present a somewhat different situation than the ordinary imposition of a civil penalty

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In a case like this, IRS policy ties the hands of the revenue agent and the immediate supervisor making the imposition of the fraud penalty against Mr. Minemyer a foregone conclusion.  In some respects, the imposition of the penalty here acts somewhat like the penalties imposed by computer because the IRS imposes the penalty automatically by virtue of its policy and not imposing the penalty requires the agent to obtain approvals.  The apparent legislative goal in passing IRC 6751(b) was to prevent the IRS from using penalties as a bargaining chip.  The goal serves a laudable purpose and a more clearly written statute enforcing that goal would receive support from everyone.  We have written before on many occasions, samples found here and here, about the defects in the statutory language of IRC 6751(b).

Here, the goal of the statute really plays no part in the imposition of the penalty.  If the IRS makes a determination that someone has committed tax evasion and refers the case to the Department of Justice for prosecution, the imposition of the fraud penalty could come as no surprise – and particularly so when the person is actually convicted of tax evasion.  In a case such as this, the imposition of the penalty must occur pursuant to the Internal Revenue Manual 25.1.6.2(9) unless the revenue agent or the supervisor get permission at a high level to not impose the fraud penalty.

The revenue agent apparently visited Mr. Minemyer in prison to secure his signature on Form 4549 consenting to the assessment of the tax and the fraud penalty.  Mr. Minemyer apparently did sign the Form 4549 but later withdrew his consent asserting that he signed it under duress.  At the Tax Court trial, the IRS did not produce the Form 4549.

This case involves the tax years 2000 and 2001.  So, the years come after the passage of IRC 6751(b) in 1998 but well before the IRS focused on compliance with IRC 6751(b).  The conviction here occurred in 2009 before the passage of the statute permitting restitution based assessments discussed here.

Nonetheless, the revenue agent actually obtained the signature of the immediate supervisor before the IRS sent the 30-day letter.  The problem the Court has with the penalty approval here turns again on the language of the poorly crafted statute, which requires the supervisor’s signature before the “initial determination” regarding the imposition of the penalty.  Here, the effort to have Mr. Minemyer sign the Form 4549 occurred prior to the sending of the 30-day letter and may have been the initial determination, which may require the IRS demonstrate supervisory approval at an earlier stage than the 30-day letter.  Here’s what the Court says:

In Frost v. Commissioner, 154 T.C. ___, ___ (slip op. at 21-22) (Jan. 7, 2020), we held that “the Commissioner’s introduction of evidence of written approval of a penalty before a formal communication of the penalty to the taxpayer is sufficient to carry his initial burden of production under section 7491(c) to show that he complied with the procedural requirement of section 6751(b)(1).” As in Frost, respondent here introduced evidence of written approval of the penalty before a formal communication (i.e., the 30-day letter). Also as in Frost, petitioner has not claimed that there was a prior initial penalty determination. Unlike Frost, our record does support the conclusion that respondent may have formally communicated his initial penalty determination to petitioner before the 30-day letter. Cf. Frost v. Commissioner, 154 T.C. at ___ (slip op. at 23) (“[P]etitioner has not claimed, nor does the record support a conclusion, that respondent formally communicated his initial penalty determination to petitioner before the date that the examining agent’s manager signed the Civil Penalty Approval Form.” (Emphasis added.)).

When the revenue agent visited petitioner in prison, he provided petitioner a Form 4549, which petitioner signed. Petitioner contends that he was under duress to sign the Form 4549 and for that reason he withdrew his consent. During respondent’s counsel’s opening statement at trial he contended that petitioner [*8] received a preliminary form before the formal communication in the 30-day letter and that petitioner signed it, agreeing to the fraud penalty for 2001. This statement is an acknowledgment that the Form 4549 communicated an intention to impose a penalty.

Respondent did not offer this Form 4549 into evidence. Therefore, we cannot determine whether the Form 4549 or the 30-day letter was the initial determination for the purpose of section 6751(b). Without the Form 4549 we cannot determine whether that form clearly reflected the revenue agent’s conclusion that petitioner should be subject to a penalty. See Carter v. Commissioner, at *30. If the Form 4549 was the initial determination of the fraud penalty for 2001, there is no evidence of its timely written approval. 

Accordingly, we conclude respondent has not met the burden of production for the determination of the section 6663(a) fraud penalty for 2001. Therefore, petitioner is not liable for the fraud penalty for 2001.

The tossing of the fraud penalty against someone convicted of tax evasion on this technicality seems a bit harsh and out of sync with the purpose of the statute but the Court must deal with a poorly written statute and seeks to establish bright line rules.  Perhaps this situation would not occur going forward because of the heightened emphasis on IRC 6751(b) at the IRS due to all of the litigation.  Maybe Congress did not care when the IRS lost lots of penalties due to the application of IRC 6751(b), since the IRS takes an approach to penalties that many might view as too zealous.  Imposing the fraud penalty against someone convicted of tax evasion can hardly fall into the over-zealous category and failing to impose the penalty on a convicted tax felon for a technicality like this should cause Congress to think about writing this provision in language that fits with the language of the tax code.

As mentioned above, the imposition of the fraud penalty against Mr. Minemyer occurred as automatically as the penalty imposed by computers.  Individuals convicted of violations of IRC 7201 always get the fraud penalty.  The IRS views it as inappropriate to ask the Department of Justice to prosecute someone for tax evasion with a guilt beyond a reasonable doubt standard and not pursue the civil fraud penalty thereafter.  My thinking on this case is no doubt colored by my view that to not impose the fraud penalty here the revenue agent and the immediate supervisor would have needed to move heaven and earth and that everyone knew this.  I realize those penalty administrative norms do not match the language of this poorly worded statute, but Mr. Minemyer’s civil fraud penalty was, in reality, approved the day his case was referred to DOJ for prosecution.  The revenue agent and the immediate supervisor served as no more than window dressing in the imposition of the penalty in a case such as this.

The decision in this case was entered on July 1, 2020, just three months and six days short of the 10-year anniversary of the filing of the petition in this case back in October of 2010.  The IRS must regret that the case did not reach a decision point during the first five years of its existence before the jurisprudence on Graev developed.  This would have been a slam dunk case for the IRS back during that period.

Filed Under: Civil Penalties, Fraud

Impact of Fraud Penalty on Only One Spouse

October 7, 2019 by 3 Comments

The case of Chico v. Commissioner, T.C. Memo. 2019-123 points out the benefits to the “good” spouse when the other spouse files a fraudulent tax return.  The case follows earlier Tax Court precedent established in the non-precedential case of Said v. Commissioner, T.C. Memo. 2003-148.  Because of the interplay of the fraud penalty and the accuracy related penalties, the “good” spouse gets a pass on penalties on the return.  While this outcome has nothing to do with the innocent spouse provisions, it has the effect of leaving the “good” spouse free of penalties when the fraud on the return relates only to the other spouse.  Thanks to our fellow blogger Jack Townsend for bringing this case to my attention.

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Mr. Chico ran several businesses including a return preparation business.  He filed returns that failed to report income from several sources and otherwise contained errors that caused the IRS to assert the fraud penalty.  When the IRS asserts the fraud penalty on a joint return, it must prove fraud of each spouse in order to have the fraud penalty apply to both spouses.  Here, Mr. Chico’s knowledge of the businesses and of return preparation made him the obvious target of the penalty while the IRS could not overcome the showing that Mrs. Chico had little knowledge of the matters on the return.  So, the court found the fraud penalty with respect to Mr. Chico but not his wife.

The finding of the fraud penalty against Mr. Chico did not end the pursuit of penalties by the IRS.  As it normally does, the IRS had asserted the lesser penalties in the accuracy penalty provisions of IRC 6662 against both husband and wife.  Here, the issue of penalty stacking comes into play.  The IRS cannot hit someone with the fraud penalty and the accuracy related penalty.  It can either obtain the fraud penalty or the accuracy related penalty but not both.  Because of the anti-stacking provision found in IRC 6662(b), the Tax Court found that it could not impose an accuracy related penalty against Ms. Chico since doing so would create a stacking of penalties.

IRC § 6662(b) states the following as it pertains to the imposition of accuracy-related penalties on underpayments.  The IRS may not stack penalties when any of the following apply:

  • When a penalty is imposed under IRC § 6663 (fraud penalties)
  • When a penalty is determined as being a “gross valuation misstatement” as defined under IRC § 6662(h)(2), the portion of the underpayment shall be penalized 40 percent in total (and not an additional 40 percent to the standard 20 percent penalty)
  • When a penalty is determined from a nondisclosed noneconomic substance transaction as defined under IRC § 6662(i), the portion of the underpayment shall be penalized 40 percent in total (and not an additional 40 percent to the standard 20 percent penalty)

Treas. Reg. 1.6662-2(c) is the anti-stacking provision in the CFR as it pertains to accuracy related penalties:

A. If a portion of the underpayment of tax shown on a return is attributable to both negligence and a substantial understatement, the accuracy-related penalty would apply only once at the 20 percent rate to this portion of the underpayment. The examiner should assert the penalty that is most strongly supported by the facts and circumstances and write up the other as an alternative penalty position.


B. The penalty is applied at the 40 percent rate on any portion of the underpayment attributable to a gross valuation misstatement. Any penalty at the 20 percent rate that could have applied to this portion is not asserted except as an alternative penalty position.


C. A penalty is applied at the 75 percent rate on any portion of the underpayment attributable to civil fraud. Any penalty that could have applied to this portion at the 20 or 40 percent rate is not asserted except as an alternative penalty position.

IRM 20.1.5.3.3.1 No Stacking Provision (12-13-2016) sets out the anti-stacking rules for IRS employees to follow. 

The application of the anti-stacking penalties allows Mrs. Chico to avoid having any penalty for filing an improper return assessed against her.  Although the IRS sought the accuracy related penalty against her it does not seem inclined to pursue the issue into the circuit courts to overturn the position stated by the Tax Court that imposing the lesser penalty on the spouse not liable for fraud creates impermissible stacking.  In the absence of a court challenge, the IRS must go to Congress and seek a change in the stacking rules to allow assessment against the spouse who did not commit fraud or forgo any lesser penalty against that spouse in these circumstances.

The spouse who did not commit fraud may still suffer because of the fraud.  Unless that spouse obtains innocent spouse relief, that spouse will owe all of the additional tax assessed as a result of the audit.  Unless the spouse who did not commit the fraud has no withholding and makes no estimated tax payments during the year, that spouse may have to repeatedly apply for injured spouse relief in subsequent years if the couple receives a refund of taxes since the IRS will likely take the whole refund to satisfy the penalty liability of the fraudulent spouse.

Here, the Chico’s filed a joint petition.  Two attorneys are listed in the opinion as representing the taxpayers.  It is not clear if one was representing Mr. Chico and the other Mrs. Chico or if they were both representing both parties.  This is a situation in which the attorneys must be careful because the interests of Mr. and Mrs. Chico do not align. 

This is also a situation in which Mrs. Chico was fortunate to have representation.  Without representation she has little chance of catching the mistake made by the IRS in seeking to impose a lesser included penalty on her.  Perhaps the Tax Court Judge would always or almost always catch this mistake and protect the unrepresented party but that puts a great deal of pressure on the judge which does not belong there.  Just because Tax Court judges do a good job of catching these issues and protecting unrepresented taxpayers does not mean that this is a perfect system.  An unrepresented taxpayer could end up owing a penalty which the IRS should not have imposed.  Even the accuracy related penalty would have been almost $40,000 for the three years at issue in this case.  That would have been a steep price for the unrepresented spouse to pay.

The court stated:

Respondent has not asserted fraud penalties against Ms. Chico but alleges that she is liable for the section 6662(a) accuracy-related penalty for each year at issue.

I interpret the court’s statement to mean that no penalty was asserted against Ms. Chico in the notice of deficiency but the attorney in Chief Counsel’s office decided to pursue the penalty after the filing of the petition.  If I have interpreted the situation correctly, it looks like the notice writers at the IRS read the IRM but the Chief Counsel attorney and supervisor did not or maybe Chief Counsel’s office does not agree with the decision in Said.  If I interpreted the situation correctly, maybe it’s time for a new Chief Counsel notice assuming that Chief Counsel’s office now agrees with this outcome.

Filed Under: Civil Penalties, Fraud, Innocent Spouse

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

December 20, 2018 by Leave a Comment

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Filed Under: Bankruptcy, Fraud

Getting Convicted of Tax Evasion Means No Discharge of the Tax in Bankruptcy

November 10, 2017 by 1 Comment

I wrote last spring about how a conviction for filing a false tax return, IRC 7206(1), provided a basis for denying a bankruptcy discharge on the basis of collateral estoppel. The recent decision in United States v. Wanland provides an example of a conviction for tax evasion, IRC 7201, which creates the same result.

At issue in the Wanland case is only the unpaid taxes and not the fraud penalties. The civil fraud penalty, like all tax penalties, can be discharged in a bankruptcy case when it becomes three years old, as discussed here. The IRS does not argue that anything keeps the fraud penalty from discharge but it does make good use of an argument regarding its levy to extend the years in which Mr. Wanland was charged with criminal behavior to earlier years to also prevent their discharge.

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Mr. Wanland was an attorney. The recently decided case seeks to obtain a judgment against him for $1,065,493.30. He is representing himself in this litigation. On September 26, 2013, he was convicted of 28 counts of criminal tax violations. One count of 7201 evasion of payment, 24 counts of concealment of property subject to levy and three counts of 7203 failing to file tax returns.

Before he was convicted of the criminal tax violations, Mr. Wanland filed bankruptcy and received a discharge of his debts on June 8, 2011. Because of the bankruptcy discharge, Mr. Wanland argues that the IRS is collaterally estopped from raising the issue of his liabilities since it did not bring an action in the bankruptcy case to except his liabilities from discharge. The issue presented is one of first impression in the 9th Circuit though other courts have addressed it. Must the IRS affirmatively seek a determination regarding the discharge of taxes or does the exception to discharge of 523(a)(1), except the described taxes from discharge without the need for affirmative action.

The IRS takes the position that it does not affirmatively need to bring an action in each bankruptcy case to have the bankruptcy court make a determination regarding which taxes are and which taxes are not discharged. At the conclusion of each bankruptcy case the IRS makes its own determination regarding the impact of the discharge on the taxpayer’s liabilities. If the IRS determines that the taxes or penalties, were discharged, it will write them off its books and the taxpayer does not need to do anything to request that the IRS do so. If the IRS determines that the taxes are not discharged, it sends them back into the collection stream. If a taxpayer thinks that the IRS decision to send the taxes back into the collection stream is wrong, the taxpayer can sue the IRS for violating the discharge injunction and cause the write-off of the taxes if it wins.

Here, the IRS has gotten to the point in the collection of the liabilities against Mr. Wanland that it is bringing a suit to reduce the liabilities to judgment. That will cause the liabilities to hang around his neck basically forever, as we have discussed here. In his effort to ward off the suit, he argues that the IRS missed the time to object to the discharge of his tax liabilities and it cannot seek to collect them at this point.

The district court rejects his arguments citing to the decisions of other courts that have faced this issue.

“Debts listed in sections 523(a)(2), (a)(4) and (a)(6) are automatically discharged in bankruptcy unless a creditor objects to their dischargeability by fiing an adversary proceeding. Fed. R. Bankr. P. 4007 (advisory committee notes). A creditor who wishes to object to the dischargeability of a debt under sections 523 (a)(2), (a)(4) or (a)(6), must file a complaint within sixty (60) days of the first scheduled meeting of creditors. Fed. R. Bankr. P. 4007(c)… Those debts excluded from discharge not listed in sections 523 (a)(2), (a)(4) or (a)(6), including certain tax debts, are automatically excepted from discharge… As a result, a complaint to determine the dischargeability of a debt, other than a debt listed in sections 523(a)(2), (a)(4) or (a)(6), may be filed at any time. Fed. R. Bankr. P. 4007(b)”

Quoting In re Walls, 496 B.R. 818, 825-26 (N.D. Miss. 2013)(citation omitted); see also In re Range, 48 Fed. App’s 103 at 5 & n.2 (5th Cir. 2002)(unpublished).

There are 19 subparagraphs of Bankruptcy Code section 523. Only three of them have been singled out in the Bankruptcy Rules to require the creditor to affirmatively bring an action early in the case to determine discharge. The first two deal with types of fraudulent activity by the debtor and the third with willful and malicious action that causes harm. Because the particular provision that prevents Mr. Wanland’s discharge is a type of fraud, there is some basis for looking at taxes excepted from discharge under 523(a)(1)(C) to determine if they create a different situation that “ordinary” taxes. It would create an enormous burden on the IRS and the bankruptcy court to have the IRS objecting to discharge in every bankruptcy case in which the debtor’s taxes are excepted from discharge because the volume would be enormous. The IRS has historically been a creditor in about 40% of all bankruptcy cases meaning that these types of motions would be filed in hundreds of thousands of cases each year.

The number of cases in which the IRS excepts the taxes from discharge under 523(a)(1)(C), however, is quite small. It would not place a big burden on the IRS or the bankruptcy court if the IRS were required to come into those cases with a motion similar to the motion made in the cases of the three provisions cited. Nonetheless, the general rule regarding tax debts prevails here and the district court finds with the other courts looking at the issue that the IRS need not affirmatively file an objection to the discharge of this debt.

The decision does not surprise me. Once the IRS gets past the issue of whether it should have raised the issue during the proceeding, the court has no trouble finding that the debtor’s conviction serves to estop the debtor from arguing that the liability is excepted from discharge for the years of the 7201 criminal conviction which were 2000-2003. The court finds it a closer question whether the IRS can use offensive collateral estoppel to the 1996-1998 tax liabilities which were not included in the criminal case. The IRS presented evidence that it served a levy to collect taxes for 1996-1998 and 2000-2003. That levy was the levy upon which the criminal case was based because he concealed his assets to keep the IRS from receiving payment on that levy. Under the circumstances, the court finds that affirmative collateral estoppel works to prevent Mr. Wanland from arguing that the taxes for all of the years are not excepted from discharge. This is an interesting extension of the collateral estoppel effect of the bankruptcy case. The court could have reached the same conclusion without the need for collateral estoppel if it found that he was trying to evade the payment of his taxes for the non-criminal years.

 

Filed Under: Bankruptcy, Fraud

Intentionally Wrong Form Not Fraudulent Filing of Information Return?

June 8, 2017 by 1 Comment

When a taxpayer receives an accidentally wrong information return, it is natural for that person to be frustrated.  It creates filing problems, and usually it is impossible to get a corrected return.  When a taxpayer receives an intentionally incorrect information return, they usually freak out.  Cases coming out of Section 7434, which allows a taxpayer to make civil claims against the issuer of an information return for fraudulent filing of information returns, usually have entertaining fact patterns.  They often revolve around business partners (sometimes family members) seeking retribution against one and other for perceived wrongdoing. One angry person will issue an information return indicating huge amounts of money were paid as compensation to the other angry person.  Often there is other litigation going on over a business divorce. This post involves Section 7434, but the fact pattern is unfortunately pretty boring, as is the primary holding.  The Court did, however, make an interesting statement (perhaps holding) that intentionally issuing an incorrect information return with correction information would not constitute the fraudulent filing of an information return.  No Circuit Courts have reviewed this issue, and it was a matter of first impression for the Central District of Illinois.

In Derolf v. Risinger Bros Transfer, Inc., two truck drivers brought suit under Section 7434 against their employer for issuing them Form 1099s for the compensation they received from the employer, Risinger Bros, believing they were employees and should have received Form W-2s instead.  There are like absolutely no interesting facts in the summary.  No Smoky and the Bandit hijinks, or lurid lot lizard tails (don’t ask).  The plaintiffs were long haul truckers, who entered into “operating agreements” and “leases” with the trucking company.  Those agreements provided significant flexibility in how the truckin was accomplished.  The primary holding of the case was that the truckers were, in fact, independent contractors, and the trucking company was correct in issuing Form 1099s to them for the work instead of Form W-2s.

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That pretty well nips the Section 7434 issue in the bud, as Risinger Bros acted properly, but the District Court for the Central District of Illinois still addressed the potential issuance of a fraudulent information return.  In general, under Section 7434, the person receiving an incorrect information return can bring a civil suit against the issuer if the issuer willfully files a fraudulent information return as to payments purported to be made to any other person.  This provides a remedy for someone who receives false information returns that the issuer was using commit tax fraud or to create issues for the person receiving the return.  This requires a showing of bad faith or deceit, which is often the main issue in these cases, and why you get all the juicy details.

The Court in Derolf stated no misclassification occurred, but that it found the claim that the wrong information return resulted in a fraudulent filed information return to be “not cognizable as pled.”  The Court noted that “there appears to be a split amongst the district courts, and no authoritative precedent as to whether the nature of the fraud pertains solely to the pecuniary value of the payments at issue or whether the scope of the fraud encompasses broader concepts.”  In the case, the plaintiff cited to two cases from the Southern District of Florida, and a case from Maryland  for the proposition that it was not solely the amount that had to be fraudulent.  The Court in Derolf dismissed those cases as failing to actually address the issue (sort of a weak split).  In one of those three, Leon v. Tapas & Tintos, Inc., the court did state that where a Form 1099 was issued instead of a proper W-2, “that the issued forms violated Section 7434 where Plaintiff could properly be classified as an employee rather than an independent contractor,” but did not spend any time discussing that issue.   The plaintiff in Leon failed to properly plead bad faith, so the matter was tossed without further discussion.

The Court in Derolf instead focused on two other district court cases, Liverett v. Torres Adv. Ent. Sols. LLC and Tran v. Tran, which both stated the fraud had to be due to a misstatement in the amount.  Liverett had a very similar fact pattern, and did a deep dive into the statutory language and the legislative history on the matter.  In Liverett, the District Court for the Eastern District of Virginia found Section 7434 was ambiguous and it wasn’t clear if the fraud was on the payment amount or the information return itself, but based on statutory construction and legislative history that the fraud had to be on the amount.  I won’t go into great detail about the analysis, but I think aspects are open to other interpretations.  For instance, the Court relies on legislative history stating the rationale for enacting the statute as “some taxpayers may suffer significant personal loss and inconvenience as the result of the IRS receiving fraudulent information returns, which have been filed by persons intent on either defrauding the IRS or harassing taxpayers.”  H.R. Rep. No. 104-506, at 35 (1996).  This doesn’t seem like a slam dunk in showing Section 7434 applies only to incorrect dollar amounts and not incorrect forms.  Perhaps the most convincing aspect of the holding was that the plaintiffs in these types of cases have other avenues of redress, specifically the Fair Labor Standards Act (although, in theory, this type of claim could arise with other forms not included under a FLSA claim, such as a Form 1099-Misc being issued when a Form 1099-B was appropriate).  Keith also mentioned this tactic seemed like potential self-help by the plaintiff in skirting the normal process for worker determination achieved by filing the SS-8.  This can be a slow process; taking many months.  It seems possible that the defendant or the Service could take the position that if the plaintiff has not sought such a determination, it has not exhausted its administrative remedies (then what happens if the plaintiff has, but the defendant still issues a Form 1099 when a W-2 would be appropriate –probably still no Section 7434 relief based on this case).

Overall, I think the statute and legislative history could be read to allow Section 7434 claims based on the filing of incorrect information returns, and not just incorrect dollar amounts on information returns.  For now, there is somewhat of a split, but most District Courts that have taken a hard look at this have come down on the side that the fraud must be in the amount reflected on the information return and not on the type of return filed.  Since 2015, there have been at least five or six cases looking at this issue, so I suspect more courts will deal with it in the coming months.

 

Filed Under: Fraud, Information Returns
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