COVID Impairs Debtors (and IRS)

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Going into bankruptcy can make taxpayers very anxious to pay the IRS, because the discharge provisions favor the IRS over many other unsecured creditors.  The last thing taxpayers going into bankruptcy want is a non-dischargeable tax debt coming out of bankruptcy, while funds of the bankruptcy estate go to pay general unsecured creditors who could be discharged in bankruptcy.  I am unconvinced this will ultimately happen in the chapter 11 bankruptcy cases of William Floyd Jr. and Joseph Floyd IV, but they have some concerns about it and tried to get the bankruptcy court to cause checks written to the IRS prior to bankruptcy to be paid to the IRS.

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You might ask why would they need to do this.  That’s where COVID comes into play.  Both men, and their spouses, with whom they filed joint returns but not joint bankruptcy cases, timely filed their 2019 tax returns shortly before the once in a lifetime (?) due date of July 15, 2020 and remitted payment with the returns of $38,792 (William) and $36,045 (Joe).  In both cases the checks remained uncashed at the time they filed bankruptcy on August 24, 2020.

The bankruptcy court stated:

the pleadings indicate that the Debtors fully intended to pay the tax debt prepetition, and only the failure of the IRS to process the tax returns in a prompt manner created the present situation. However, the debtors are not privy to the thoughts of the IRS in this matter. The IRS could be considering an audit or other action. Its motives are unknown. The Debtors’ assertion of possible criminal liability is far too remote, speculative, and unsupported by pleadings or evidence to be considered.

The bankruptcy court and maybe the debtors seem unaware of the extreme backlog of mail the IRS was seeking to process at the time of the filing of these returns.  I feel pretty certain that the IRS motives for failing to process the checks are clear – it was seeking to work its way through a mountain of mail.  It was not considering anything except putting one foot in front of the other in an effort to clear out the backlog.

In this case we see yet another impact of the closure of the IRS caused by COVID. 

The debtors argue that the failure to allow these checks to be paid could cause criminal liability in North Carolina and additional penalties and interest due to the IRS.  The court correctly swats away concerns of criminal prosecution against individuals who sought to timely comply.  The IRS also would likely abate penalties for non-payment if sufficient funds existed at the time the checks were sent.  That still leaves the debtors with concerns about the tax debts surviving bankruptcy simply because the IRS lacked the capacity to open and process its mail during the 2020 filing season.

Part of the bankruptcy court’s concern about audit stems from the reason the debtors entered bankruptcy in the first place – an alleged Ponzi type scheme headed by them.  If true, they could indeed face an audit of their returns which would increase their liabilities and cause tax liabilities on the other side of bankruptcy.

Their arguments were straightforward but unavailing.  First, they asked the bankruptcy court to allow the payment of this prepetition debt.  The bankruptcy court likened the uncashed checks for taxes to uncashed checks in other situations.  It pointed to the ordinary rule regarding prepetition debts:

The Bankruptcy Code does not explicitly authorize courts to allow preferential payment of pre-petition obligations in spite of the priority scheme or outside of a confirmed plan of reorganization.

To allow the payment of a prepetition debt outside of the scheme of payments pursuant to the chapter 11 plan their needs to be some benefit to the estate and not just a benefit to the debtors with respect to discharge.

Next, the debtors argued the checks should be honored based on the doctrine of necessity pursuant to BC 105(a).  This doctrine also bases payments on the need to pay some prepetition creditor out of order for the benefit of the estate.  The great concern in allowing payment of a prepetition creditor before confirmation of a plan is preference of one unsecured creditor over another pursuant to the scheme of priority under the bankruptcy code.  The court said there must exist a real and immediate threat that failure to pay the debt puts the bankruptcy in jeopardy.  Debtors could not make that showing here because the purpose of the payment benefited them but not necessarily the bankruptcy estate.

Debtors filed chapter 11 cases.  Most individual debtors do not go into chapter 11.  Individual debtors use chapter 11 when they seek to reorganize, rather than liquidate their debts, and their debts exceed the limitations of chapter 13.  These debtors will propose a plan of reorganization which will propose the full payment of the 2019 taxes in order to satisfy the plan confirmation requirements.  A successful bankruptcy will necessarily mean that the 2019 taxes get paid and debtors will not continue to owe the taxes after bankruptcy.  So, if everything in the bankruptcy cases goes according to the plan they will propose, they should have no problem.

Their effort to cause the special payment of the IRS as a creditor at the outset of their bankruptcy reflects their legitimate concern that everything will not work out.  Many chapter 11 cases fail on their way to confirmation or even post confirmation.  If they could have persuaded the bankruptcy court to allow payment of the tax debt at the outset of the cases they would have had less to worry about as the bankruptcy cases moved forward.  Of course, they would have had less incentive to complete their chapter 11 plans.

The decision of the bankruptcy court logically forces the debtors to wait before paying the IRS and forces the IRS to wait before receiving payment because it could not process their check prior to the filing of bankruptcy.  Had the IRS processed their checks in the 35-40 days it had the checks before the filing of the bankruptcy, both the IRS and the debtors would have lived happily after ever with respect to the 2019 tax year – at least until the IRS decided to audit the returns.

The payment to the IRS in this instance would not have been clawed back into the bankruptcy estate as a preference, because the payment fulfilled a current obligation and not an antecedent one.  COVID’s breakdown of functionality at the IRS denied it the ability to satisfy the liability of two of its accounts.  There must be other cases with similar facts where the inability to process the checks in a timely fashion could lead to ongoing headaches for the taxpayers and the IRS.

Comments

  1. Questions: why didn’t the debtors use alternatives to bank checks (I am assuming these were checks drawn on the debtors accounts) to pay the tax liability. Two alternatives come to mind: cashiers checks, and direct payment through the IRS online system. Either of these would have ensured that the money cleared the debtors accounts. These payment methods aren’t secret. Makes me wonder if the debtors had other, unrevealed intentions by using “the check is the mail” approach.

  2. Kenneth H. Ryesky says

    As of when I checked within the past 10 minutes, the IRS still has not deposited my personal 2019 1040 refund into my bank account. The tax return was received by the IRS on 10 June 2020. Other people who similarly are owed refunds for timely-filed returns are also still waiting.

    So it seems that the IRS not only is not paying out the refunds it is supposed to pay out, but is also not depositing the checks it is supposed to deposit.

    Query: Why is being short-staffed and swamped with work a valid excuse for the IRS (or, presumably, a state tax agency), but not a valid excuse for lateness on the part of the taxpayer?

    [See, e.g., Alaska Dept. of Revenue v. DynCorp, 14 P.3d 981 (Alaska, 2000)
    https://www.leagle.com/decision/200099514p3d9811986%5D.

  3. My goodness, these debtors could have simply paid the $35.00 cancel check fee and paid their priority, nondischargeable liabilities online before filing. Particularly if they are debtors-in-possession, it’s unlikely anyone would have expected them to attempt to claw back such prepetition payments. I’m baffled by why so many people prefer to send checks rather than making a secure online payment that guarantees immediate account credit, plus a printable receipt to satisfy their desire for an actual “paper” trail.

    • Kenneth H. Ryesky says

      Nancy (and Bruce),

      One possible problem there is that the IRS might not allow you to pay them online.

      In order to access the direct transfer from bank account, you need to give the IRS details from previously filed tax returns. For the past 5 years since I have been overseas, the latest tax return which shows up on the system and which the IRS avails to me when I do online payments is my 2014 return, and I fear that it will drop off the day the 2021 filing season for 2020 tax returns opens (they only make the previous 5 years available).

      I know that the IRS has processed my tax returns through 2018 because I have received IRS correspondence relating to those returns. And I know that my 2019 tax return was actually received by the IRS, even though there is no indication (read “refund” that it has been processed because I filed it via trackable overseas mail and received a delivery confirmation.

      That said, I share your incredulity that these particular debtors failed to use a more efficient means of money transfer, particularly in this era when they should have known that the IRS bureaucracy was shorthanded so many bureaucrats whose activities would be required to process the paper check.

  4. If there are no unsecured creditors, would the Bankruptcy Code preference scheme pay off the IRS before most other unsecured creditors. About 30+ years ago I did a lot of work on a personal Ch 11 case [plan confirmed], but I don’t remember the priorities.
    Ron Wiener

    • In BC 507 the IRS is the number 8 priority unsecured creditor and all of the priority unsecured creditors in front of them must be paid in full before the IRS would receive anything if the case becomes a liquidating case. Typically, there may not be creditors in many of those seven categories ahead of the IRS. I do not know how many exist in this case. If the case remains a viable chapter 11 reorganization case the debtors will propose full payment of the IRS in their plan and pay out the IRS on these liabilities over the life of the plan. Under those circumstances, the failure of the IRS to deposit the check or of the debtors to make payment online and avoid this problem will not matter.

  5. Hello! It was interesting to read your article on the IRS and COVID. An in-law of mine has worked for the IRS for the past thirty years. Let me correct myself: an in-law of mine has collected a check from the IRS for the past thirty years. He hardly ever works, takes hours-long “lunches” in the middle of the workday, and he’s an abusive alcoholic. The entire family hates the guy, and yet taxpayers finance his life of luxury and the pension he’s about to enjoy after a life of never having worked a real job. We need to abolish this institution once and for all.

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