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COVID Impairs Debtors (and IRS)

Posted on Oct. 27, 2020

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.

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.

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