New Circuit Precedent on Issue of Litigating Tax Merits in Bankruptcy

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

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

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

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

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

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

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

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

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

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

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

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

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

Comments

  1. I looked at the Tax Court docket for this case (022157-13). The taxpayers and their attorney appeared at the calendar call on September 29, 2014. The case was recalled on September 30, and only the IRS attorney appeared to report that the taxpayers had filed a Chapter 13 bankruptcy petition that morning. Left unsaid is that last-minute negotiations must have failed.

    The appeals court opinion states that the notice of deficiency proposed a $107,000 deficiency for the years 2009 through 2011, but by the time of trial it had been stipulated as $100,000. Only the penalty was unagreed: IRS wanted 75%, the taxpayers offered 20%.

    Chapter 13 may have had some advantages, both as to the tax debt and to other claims. But it must have had some disadvantages as well. Apparently the taxpayers decided to forego the payment plan and convert their case. By March 16, 2015, the bankruptcy court had entered a Chapter 7 discharge and the Tax Court lifted the stay. On August 22, 2016, the taxpayers filed a motion for continuance of the Tax Court trial, then scheduled for the following month, until the “outcome of appellate decisions in the 7th Circuit Court of Appeals in another case.” IRS objected to this motion (why?) but on September 9, 2016, Judge Vasquez granted the stay.

    Now that the case heads back to the Tax Court, assuming there is no Supreme Court appeal, will some lucky judge get to try a very stale penalty case? Or might it be quickly resolved because of a Graev managerial approval issue under Section 6751? Sometimes justice delayed is justice allowed.

  2. With so many liabilities now assessed without deficiency proceedings, Congress needs to take a new look at the situation.

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