Bankruptcy debtors generally have two main avenues to fix the amount of their tax liability for a given year: (1) file a motion for the bankruptcy court to determine the amount of their tax debt pursuant to 11 U.S.C. § 505; or (2) object to the IRS’s proof of claim. See Internal Revenue Service v. Taylor, (In re Taylor), 132 F.3d 256, 262 (5th Cir. 1998). In Breland,the Tax Court considered the effect of a resolved proof-of-claim objection on the ability of the IRS to pursue post-petition claims “regardless of whether a claim for the tax was filed or allowed,” as contemplated in § 523(a)(1)(A).

Breland involved a commercial-real-estate investor who allegedly owed a substantial sum to the IRS post-bankruptcy. The issue was whether the IRS could agree in the bankruptcy to a consent order setting the amount of its priority claim, allowing the debtor to pay a substantial sum to creditors subordinate to the IRS, and then later issue a notice of deficiency seeking up to $45 million more for the same tax years that it had compromised. The Tax Court held that it could, narrowly interpreting the bankruptcy court’s order as not addressing the total amount of the debtor’s federal tax liability. The Tax Court reached that result even though its interpretation conflicted with the interpretation of the bankruptcy court that entered the order. The Tax Court’s holding is surprising given that proof of claim objections are generally res judicata on the IRS and final orders resolving contested matters in bankruptcy are typically given broad preclusive effect. The Breland ruling forces bankruptcy practitioners to be particularly vigilant in addressing tax issues in the bankruptcy context.

Breland undercuts the ability of individual debtors to rely on proof of claim objections to fix the amount of their tax liabilities. In Breland, the debtor filed a Chapter 11 bankruptcy case and the IRS filed a proof of claim stating it was owed over $2 million in income tax for the years 2004 to 2008. The debtor filed an objection, stating in its entirety, that the “Debtor objects to the penalties assessed against him on the grounds that the Debtor had reasonable cause for not paying the taxes on time.” The parties entered into a consent order in which the IRS agreed to settle the debtor’s objection by agreeing to specific amounts for its priority tax debts with both sides agreeing that the disputed penalty portion was a general unsecured claim to be resolved after bankruptcy plan confirmation. After conducting discovery related to the disputed penalty portion, the IRS filed an amended proof of claim and asserted additional tax was due. The debtor objected on the grounds that the consent order fixed the debtor’s tax obligation. The bankruptcy court granted the objection and the IRS appealed. The district court remanded to the bankruptcy court for clarification as to the preclusive effect of the consent order. In response to the remand from the district court, the bankruptcy court ruled:

[T]he Court finds that the Consent Order . . . is the controlling document as to the extent of the Debtor’s tax obligation to the IRS. The Consent Order contains a clear statement of the total IRS claim amount and divides that amount into priority and general unsecured values. . . Moreover, by its terms, the Consent Order appears binding and complete. No specific limitation on the Consent Order’s effect is indicated in its terms. The IRS did not reserve the right to assert additional claims. Indeed, the Consent Order did not reserve any rights to the IRS, only to the Debtor. The purpose of the Consent Order is unclear if it was not meant to bind the IRS to its terms.

The IRS appealed, losing in the district court and stipulating to dismissal of its appeal to the 11th Circuit. In the midst of the proceedings in the bankruptcy and district courts, the IRS issued its notice of deficiency, triggering the filing of the debtor’s petition before the Tax Court.

Outside of bankruptcy, a consent order would normally be res judicata on the IRS’s attempt to collect additional amounts for the tax years set forth in the consent order. See United States v. Int’l Bldg. Co., 345 U.S. 502, 506 (1953) (consent order not binding on the United States for tax years subsequent to those years covered in the consent order). The consent order would also be binding if the tax in question were dischargeable. And Breland agreed that the consent order would be res judicata on the IRS if the “order had fixed petitioner’s total Federal tax liability for the subject tax years.”

Even though on remand the bankruptcy court had directly addressed the issue before the Tax Court and found its own order to be “the controlling document as to the extent of the Debtor’s tax obligation to the IRS,” the Tax Court interpreted the consent order narrowly. In the Tax Court’s view, the bankruptcy court’s order did not control for two reasons: First, the Tax Court believed res judicata did not apply because it believed that the consent order establishing the amount of the IRS’s claim and resolving an objection to plan confirmation is an inherently different proceeding than a proceeding to determine whether a particular liability is owed. The Tax Court noted that debtor’s proof of claim objection only challenged the penalties assessed, which the Court found undercut his argument that the consent order determined the total pre-petition tax liability. Second, in the Tax Court’s view, reading the consent order as a final determination of the debtor’s tax liabilities would have the effect of discharging otherwise non-dischargeable debts and contradict § 523(a)(1)(A). The Tax Court did not think res judicata applied because in its view the consent order was not “a final judgment on the merits of [the debtor’s] entire Federal tax debt for any given year.”

The Tax Court’s statement that a determination of an individual’s tax debt in bankruptcy is not the same cause of action as determining the tax debt generally is puzzling. The Court did not cite to any cases in its res judicata analysis that arose in the context of a settled or litigated proof of claim objection. The Tax Court’s view that the consent order was a different cause of action than a determination of tax liability is a more restrictive interpretation than is typically applied in a res judicata analysis. Generally, causes of action are the same for res judicata purposes if they arise “out of the same nucleus of operative fact.” In re Piper Aircraft Corp., 244 F.3d 1289 (11th Cir. 2001). In the context of a contested proof of claim, it is difficult to see how a dispute over the amount of the same tax, for the same years, and involving the same individual, can possibly not arise out of a common factual nucleus, which is precisely the reason that proof of claim objections generally are res judicata. See Hambrick v. Commissioner, 118 T.C. 348, 353 (2002) (recognizing that unlike proof of claim objections or a tax liability determination by the bankruptcy court, the mere confirmation of a Chapter 11 plan generally does not require a determination of the amount of a debtor’s non-dischargeable tax liability).

Similarly, the Tax Court’s consideration of the non-dischargeable nature of the debt also does not make much sense in the context of interpreting the scope of the bankruptcy court’s order regarding a proof of claim settlement. While unpaid non-dischargeable debts will generally survive whether the plan is confirmed or not, the purpose of a proof of claim objection is different. A claim objection is generally filed to determine the total amount owed, which does not turn on dischargeability (though a claim objection often establishes the facts from which dischargeability can easily be determined). In this case, the debtor conceded the non-dischargeability of the tax at issue. So in compromising the amount of the priority claim under the consent order, the IRS knew it was establishing the amount of the non-dischargeable portion of its claim. The bankruptcy court clearly understood this difference, which is why it interpreted its order as controlling for the amount of tax at issue.

Moreover, the Tax Court did not give any consideration to the way proofs of claims fit within the bankruptcy scheme as a whole. A basic underpinning of bankruptcy law is the absolute priority rule: the concept that higher priority claims (such as priority tax claims) must be paid in full before estate assets are used to pay lower priority claims. See Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 983 (2017) (recognizing that the “priority system has long been considered fundamental to the Bankruptcy Code’s operation”). Establishing the amount of priority tax claims and paying those claims before funds are lost paying lower priority debts is central to both the bankruptcy priority scheme and claims filing process – so much so that the Bankruptcy Code permits debtors to file a proof of claim on behalf of the IRS when doing so is necessary to determine the amount of the tax debt. 11 U.S.C. § 501(c); Taylor, 132 F.2d at 262 (suggesting the option of filing a claim for the IRS to fix the amount of the tax debt). The Tax Court’s decision to apply a restrictive reading of the consent order, at odds with the bankruptcy court’s own interpretation, frustrates these objectives of the Bankruptcy Code. It is also incompatible with the deference courts typically exercise in favor of orders entered by another court. See Colonial Auto Center v. Tomlin (In re Tomlin), 105 F.3d 933, 941 (4th Cir. 1997) (recognizing that the bankruptcy court is in the best position to interpret its own order and its interpretation warrants customary deference).

On May 7, 2019, the debtor filed a Motion to certify the Tax Court’s order to permit an immediate appeal and the Tax Court issued an order requiring the IRS to respond by June 10, 2019. Regardless of the outcome of any appeal, Breland is instructive for practitioners with bankruptcy clients facing tax debts. The Tax Court made much of the fact that neither the plan nor the consent order referenced the bankruptcy court’s authority under 11 U.S.C. § 505 to determine the amount of a debtor’s tax liability. It would be advisable for practitioners to seek to include language either in the Chapter 11, 12, or 13 plan or in orders resolving the IRS claims that specifically reference Bankruptcy Code § 505 and state that the plan or the order constitutes a determination of the amount of the total tax due for the years at issue. Similarly, the Tax Court in Breland also appeared troubled that the debtor’s proof of claim objection only stated that the objection was to the amount of the penalties. If a debtor is going to file an objection to the IRS’s proof of claim anyway, it may be helpful to include an objection to any amounts in excess of those asserted in the IRS proof of claim with a reference to 11 U.S.C. § 505.

Update: coincidentally, on the date this post was published the Tax Court issued a memorandum opinion holding that the Brelands had overstated their long-term capital loss by nearly a million dollars. Christine