Vaught & Boutris

I. 1998 PROPOSED LEGISLATION FOR SWEEPING BANKRUPTCY REFORM

II. TAX LIENS IN BANKRUPTCY

DO TAX LIENS SURVIVE BANKRUPTCY?
1. If a tax claim is dischargeable but a valid lien has been filed by the taxing authority, the tax claim is secured up to the amount of the debtor’s equity in any real or personal property to which the lien attaches. The tax claim itself is an in personal claim that is dischargeable but a perfected tax lien is an in rem claim that remains enforceable even after the bankruptcy is concluded. In re Isom, 95 B.R. 148 (9th Cir. 1988), 901 F.2d 744 (9th Cir. 1990).
2. If a tax claim is dischargeable, it survives only on the debtor’s property which existed on the bankruptcy filing date, not property acquired after the bankruptcy filing date. In re Ridgley, 81 B.R. 65 (1987); In re Leavel, 124 B.R. 535 (Bkrtcy.S.D.Ill.1991).
3. The value of the property to which the lien attaches is fixed as of the date of filing the bankruptcy. Subsequent appreciation of the property should not be subject to the lien. Note: It may be advisable, where possible, to file a motion to determine the value of the lien so as to avoid a later dispute as to the value of the property subject to the lien on the date of the bankruptcy filing.
4. Tax liens attach to all equity in real or personal property regardless of the fact that such equity may be protected, for bankruptcy purposes, by a bankruptcy exemption. U.S. v. Barbier, 896 F.2d 377 (9th Cir. 1990); Crow v. Long, 107 B.R.184 (E. D. Mo. 1989). In contrast, the bankruptcy exemptions do apply to protect assets where no tax lien has been filed and the tax liabilities are dischargeable. 11 U.S.C. 522(c)(1) & (2).
5. The fact that certain property is exempt from levy by Section 6334 of the Internal Revenue Code (wearing apparel, furnishings and personal effects, books and tools of trade, etc.) does not mean that it is exempt from a tax lien. A Chapter 13 plan normally requires sufficient payment to pay all secured claims including tax liens on all personal property. The debtor must surrender the property or pay the cash equivalent of his or her equity interest in the property. See In re King, 137 B.R. 43 (D.Neb. 1991); In re Barbier, supra.
6. A tax lien attaches to the debtor’s property even if such property is not property of the estate (e.g. an ERISA-qualified retirement plan). In re Anderson, 149 B.R. 591 (9th Cir. BAP 1992).
  1. A tax lien attaches to social security payments. In re Morris, 1993 Bankr. LEXIS 1913 (Bkrtcy. W.D.Tenn. 1993).
  2. A tax lien attaches to postpetition civil service annuity payments. In re Tillery, 204 B.R. 575 (Bkrtcy.E.D.Okla. 1996).
  3. State law controls in determining the debtor’s legal interest in the property for federal tax purposes. United States v. National Bank of Commerce, 472 U.S. 713 (1985).
7. Query: Does a tax lien attach to retirement or pension plan payments that are not fully vested? Does a tax lien attach to a retirement plan or pension plan that is partially vested to the extent of the partial amount vested? There is little or no case law regarding this issue.
STRIPPING TAX LIENS
1. 1. Can a debtor bifurcate an undersecured tax lien into two separate claims, one a secured claim equal to the debtor’s equity in real and personal property and the other an unsecured claim for the balance? In Dewsnup v. Timm, 112 S.Ct. 773 (1992) the Supreme Court ruled that lien stripping was not permissible in a Chapter 7 case. The lower court opinion emphasized that Section 506 could not be utilized to strip the lien because the trustee had abandoned the property and such assets were no longer part of the bankruptcy estate.
2. 2. The majority rule is that lien stripping is allowed in Chapter 13 cases. In re Dever, 164 B.R. 132 (Bkrtcy.C.D.Calif. 1994). In Chapter 13 cases, the debtor is permitted to modify the rights of secured claim holders. 11 U.S.C. Sec. 1322(b)(2).
CALCULATING THE VALUE OF TAX LIENS
1. The Supreme Court has recently ruled that a secured creditor’s lien should be valued at the debtor’s replacement cost (rather than retail cost or wholesale cost). Associates Commercial Corp. v. Rash, __ S.Ct. ___.
2. The Rash decision still leaves open many questions: Can closing costs (e.g. sales commissions) be deducted in determining the equity in the property? Can capital gains taxes be deducted? Is there a reduction for quick sale value?
3. Post-Chapter 7 bankruptcy planning/strategy: To the extent that the property to which the tax lien attaches has little or no equity, the debtor should consider simply requesting that Special Procedures release the lien.

III. HOT ISSUES REGARDING CALIFORNIA STATE TAXES

DOES FAILURE TO FILE A REPORT OF A FEDERAL TAX ASSESSMENT TRIGGER A NEW TWO-YEAR RULE?
1. Hypothetical: Your client owes taxes for a past year’s return that was filed over two years ago. Your client is then audited by the IRS and additional taxes, penalties and interest are assessed. However, your client does not report the assessment to the Franchise Tax Board nor file an amended return with California. The FTB, through its information sharing program with the IRS, then issues an additional assessment of state taxes by piggy-backing on the IRS audit determination.
2. Query: Does the California requirement that the taxpayer "report" an additional federal tax assessment mean that under Section 523 your client is actually required to file an amended return or report with the state and therefore the additional assessed California taxes are not dischargeable until two years after such a return is filed or reported to the FTB? If that is the case, then your client cannot discharge the taxes in a Chapter 7 bankruptcy for at least two more years.
3. FTB’s position: The FTB has been aggressively asserting this position based on a New York case, In Re Blutter, 177 B.R. 209 (Bkrtcy.S.D.N.Y. 1995). However, in a recent Bankruptcy Appellate Panel decision, In re Jerauld, 97 C.D.O.S. 3987 (May 29, 1997), the court rejected the FTB’s position and held that the requirement under California law to file a report of a reassessment is not the same for purposes of Section 523(a)(1)(B)(I) as the requirement to file an amended return. However, the FTB is in the process of appealing the Jerauld decision to the Ninth Circuit based on a Seminole (supra) sovereign immunity argument. The FTB will not pursue enforced collection action against taxpayers in this situation provided the taxpayers agree to be bound by the ultimate resolution of the Blutter issue.
JURISDICTION OF THE BANKRUTPCY COURT OVER THE STATE
1. Hypothetical: Debtor files a Chapter 7 case to discharge past state taxes amounting to $300,000. With respect to one year there is an issue as to whether the two-year rule was met based on whether one looks to the filing date or the posting date. With respect to another year there is an issue as to whether the assessed taxes were actually owed at all (a false Form 1099 was issued). After the completion of the bankruptcy the FTB garnishes the debtor’s wages for the supposedly discharged taxes. The debtor reopens the Chapter 7 case and files an adversary complaint against the FTB to determine dischargeability of the taxes.
2. Seminole Case: The U.S. Supreme Court ruled in Seminole Tribe of Florida v. Florida, 116 S.Ct. 1114 (1996), that the Seminole Tribe of Florida could not sue the state of Florida in federal court to enforce the Indian Gaming Regulatory Act because the Constitution bars Congress from restricting the sovereign immunity of the states.
3. FTB’s Position: The FTB routinely asserts the Seminole case to deny jurisdiction to the U.S. Bankruptcy Court. The debtor must file a claim in California Superior Court to have the matter litigated while the FTB may pursue enforced collection action to collect the contested liability. Further, under the FTB’s current policy, unless the debtor pays the full amount of the taxes, penalties and interest, he will not be permitted to contest the merits of the tax assessment for the year of the falsely issued Form 1099. The FTB will, however, grant state court jurisdiction to the debtor without payment of the tax for the other year since the issue does not go to the merits of the case.
  1. Sovereign immunity will be waived if the State files a proof of claim. In re Burke, 146 F.3d 1313 (11th Cir. 1998). In Burke, the court rejected Georgia’s argument that only the State Legislature could waive sovereign immunity. But see Silver v. Baggiano, 804 F.2d 1211, 1214 (11th Cir. 1986) (Attorney General’s removal of suit to federal court did not result in a waiver of state immunity because state law did not vest him with the power to waive immunity).
  2. State may not collaterally attack a confirmed Chapter 11 plan. Maryland v. Antonelli Creditors’ Liquidating Trust, 123 F.3d 777, 784 (4th Cir. 1997).
  3. In a Chapter 7 the bankruptcy court does not have jurisdiction to determine whether a state tax is dischargeable. In re Elias, 218 Bankr. 80 (9th Cir. BAP 1998). But sovereign immunity does not mean that state taxes are nondischargeable.
  4. The State Courts have the power to determine the dischargeability of state taxes in federal bankruptcy. See In re Elias, supra.
  5. A debtor may be able to pursue a cause of action against the individual state employee who undertook the action constituting violation of the automatic stay based on the doctrine of Ex Parte Young, 209 U.S. 123, 28 S.Ct. 441 (1908); CSX Transp., Inc. v. Board of Pub. Works of West Virginia, 138 F.3d 537 (4th Cir. 1998); See, Natural Resources Defense Council v. Cal. Dept. of Transportation, 96 F.3d 420 (9th Cir. 1996). However, since the Ex Parte Young doctrine only applies to prospective actions, it is of no help where the State has already collected and the debtor is seeking a refund.
  6. A debtor may have a possible remedy in the form of a lawsuit in State Court for violation of federal rights. In re Lazar, 200 B.R. 358 (Bkrtcy.C.D.Cal. 1996); In re Midland Mechanical Contractors, Inc., 200 B.R. 453 (Bkrtcy.N.D.Ga. 1996).

IV. LITIGATING TAX LIABILITIES IN BANKRUPTCY COURT

BANKRUPTCY COURT AS ALTERNATIVE FORUM TO U.S. TAX COURT.

If a taxpayer has failed to exercise his or her administrative remedies by filing a Tax Court Petition within 90 days of the Notice of Deficiency, the assessment becomes final and normally cannot be litigated without full payment of the liability. A taxpayer with limited funds may, however, initiate a bankruptcy and object to the claim of the IRS. The Bankruptcy Court would then have jurisdiction to determine the correct tax liability, if any.
GREATER ACCESS TO BANKRUPTCY COURT JURISDICTION OF TAX CONTROVERSIES IN CHAPTER 13 THAN CHAPTER 7.

Although any tax dischargeability complaint may be litigated in Bankruptcy Court, a number of courts have declined jurisdiction for litigating the amount of a tax liability in no-asset Chapter 7 cases (the great majority of Chapter 7 cases are no-asset cases). Bankruptcy Code Sec. 505(a); Parsons v. United States, 153 B.R. 585 (M.D.Fla. 1993); Queen v. United States, 148 B.R. 256 (S.D.WVa. 1992); but see Anderson v. United States, 171 B.R. 549 (W.D.Va. 1994) (it is necessary to determine the tax liability in Chapter 7 no-assets case in order to grant debtor a fresh start).
PROTECTION OF AUTOMATIC STAY.

By litigating a tax case in Bankruptcy Court the debtor can receive protection from IRS levies and other enforced collection action during the pendency of the bankruptcy.
BURDEN OF PROOF MAY BE ON THE IRS IN BANKRUPTCY COURT.

See California Franchise Tax Board v. MacFarlane, 83 F.3d 1041 (9th Cir. 1996).
POTENTIAL TO TRAP CAPITAL GAINS IN BANKRUPTCY ESTATE.
LITIGATING TOTI ISSUE IN BANKRUPTCY COURT

V. OTHER ADVANCED BANKRUPTCY TAX PLANNING ISSUES

BANKRUPTCY ESTATE TAX LIABILITIES
1. Who is responsible for any tax liability that results during the operation of the bankruptcy estate? This issue comes up when the trustee sells property of the estate and there will be a capital gain on the sale. The estate is always responsible for any tax liability it incurs during the administration of the bankruptcy estate. These are considered administrative expenses and are paid out of non-exempt estate property. 11 U.S.C. Section 522.
2. Understanding this rule will provide the practitioner with the ability to do some prepetition tax planning. For example, if the debtor owns property that will result in a substantial capital gains if sold, the attorney should wait to file a bankruptcy petition and try to get the trustee to sell the property. Even if the estate ultimately does not have sufficient funds to pay the tax claim, it will not be a claim the debtor will have to be concerned with after he obtains his discharge.
3. The practitioner should be particularly aware of this rule when there are potential foreclosures in the near future. Filing the petition at the right time could relieve a debtor of a substantial future tax liability that would not be discharged in the bankruptcy. The only flaw in this planning could occur if the trustee decided to abandon the property to the debtor before the sale.
SHORT YEAR ELECTION
1. When a bankruptcy is filed, a new entity is created for tax purposes. The bankruptcy estate has its own tax year and tax obligations. The filing, however, does not necessarily affect the debtor's tax year as it does not automatically terminate. The debtor may file an election to terminate her tax year as of the day before the bankruptcy commences. IRC § 1398(d)(2)(A). When this election is made the debtor has two tax years, one that begins on January 1 and ends on the day before the bankruptcy is filed, and the other that begins the day the petition is filed and ends on December 31. The election must be made within four and one-half months after the filing of the petition. In Re Kreidle, 91-2 U.S.T.C. ¶50,371 (Bkrtcy. D. Colo. 1991).
2. This election can be significant to debtors who have a tax liability that will arise for the short tax year period before filing the bankruptcy petition and there will be funds in the estate to pay for some or all of the tax liability. Because the short year liability will be considered a prepetition priority tax (the tax due is assumed assessed as of the day before the petition is filed), it will be entitled to priority payment during liquidation of the estate. If the election were not made, the tax will not be assessed until the debtor files his return the next year and thus cannot be considered a liability the estate is responsible for because it will be a postpetition tax.
3. A practitioner should always ask his or her clients about the client's tax year before filing the petition. If there is a chance that the practitioner can make some of the current year's tax liability a prepetition priority claim, this should be explored with the debtor and his tax preparer. Failure to do so may be malpractice if there are funds in the estate to pay some or all of this liability.
TAX REFUNDS
1. A tax refund due to a taxpayer at the time she files her petition is property of the estate under Section 541. Always determine from a client whether a refund is expected at the time the petition is filed as this will have to be listed as an asset on the debtor's schedules.
2. A refund can be exempted from the estate if it falls within one of the permitted exemptions. For example, under California law, the refund can be exempted under CCP § 703.140(b)(5). A debtor cannot exempt an expected refund, however, under the paid earnings exemption of CCP § 704.070. In Re Orndoff, 100 B.R. 516 (Bkrtcy. ED Cal 1989).
3. If the debtor is due a refund but also owes the taxing agency for an unpaid assessment, the taxing agency may be able to retain the anticipated refund as an offset under Section 553(a). An exception to this rule arises when the debtor's tax liability is discharged in her bankruptcy. If this occurs, the taxing agency can only offset the liability with the refund to the extent the refund is not for postpetition taxes paid. This is because the postpetition taxes paid is the debtor's property. Under this circumstance, the refund should be prorated between the taxing agency, or the estate if the debtor has no tax liability, and the debtor based on the time of year when the petition was filed. In Re Doan, 672 F.2d 831 (11th Cir. 1982); United States v. Reynolds, 764 F.2d 1004, 1005-6 at n. 4. The refund will be allocated on a calendar day basis unless the debtor can allocate the refund to a specific time period. In Re Rash, 22 B.R. 323, 326 (Bkrtcy. Kan. 1982).
BANKRUPTCY STAYS COLLECTION, BUT NOT PROPOSED ASSESSMENT
1. Many debtors file bankruptcy petitions to forestall collection of tax obligations. Under Section 362(a), once the bankruptcy petition is filed most collection activities against the debtor are stayed including collection of tax debts. Of course, unless the tax liability is discharged the collection of the liability will continue post-discharge. Section 727(b).
2. For cases filed before the enactment of the Bankruptcy Reform Act of 1994 the automatic stay of Section 362 also prohibits any taxing agency from assessing a tax liability against a debtor for a prepetition debt. Section 362(a)(6). An assessment made in violation of the automatic stay is void. In Re Stack Steel & Supply Co., 28 B.R. 151 (Bkrtcy. WD Wash. 1983). In fact, the IRS has been held to be subject to sanctions in the form of costs and attorney's fees under Section 362(h) for the violation of the automatic stay. In Re Bulson, 117 B.R.537 (9th Cir. BAP 1990). After the passage of the Act, the tax agencies were not prohibited from assessing a tax during the pendency of a bankruptcy case. Section 362(a)(9).
3. While the filing of a petition will stay collection during the pendency of a bankruptcy case, there is no stay on the issuance of a notice of deficiency by a tax agency. Section 362(b)(9); IRC § 6871(b). However, a debtor can forestall the effects of a notice of deficiency. If the notice of deficiency is received before a bankruptcy petition is filed, then IRC § 6213(f) will suspend the time to file a Tax Court petition for 60 days after the bankruptcy case is dismissed or the case is closed. The timing of the bankruptcy petition can be crucial depending on whether the debtor wishes to deal with the tax matter during or after the bankruptcy case. If an adversary complaint to determine the tax is not filed, make sure that a Tax Court petition is timely filed after the bankruptcy case is over.
TURNOVER OF THE DEBTOR'S PROPERTY
1. If the taxing agency has collected property of the estate prior to the filing of a bankruptcy petition all is not lost. The United States Supreme Court ruled in United States v. Whiting Pools, Inc., 462 U.S. 198 (1983) that property seized by the IRS prior to the bankruptcy petition (and not yet sold) can be required to be returned to the debtor if the debtor can provide the IRS with adequate protection for the value of the property seized. If a debtor who has just had his property seized by the IRS can provide the IRS with adequate assurance of repayment, possibly in the form of a priority lien on the seized property, the court can force the IRS to return the property to the debtor. This will be helpful in situations in which the property seized is essential to the debtor's business and/ or livelihood.
2. The availability of a turnover order outside of Chapter 11 is unclear. It has been held not to be available in a Chapter 7 case. Altman v. Commissioner, 83 B.R. 35, 38 (D. HI 1988). On the other hand, turnover has been ordered in Chapter 13. In re Brown, 106 B.R. 546 (1989).
3. The law is divided as to whether a levy on a cash equivalent such as a bank account will completely transfer ownership to the IRS so as to make Whiting Pools inapplicable. In In re Brown, 106 B.R. 546 (1989), the court ordered the turnover of funds in the debtor’s bank account that were levied prepetition, but not yet actually transferred to the IRS as of the date the Chapter 13 petition was filed, upon a showing that the IRS was adequately protected. Contra, In re Eisenbarger, 160 B.R. 542 (B.C.D.C. Va. 1993)(Notice of levy served on commissions earned by a debtor, which was untitled.