If someone owes you money and a debt to the IRS stands between you and the ability to receive payment, wouldn’t it be nice if you could review the person’s return, find mistakes that would reduce the liability and file an amended return in order to significantly reduce or eliminate the liability to the IRS and open up a payment path for yourself? Essentially, Morris v. Zimmer, No. 17-20543 (W.D. PA. 2020) involves that fact pattern, with the twist that Mr. Zimmer filed a petition in bankruptcy court initiating a chapter 7 proceeding. Unfortunately for the competing creditors, the Morrises, the bankruptcy court does not allow their arguments to reduce Mr. Zimmer’s tax liability for reasons discussed below.
Mr. Zimmer filed bankruptcy in the summer of 2019 back when the living was easy. While most chapter 7 cases of individuals occur as no-asset cases because no assets exist for the trustee to distribute to unsecured creditors, Mr. Zimmer must have had assets, because the IRS filed a proof of claim in his case for just over $12,000 reflecting the unpaid tax from the amount of tax self-reported on his 2016 return. Taxpayers occasionally end up fighting with the IRS about whether they owe the amount of tax self-reported; however, those types of disputes occur less frequently than ones where the IRS seeks to increase a reported liability. Here, the much, much less frequent situation of a third party disputing the filed return occurs.
Because the 2016 tax debt stemmed from a tax return due within three years of the filing of the bankruptcy petition, the IRS would receive a priority for this unpaid liability pursuant to BC 507(a)(8)(A). Having a priority claim does not guarantee payment but positions the IRS much better than the holder of a general unsecured claim. I am guessing that Mr. and Mrs. Morris’ claim against Mr. Zimmer fell into the general unsecured claim category. I do not know how much money the Morrises sought to recover but they made an unusual argument that would have required a fair amount of effort on their part to build.
They argued that during 2016 Mr. Zimmer resided part of the year in Canada and that he should have claimed a foreign tax credit that would have significantly reduced his outstanding liability. They objected to the proof of claim filed by the IRS as inaccurate, since the IRS based its claim on the “incorrect” return filed by Mr. Zimmer. So, the adversary proceeding on the claim objection results in a tax merits trial regarding Mr. Zimmer’s return, where Mr. Zimmer defends the correctness of his return from an attack by a creditor and not by the IRS. The IRS essentially takes the position that Mr. Zimmer correctly filed the return. For those who may think the IRS only goes after taxpayers, this case provides a nice example of role reversal.
Mr. Zimmer testifies that
he paid no Canadian taxes during the relevant period of time because the income he earned during the relevant period of time was earned outside of Canada. He also testified that he filed no Canadian tax returns because he earned no income in Canada, because Canada denied his ability to have a taxpayer identification number, and because the Canadian authorities would not extend Mr. Zimmer’s stay in the country.
Based on reading the opinion, it did not appear that the Morrises put on contrary testimony. The court pointed out that in the absence of admissible evidence supporting a conclusion that the 2016 return was incorrect, it has no basis for changing the amount on the claim filed by the IRS.
In addition to arguing the legal incorrectness of the 2016 return, the Morrises also objected to the claim of the IRS on the basis that the IRS failed to attach a copy of Form 4340 (a type of transcript) to the claim itself, arguing that Bankruptcy Rule 3001(c)(1) requires a claim based on writing must attach the writing to the claim. The bankruptcy court dismisses this objection stating:
The majority of courts to consider this issue in the context of claims by the IRS have concluded that because tax claims are based on statutory obligations rather than obligations created by a writing, Fed.R.Bankr.P. 3001(c) does not apply to proofs of claims filed by taxing authorities.
In support of this statement the bankruptcy court cites a host of cases. Had the bankruptcy court held for the Morrises on this issue it not only would have reversed a fair amount of precedent developed in courts across the country but would have placed an unnecessary burden on the IRS in the claim filing process.
The Morrises also questioned the burden of production and the burden of persuasion. They sought to shift to the IRS the burden to prove the correctness of the proof of claim. The burden issue in tax merits litigation in bankruptcy proceedings was litigated with some frequency during the first two decades after passage of the current bankruptcy code in 1978. I thought this issue was laid to rest by the Supreme Court’s decision in Raleigh v. Illinois Dept. of Revenue, 530 U.S. 14 (2000). The bankruptcy court cites this opinion, after citing two lower court opinions, in support of its reasoning in denying this argument. The court pointed out that the IRS during the trial established the prima facia validity of its claim by showing that the claim arose straight from the unpaid taxes self-reported by the debtor. The court then spent some additional time rehashing the testimony of Mr. Zimmer regarding the foreign tax credit.
The Morrises made a fourth argument regarding the claim which the court addresses in a few sentences “for sake of completeness.” This argument raises a rather esoteric tax issue to attack the claim:
Morris Creditors argue that certain tolling provisions of 11 U.S.C. § 108 and 26 U.S.C. § 6511 somehow bar the IRS’s claim. This argument is apparently being raised by the Morris Creditors because a taxpayer is required to notify the Secretary of Treasury of accrued but unpaid foreign taxes “before the date 2 years after the close of the taxable year to which such taxes relate,” 26 U.S.C. §905(c)(1)(B), and this time period has now passed.
The court explains that no evidence exits that Mr. Zimmer owed foreign taxes and so no basis for concluding this unusual basis for tossing a claim exists.
The IRS argued that the Morrises lacked standing to challenge the report liability on Mr. Zimmer’s return. The court engages in a rather extensive analysis of Third Circuit law both before and after the passage of the Bankruptcy Code and concludes that the Morrises did have the right to challenge the claim filed by the IRS under BC 502. I kept thinking about the inventive arguments made by Michael Saltzman in the case of Brandt Airflex seeking to push the envelope of BC 505, which specifically governs the litigation of tax merits in bankruptcy. I was surprised that the court dealt strictly with BC 502 and did not address BC 505. I was not surprised that the IRS objected to standing in this case. I expect that it would do so again under similar circumstances.
The Morrises expended a lot of effort over a $12,000 claim. The amount of effort here for the amount at issue surprises me. I would understand if the IRS defended a small dollar issue because of the precedent, but for a private litigant to expend this much effort making some time consuming and technical arguments does not seem like a formula for reasonable return on the dollar even if they had succeeded. Nonetheless, the case provides another example of things that can happen in a bankruptcy case that would not happen in any other tax context.