Tax Notes logo

Erroneous Refund Case Reveals the Intersection of Bankruptcy and Tax Procedure

Posted on Oct. 17, 2013

A recent erroneous refund case provides an opportunity to talk about some similarities and differences between that statute and “regular” fraud cases.  On August 27, 2013, United States Magistrate Judge Paige Gossett entered an opinion determining that Gloria Frazier received a $51,060.00 erroneous refund on February 16, 1999.

The first thing that caught my eye here was the timing of the refund.  It was issued more than 14 years ago.  How, I wondered, could a decision favorable to the Government appear in an erroneous refund case that long after the issuance of the refund?  The first difference between the fraud provision in erroneous refund cases and in “regular” tax cases is the fixed time frame for bringing the erroneous refund suit – five years after the refund.  Any suit brought within five years after February 16, 1999, should have been decided by a magistrate judge long before the end of 2013.  The judge explained why the opinion came out so long after the erroneous refund with a cryptic reference to multiple bankruptcy filings by the defendant.

The bankruptcy aspects of the case deserve discussion.

I did not research Ms. Frazier’s bankruptcy filing history but the case provides a glimpse at a provision of the automatic stay that most tax lawyers do not see.  Upon the filing of a bankruptcy petition, the automatic stay stops, or stays, the actions described in the eight subparagraphs of B.C. section 362(a). Tax lawyers frequently see Tax Court cases stayed by B.C. 362(a)(8).  Tax practitioners involved in collection cases regularly see collection stopped by a bankruptcy filing because of B.C. 362(a)(6).  Although the Court does not explicitly say so, the Frazier case involves the stay of B.C. 362(a)(1), which stops the commencement or continuation of a proceeding against the debtor that could have been commenced before the filing of the bankruptcy petition.  Seeing (a)(1) in action to stay a tax case provides a rare opportunity because the IRS, through the Tax Division of the Department of Justice, brings so few affirmative suits and those suits infrequently intersect with bankruptcy.

In addition to the automatic stay aspect of the Frazier case, it also presents an opportunity to think about the discharge of the erroneous refund liability now determined against her.  This liability will not have priority status as a claim against the estate.  The IRS could record the judgment and perhaps obtain secured status.  Assuming Ms. Frazier does not have property to which the judgment lien could attach, the IRS will have a general unsecured claim.  Assuming further that Ms. Frazier will choose to go into bankruptcy again in the future, the question of discharge regarding this liability may soon come.  (It may have already arisen in her earlier bankruptcy cases since the existence of the erroneous refund case would have formed the basis for a claim by the IRS in those earlier bankruptcy cases.  Without researching those cases, I will assume that dismissal or some other event occurred prior to discharge since the parties pursued the erroneous refund case without discussing the discharge injunction and without discussing litigation in the bankruptcy court that would have established the claim as non-dischargeable and might have had a collateral impact on this litigation.)

The discharge issue here will turn on the application of the exception to discharge found in BC 523(a)(1)(C), which provides that tax debts are excepted from discharge (not discharged) if “the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” Did Ms. Frazier make a fraudulent return when she filed the return resulting in the erroneous refund?  The decision in the erroneous refund case would not seem to provide the same collateral estoppal benefits that a civil or criminal fraud penalty case would since the language of erroneous refund statute mentions either fraud or material misrepresentation.  The court appeared to decide the case on the material misrepresentation prong of the test for extending the erroneous refund statute of limitations.

Even if fraud existed in the filing of the claim for the refund, the preparer of the return, rather than Ms. Frazier, may have perpetrated the fraud.  If the fraud in the refund claim stems from the actions of the preparer rather than the debtor, the application of the exception to discharge under BC 523(a)(1)(C) may not apply.  This type of derivative fraud, which the Tax Court approved as keeping open the statute of limitations in Allen v. Commissioner and which Les recently wrote about concerning the BASR v. United States case, may not apply to prevent the discharge of a debt. Given Ms. Frazier’s apparent willingness to use the bankruptcy process, this case may offer the opportunity to see how the erroneous refund provision keeping open the statute of limitations where fraud or material misrepresentation exist mesh with the exception to discharge provision for attempting to evade or defeat the tax.

I will write separately about the more traditional tax aspects of the Frazier case.

Copy RID