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How Bankruptcy Can Create a Pyrrhic Victory out of a Tax Court Win

Posted on Aug. 6, 2014

In Galluzzo v.  Commissioner the Third Circuit sustained the decision of the Tax Court that it did not have jurisdiction over this case, involving a husband and wife, because the IRS did not prove that it sent the statutory notice of deficiency to their last known address.  The Tax Court has jurisdiction to determine when it does not have jurisdiction and to state why it does not have jurisdiction.  This becomes very handy for taxpayers challenging an assessment long after the 90 period has run within which to petition the Tax Court.  In these circumstances the taxpayer petitions the Tax Court knowing that it does not have jurisdiction but hoping that it will determine it does not have jurisdiction because of a screw up by the IRS and not a screw up by the Taxpayer.

Taxpayers who win these jurisdictional dismissals frequently win a total victory because the statute of limitations on assessment has run.  In these circumstances the IRS cannot fix its mistake and the happy taxpayer is off the hook for the periods in the defective notice.  Mrs. Galluzzo may be one of the lucky ones who receive a determination after the statute of limitations has run and who no longer gets hit with a liability for the periods in the notice.  Mr. Galluzzo, who shared the Tax Court and Third Circuit victories with his wife may not be so lucky because of his intervening Chapter 11 bankruptcy case.  The reason Mr. Gulluzzo may not share in his wife’s good fortune deserves examination.

The IRS examined the joint returns filed by the Galluzzos for 1999, 2000 and 2001. By the time Mr. Galluzzo filed a chapter 11 in bankruptcy in 2006 the tax, interest and penalties for these three years that the IRS claimed as a secured claim against his estate was $1,251,456.99. The IRS should only have filed a secured claim if it had filed a notice of federal tax lien prior to the filing of the bankruptcy petition and if the lien attached to property equal in value to the claim. The fact that he reached a settlement on the claim suggests that the IRS lien claim had merit (not taking into account the subsequent challenge to the validity of the underlying assessment.) While individuals rarely file chapter 11 cases, they may do so and the amount of Mr. Galluzzo’s debt appears large enough to have prohibited him from filing a chapter 13 petition based on the debt dollar limits for that chapter. While the bankruptcy code permits married individuals to file joint petitions, the decision to do so rests with the individuals similar to the decision to file joint returns. Here, the couple decided not to file joint petitions. I think that will work to Mrs. Galluzzo’s benefit although it may not matter in the end.

The bankruptcy court confirmed Mr. Galluzzo’s plan. The plan here has critical importance. Prior to confirmation he had brought an adversary proceeding objecting to several secured claims including the secured claim of the IRS. The adversary proceeding settlement reduced the IRS secured claim by $200,000 and provided that the IRS would “retain its lien for any remaining balance” on the Galluzzos’ New Jersey properties. The confirmation order added a directive that Mr. Galluzzo pay the secured claim within six years from the date of assessment. This language follows the language in BC 1129 regarding secured claims owed to the IRS. The six year period ran in November 2011.

Meanwhile, Mrs. Galluzzo had filed two chapter 13 bankruptcy petitions. Her petitions were filed on April 25, 2005 and July 26, 2005, and each was voluntarily dismissed prior to confirmation because her bankruptcy cases did not move forward, they play no role in the discussion of this case. The determinations regarding property in Mr. Galluzzo’s bankruptcy may impact Mrs. Galluzzo through their effect on property in which she has an interest. Otherwise, his bankruptcy has little impact on her and will not prevent the defeat of the tax liability for failure to send a valid notice of deficiency.

In March, 2011, the Galluzzos brought suit in the district court attacking the IRS assessment based on the failure to mail the notice of deficiency to the proper address. The federal magistrate dismissed that suit but pointed out to the Galluzzos that they could achieve the result they wanted from him by filing a petition in the Tax Court. They then filed a petition in the Tax Court which agreed with them that the IRS had failed to satisfy its burden that the notices were properly mailed. The Third Circuit affirmed the Tax Court. This destroys the assessment but what does it do to the debt Mr. Galluzzo took on with the settlement of the adversary proceeding and the confirmation of the plan?

In the Third Circuit the IRS argued that the Tax Court should not have made its own determination concerning the validity of the notice of deficiency because the Bankruptcy Court’s consent and confirmation orders establish by res judicata that Mr. Galluzzo owes and must pay the debt to the IRS. The res judicata effect of these orders may save the day for the IRS here even though it has lost on the validity of the assessment, and therefore lost its right to collect administratively on the debt as well as lost the ability to collect separately from Mrs. Galluzzo.

The Third Circuit rejected that portion of the IRS argument that the Tax Court was wrong to determine the validity of the statutory notice. It held “a party’s invocation of res judicata, even if well-founded, cannot prevent the Tax Court from fully assessing its own subject matter jurisdiction,,,,” So, Mr. Galluzzo’s failure to raise the validity of the notice before the bankruptcy court, which he could have done to defeat the debt there, does not keep him from raising that issue before the Tax Court and does not keep the Tax Court from holding that the IRS failed to prove the proper sending of the statutory notice. That still leaves open the question of what happens to the debt established by the bankruptcy court.

In its final paragraph the Third Circuit notes that the favorable ruling for the taxpayers has come in the Tax Court but it does not say that the ruling undercuts the plan or the debtor’s obligation to pay under the plan. In most situations, such a ruling would not undercut the plan obligation. Here, the language of the plan appears to tie the timing of the payment to six years from assessment. The plan language did not say six years from a valid assessment. The assessment, while now shown invalid, still occurred in November, 2005. Mr. Galluzzo may still have a requirement despite his success in the Tax Court case   I failed to find anything in PACER to tell me if the issue continues. Perhaps the absence of further litigation in the bankruptcy matter means the IRS has conceded the liability or perhaps the matter has not come to a head yet or perhaps I missed the subsequent action.

This case reminds me of a case 25 years ago involving the Hunt brothers, Nelson Bunker and William Herbert Hunt. In the late 1970s these brothers were reputed to be the richest men in the world. They fell on hard times and ended up in bankruptcy in 1989 because of lawsuits involving their attempt to corner the silver market. In the bankruptcy they also had issues with the IRS arising from certain gifts. The tax issues were pending before the United States Tax Court at the time of the filing of their bankruptcy petitions and resulted in the leading case on when a bankruptcy court will take jurisdiction away from the Tax Court in order to make a quicker tax merits determination. The bankruptcy court essentially declined to remove the case for it to decide the merits because the Tax Court case also included a third brother not in bankruptcy, the late Lamar Hunt, longtime owner of the Kansas City Chiefs and one of the founders of the American Football League. Rather than wait for the Tax Court decision or try the case in Bankruptcy Court under BC 505(a) a settlement was reached and a plan confirmed in which the Hunts conceded all or almost all of the liability in exchange for other concessions. An expert witness for the Hunts testified at confirmation concerning the strength of the government’s case and the plan was confirmed. A few months after confirmation, the Tax Court issued its opinion basically holding for the Hunts.  Despite the Tax Court decision in their case, the Hunts were bound by the confirmation order. One happy note from the Hunt case is that William Herbert Hunt has risen from the financial ashes of his bankruptcy case, which I believe is still the largest personal bankruptcy case in US history, to once again make the list of richest people in America.

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