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Making Claims and Spending Refunds in Bankruptcy

Posted on Mar. 7, 2016

A pair of bankruptcy cases provides insight into bankruptcy procedures. In the first case singer M.C. Hammer fails to capitalize on the IRS leaving a couple of years off of its claim in his bankruptcy case.  In the second case the bankruptcy court enjoins a physician from spending a refund that might belong to the bankruptcy estate of his corporation.  Both cases involve frustrated debtors who do not get the result they seek vis a vis the tax issue involved and both raise minor points of interest concerning bankruptcy.

M C. Hammer and his wife filed bankruptcy at some point in the past when they owed taxes for the years 1996 and 1997. The 9th Circuit recently affirmed the district court opinion granting summary judgment to the IRS in a case brought by Mr. Stanley Burrell aka M C Hammer seeking to equitably estop the IRS from collecting on taxes for two years which it failed to include on the proof of claim in his bankruptcy case.  The court said he had to prove two things to achieve equitable estoppel: 1) affirmative misconduct on the part of the government and 2) serious injustice.  He proved neither.  The court said the IRS may have been negligent in failing to include the years on the proof of claim but no evidence suggested the omission resulted from affirmative misconduct.  It also found holding the taxpayer liable for the taxes he owed did not cause a serious injustice and that his lawyer had represented to the bankruptcy court that the taxes for the two years would be paid later.

The one page affirmance gives short shrift to the almost frivolous argument made regarding equitable estoppel where the IRS fails to list a period on its claim. Debtors who notice that the IRS has failed to list a claim should almost always fix the claim for the IRS.  There can be a situation where the failure by the IRS to list a period on the claim will benefit the debtor but much more often than not will not help the debtor and might hurt the debtor by allowing dischargeable claims to get paid before a non-dischargeable tax claim.  If you are working on a case and the IRS makes this mistake, which it occasionally does, consult with a bankruptcy specialist about the mistake and do not assume that the mistake will benefit the debtor.

Dr. Briggs was both a medical doctor and an entrepreneur and formed a number of medical groups between 1993 and 2013. Four of the entities he formed file Chapter 11 petitions in May, 2015.  When he formed each of these businesses, Dr. Briggs elected to treat each one as a pass-through entity for tax purposes.  His individual return for 2012 showed a refund of $122,014 and for 2013 a refund of $65,831.  These refunds resulted because of over $800,000 of net operating losses of the four debtor companies.  Because he owes his ex-wife $1.8 million and he does not have sufficient assets or an income stream to satisfy that liability, the bankruptcy court in Unsecured Creditors Committee v. Briggs found that Dr. Briggs was insolvent.

The issue is what happens to the big NOLs of the now bankruptcy companies and whether Dr. Briggs can use those losses on his personal return because of the flow through nature of the tax structure of the business or whether the NOLs represent a valuable asset of the bankruptcy estate of the businesses which should be used to satisfy the creditors of the businesses rather than just go in refund form to Dr. Briggs for him to use for whatever purposes he might have. The creditors showed that over 99% of the refunds were attributable to the NOLs.  They sought to enjoin him from using the refunds until a full hearing on whether the refunds belonged to him or to the companies.  The court granted the injunction after walking through all of the tests a party must prove to satisfy such a remedy.

The important bankruptcy issue here is the ownership of the refund which the court does not decide but does tee up in its discussion of the likely success of the creditors on the merits. This is not the first time that a NOL generated refund has been the subject of litigating in bankruptcy though the issue does not arise with frequency.  In the case of In re Forman Enterprises, Inc., in the bankruptcy court for the Western District of Pennsylvania, the trustee brought a similar action seeking to recover tax refunds stemming from the debtor’s NOLs from the corporate shareholders.  The trustee argued unjust enrichment.  That court held that the refunds were not available to satisfy the claims of the creditors because “the debtor was merely a conduit through which the NOL and the right to use it passed….”

The only other case cited by the bankruptcy court here involved the sale of property of the debtor to pay tax refunds of the owners of the LLC debtor. In the case of In re KRSM Properties, LLC, the Bankruptcy Appellate Panel in the 9th Circuit held that the property belonged to the bankruptcy estate and ordered the IRS to return the payments of the individuals to the estate.  This case seems sufficiently different to not deserve too much attention here but the issue of the entitlement to NOLs raises serious concerns for owners of pass through entities that head into bankruptcy.  These owners will frequently receive some tax benefit for an entity losing money as most debtors do.  The Briggs case deserves watching if you know an owner in this situation as the law here is sparse.  The IRS generally sits on the sidelines of these cases as the parties fight out their ownership rights over the value offered by the NOLs.

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