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Notice is a Big Deal When Dealing With Tax Debts in Bankruptcy

Posted on Aug. 3, 2020

A pair of recent cases demonstrate the importance of notice. In one case where the outcome shocked me, the IRS loses out on a $90,000 trust fund recovery penalty. In the second case, which provided a routine result still worth the reminder, the purchaser of property loses in an effort to remove the federal tax lien in a quiet title action.

Notice to the government when trying to obtain relief from something the IRS has done or seeks to do can make or break a case. Generally speaking, a fair amount of protection exists for the IRS regarding notice, because it needs protection in order to insure that the information gets to the right place in time for the IRS to react properly to the request of a third party seeking to cut off rights the IRS would seek to assert or preserve. Because it receives such a volume of mail, establishing systems that allow the IRS to properly recognize and respond to important documents plays a huge role in having the system work properly. One of these cases demonstrates what happens to the IRS when the notice does not arrive at the places set up to respond, while the other cases demonstrates what happens when the party seeking relief fails to follow the very precise rules for providing notice to the IRS when seeking to cut off its lien rights.

Taxpayer Escapes Liability As Court Finds Adequate Notice of Objection to a Proof of IRS’s Claim

In Nicolaus v. United States, No. 19-1155 (8th Cir. 2020) the Eighth Circuit reverses the bankruptcy and district courts handing a victory on procedural grounds to a debtor in a case in which the IRS filed a claim for the Trust Fund Recovery Penalty (TFRP). We don’t know if the TFRP assessment against Mr. Nicolaus should exist on substantive grounds because the Eighth Circuit determines that the failure of the IRS to respond to his objection to the claim provides a basis for disposing of the claim. The issue in the case stems from an interpretation of the bankruptcy rules. As I mentioned above, the outcome shocks me and, I am sure, the government.

Mr. Nicolaus filed bankruptcy. The IRS timely filed a proof of claim. Mr. Nicolaus objected to the proof of claim and sent notice of the objection to the IRS at the address listed on the proof of claim. Although the Eighth Circuit’s opinion does not state this address, it would be an address at the IRS either in the local Iowa office or the centralized bankruptcy office in Indianapolis. Nothing happened. After 21 days and no response from the IRS, the bankruptcy court sustained the debtor’s objection and disallowed the claim. A year later, after the bankruptcy case had closed and Mr. Nicolaus had long since celebrated his easy victory over the large liability, the IRS filed a motion to vacate the order disallowing the claim, based on a lack of personal jurisdiction because of the improper service of the objection to claim. While it may seem harsh to have a motion filed a year later, the timing does not impede the ability of the IRS to set aside the disallowance and probably reflects the amount of time the case took to cycle from the bankruptcy into collection mode, where someone at the IRS actually took notice of the disallowance.

The bankruptcy court agreed with the IRS that service of the objection was improper and it vacated the order disallowing the claim. Because of the type of debt, the discharge Mr. Nicolaus received could not discharge the liability which meant that the IRS could come after him post-discharge to collect the debt. B.C. 507(a)(8)(C) provides that a debt for taxes a taxpayer collects on behalf of the IRS receives treatment as a priority claim no matter how old the debt. If a debt has priority status, an individual cannot discharge it based on the exception to discharge in B.C. 523(a)(1)(A). So, the issue of the disallowance of this debt has a significant impact on Mr. Nicolaus.

At the time of filing the objection Federal Rule of Bankruptcy Procedure 3007(a) provided “[a]n objection to the allowance of a claim shall be in writing and filed. A copy of the objection with notice of the hearing thereon shall be mailed or otherwise delivered to the claimant, the debtor or debtor in possession, and the trustee at least 30 days prior to the hearing.” I will note that earlier the court described the default occurring after 21 days but don’t focus on that issue. Footnote 2 of the opinion notes that “[W]ith an effective date of December 1, 2017, an amendment to Rule 3007(a) now expressly requires objections to a federal agency’s claim to be mailed to the Attorney General and the local United States Attorney’s Office. The pre-amendment version applies here, however, because Nicolaus filed his objection before the effective date of the 2017 amendment.

At issue in this case is whether the debtor needed to serve the Attorney General of the United States and the local United States Attorney’s Office under the prior version of the rule. The lower courts looked at Bankruptcy Rule 9014(b) governing service in contested matters and found that it required service in the manner required by Bankruptcy Rule 7004, which clearly requires service on the AG and US Attorney; however, the Eighth Circuit noted that in 9014(b) the key word was “motion” triggering this type of service and the objection was not a motion. The Eighth Circuit did not find the advisory notes to the rules controlling but rather the plain language of the rule as it read prior to its amendment. Accordingly, it reversed and Mr. Nicolaus once again has his victory which through this litigation became a hard earned victory, albeit on procedural rather than substantive grounds.

The amendment to the rules almost certainly means that the government will not seek a ruling from the Supreme Court on this issue. The rule appears to have been changed to partially resolve a split in authority on how to interpret 3007, with different bankruptcy courts taking contrary approaches. Compare In re Hensley, 356 B.R. 68 (Bankr. Kan. 2006) (holding that service of a claim objection need not follow Rule 7004) with In re Boykin, 246 B.R. 825 (Bankr. E.D. Va. 2000) (holding the reverse). In addition, the Advisory Committee notes for the 2017 amendment suggest a need to centralize and standardize service on the government, stating that “the size and dispersal of the decision-making and litigation authority of the federal government necessitate service on the appropriate United States attorney’s office and the Attorney General[.]”Not many cases will still exist from before 2017. So, Mr. Nicolaus may be the last beneficiary of the Eighth Circuit’s interpretation of the bankruptcy rule.

Purchaser Loses As Failure to Follow Notice Rules Led To No Extinguishing of Tax Lien

In contrast to the victory achieved by Mr. Nicholas, another case decided on July 6, 2020 went the opposite way based on a failure to give proper notice to the IRS. In LN Management LLC Series 7241 Brook Crest v. Brandon Jhun, No. 2:14-cv-01936 (D. Nev. 2020) the District Court determined that the purchaser of property could not quiet title to remove the IRS lien. The plaintiff purchased property at a non-judicial foreclosure sale. Prior to the foreclosure sale the IRS assessed taxes against the owners of the property for 2008 and 2009 on October 12, 2009 and June 7, 2010, respectively. The IRS properly recorded its notice of federal tax lien on May 18, 2011. I previously discussed the notice requirements of 7425 here.

The property owners failed to pay their homeowners association fees, and the HOA brought a foreclosure action in 2013. The HOA did not mail foreclosure notices to the IRS. The plaintiff bought the property. At some point, presumably after purchase, the plaintiff noticed the federal tax liens encumbering the property and brought this action. The law is so well settled on this issue that it’s hard to know why the purchaser bothered with this suit but maybe it hoped for the same luck as Mr. Nicolaus.

In order to extinguish the federal tax lien in a non-judicial foreclosure sale when the IRS has properly filed notice of the lien more than 30 days before the sale, the party bringing the action must give notice to the IRS in the manner described in IRC 7425(b)(1), or the sale will not extinguish the federal tax lien.

A party trying to extinguish the federal tax lien under these circumstances must follow very specific steps for notice. Once the IRS raised its objection, the plaintiff did not even respond. At that point it must have realized the futility of its case. Because the IRS did not seek to foreclose its lien or respond to alternate grounds for relief, the court granted the motion for summary judgement on the quiet title portion of the case but remanded the parties to discuss the remaining issues.

The plaintiff should have performed a title search before purchasing the property, just as the HOA should have done before filing its complaint. The purchaser may have thought that it bought the property for a bargain. By now, it has realized that the bargain just embroiled it in a quagmire. Purchasing property encumbered by the federal tax lien requires careful planning. That obviously did not occur here because of the failure of notice in the specific manner required by the statute in order to give the IRS the opportunity to participate in the foreclosure proceeding.

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