Framing the Issue of Bankruptcy Courts Determining Tax Liability

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Framing the Issue of Bankruptcy Courts Determining Tax Liability

Whether or not a bankruptcy court has the authority to determine a debtor’s tax liability may depend on how the court characterizes the issue before it. Judge Easterbrook, writing for the Seventh Circuit Court of Appeals in Bush v. United States,[1] recently vacated and remanded a district court case deciding this precise issue because the district court based its opinion on an “erroneous jurisdictional view.” The Bush court’s jurisdictional approach in answering the question of bankruptcy authority to determine tax liability deviates from the norm and ends in limitations on bankruptcy court jurisdiction.

The debtors in Bush filed for bankruptcy on the morning their tax dispute was scheduled to proceed to trial in the Tax Court. The dispute involved how much the debtors owed in federal tax penalties. When a debtor files a petition for bankruptcy, that filing acts as a judicial order, automatically halting nearly all collection attempts and proceedings against the debtor.[2] This automatic stay enables debtors to obtain relief from most creditor attempts to collect on the debtor’s pre-petition debts, including tax liabilities pending before the Tax Court at the time the bankruptcy petition is filed.[3] The bankruptcy judge in the Bush case declined to exercise his authority to lift the stay and allow the debtors’ tax dispute to continue in Tax Court.

A few months after their proceedings in the Tax Court were stayed, the debtors filed a motion in bankruptcy court, requesting a determination of their tax liability. Section 505 of the Bankruptcy Code broadly authorizes bankruptcy courts to determine the amount or legality of any tax or tax penalty of a debtor. The bankruptcy court granted the debtors’ motion, determining it had jurisdiction and declining the United States’ request that the court abstain. The United States, in turn, filed a motion to reconsider the bankruptcy court order, which the court denied. The United States appealed the bankruptcy court’s order granting the debtor’s motion and the order denying the United States’ motion to reconsider.

The United States District Court for the Southern District of Indiana reversed and remanded the bankruptcy court’s rulings because it concluded the bankruptcy court lacked jurisdiction to determine the amount of the debtors’ tax liability. Since the tax claim was subordinate and the estate had insufficient funds to reach the claim, the district court reasoned that a determination of the amount owed was not sufficiently related to the bankruptcy case for purposes of establishing bankruptcy court jurisdiction. The court saw no scenario where money would be left in the debtors’ bankruptcy estate to pay the tax claim, so determining the amount of the claim could not affect the amount of funds left in the estate for distribution to creditors. Rather, the amount of property left in the estate would be the same regardless of how much the debtors owed on the tax claim.

On appeal, the Seventh Circuit disagreed with the district court’s ex post jurisdictional inquiry because it violated one of the most fundamental rules of federal jurisdiction, the time-of-filing rule.[4] Since judicial authority depends on the state of affairs when a claim is filed in bankruptcy, bankruptcy court jurisdiction cannot turn on how things look at the end of bankruptcy, i.e., how much is left in the estate or how many creditors’ claims have been filed. “But taking that ex post view would contradict the norm that jurisdictional issues must be resolved ex ante, not in light of how things turn out.”[5] Rather, a bankruptcy court has related-to jurisdiction[6] to determine tax liability if, at the outset of the dispute, the resolution of the tax dispute has a “potential effect” on other creditors.[7] Therefore, the court held the bankruptcy court had jurisdiction to determine the amount of the debtors’ tax liability while the bankruptcy was ongoing.[8]

Even though the bankruptcy court could exercise its jurisdiction over the tax dispute, the Seventh Circuit nevertheless found that it should not, where nothing was left to be done in the bankruptcy case.[9]Instead, the bankruptcy court should, “in the interest of justice,” relinquish the tax dispute to the specialist judges of the Tax Court.[10] The court found it noteworthy for determining the appropriate forum that the tax dispute stood in the same posture as it did when the debtors filed for bankruptcy.[11]

While the result in Bush makes sense, its approach departs from that of many courts deciding the same issue. As an initial matter, several courts view the bankruptcy power to make tax liability determinations in § 505 of the Bankruptcy Code as jurisdictional, in as much as it authorizes bankruptcy courts to determine a certain class of tax claims.[12] Many courts also interpret the decision to determine a debtor’s tax liability under § 505 as a discretionary authority,[13] leaving the decision of whether or not to abstain to the bankruptcy judge absent an abuse of discretion.[14] The court in Bush said the mischaracterization of 505 as jurisdictional was “unfortunate.” Rather, Section 505, like most of the Bankruptcy Code, merely sets out a task for bankruptcy judges and does not even mention the term “jurisdiction.”

Moreover, Bush was decided under Section 1334 of Title 28, where the court noted “[m]ost genuine jurisdictional rules appear” in the United States Code.[15] Section 1334(c)(1) allows courts to abstain from hearing bankruptcy matters “in the interest of justice.” Many courts would view the issue in Bush as a question of discretionary authority under § 505 of the Bankruptcy Code, leaving the decision to make tax liability determinations largely to the bankruptcy judge. But in holding that a bankruptcy court cannot determine the amount of a debtor’s tax liability when the debtor is unlikely to pay them, Bush essentially removed the bankruptcy court’s discretion to decide whether or not to abstain.

The court’s jurisdictional analysis was much less accepting of bankruptcy court authority than many other courts would have been under a § 505 discretionary analysis. The Bush approach limits the jurisdiction of bankruptcy courts by prohibiting the exercise of their authority over certain tax disputes when the courts of appeal find the Tax Court to be a more appropriate forum for resolving the dispute. At a minimum, bankruptcy courts in the Seventh Circuit lack the authority to determine the amount a debtor owes in a federal tax dispute, where the debtor is unlikely to pay and nothing remains to be done in the bankruptcy case.

 

 

[1] 939 F.3d 839 (7th Cir. 2019).

[2] 11 U.S.C. §§ 301, 362(a).

[3] 11 U.S.C. § 362(a)(8).

[4] See Mollan v. Torrance, 22 U.S. 537, 539 (1824) (“[T]he jurisdiction of the Court depends upon the state of things at the time of the action brought.”).

[5] Bush, 939 F.3d at 846.

[6] Title 28 establishes three categories of bankruptcy matters for purposes of bankruptcy court jurisdiction: (1) proceedings arising under title 11, (2) proceedings arising in title 11, and (3) proceedings related to cases under title 11. 28 U.S.C. §§ 1334(b). Because the tax dispute was not exclusive to bankruptcy law and did not present a substantive question of bankruptcy law, the court’s analysis only concerned the third category, “related to” jurisdiction. Bush, 939 F.3d at 844.

[7] Id. at 846. The court distinguished the requirement of an “actual effect” on creditors at the end of a case from requiring a “potential effect” at the outset. Id.

[8] Id. at 847.

[9] Id. at 846.

[10] Id.

[11] Id. at 846–47.

[12] United States v. Bond, 762 F.3d 255, 262 (2d Cir. 2014) (“Section 505(a) is a grant of jurisdiction to the bankruptcy court over certain tax claims, not a grant of powers to trustees.”); Wilshire Courtyard v. Cal. Franchise Tax Bd. (In re Wilshire Courtyard), 729 F.3d 1279, 1291 (9th Cir. 2013) (“we have consistently interpreted § 505 as jurisdictional because it explicitly confers upon or deprives the bankruptcy court of certain authority”); IRS v. Luongo (In re Luongo), 259 F.3d 323, 328 (5th Cir. 2001) (noting “the broad grant of jurisdiction in § 505(a)(1) permitting a bankruptcy court to determine ‘the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction’”); City of Perth Amboy v. Custom Distribution Servs., Inc. (In re Custom Distribution Servs. Inc.), 224 F.3d 235, 239–40 (3d Cir.2000) (“We have consistently interpreted § 505(a) as a jurisdictional statute that confers on the bankruptcy court authority to determine tax claims.”).

[13] Cent. Valley AG Enters. v. United States, 531 F.3d 750, 764 (9th Cir. 2008) (“The bankruptcy court may, in its discretion, decline to exercise its authority to redetermine a debtor’s tax liabilities … because [t]he assumption of the power is discretionary with the Bankruptcy Court.”); Luongo, 259 F.3d at 328–30 (“The bankruptcy court’s ability to abstain is premised on Congress’ use of the word ‘may’ in § 505.”); New Haven Projects Ltd. Liab. Co. v. City of New Haven (In re New Haven Projects Ltd. Liab. Co.), 225 F.3d 283, 288 (2d Cir. 2000) (“Therefore, based on the plain language of the statute, its legislative history, and relevant case law, we interpret the verb ‘may’ in 11 U.S.C. § 505(a)(1) as vesting the bankruptcy court with discretionary authority to redetermine a debtor’s taxes.”).

[14] Courts routinely cite to legislative statements for the rule that “the bankruptcy judge will have authority to determine which court will determine the merits of the tax claim both as to claims against the estate and claims against the debtor concerning his personal liability for nondischargeable taxes.” See Luongo, 259 F.3d at 328 (emphasis omitted) (quoting legislative history).

[15] Bush, 939 F.3d at 843.