Attorney Danny Newman has an in-depth article recapping several recent Ninth Circuit case decisions published in the newest installment of the OSB Debtor-Creditor Section Newsletter. You can read Danny’s article in full below.
Ninth Circuit Case Notes
By Danny Newman
The Ninth Circuit’s published debtor-creditor decisions continue to be on the lighter side, with (interestingly) four of the five published decisions during this period relating to tax debts or issues. This is likely a sustained result of the various COVID-19 emergency protections for borrowers promulgated by various states and the federal government. Fewer bankruptcy filings and fewer foreclosures has led to fewer cases reaching the Ninth Circuit for decision.
Abandonment Requires Inclusion on Schedules
In re Stevens, 15 F.4th 1214 (2021)
The Ninth Circuit has held, as a matter of first impression at the circuit level, that abandonment required inclusion of an asset in the schedules, not merely disclosure in the statement of financial affairs (SOFA) or to the trustee.
Debtors Jasper and Brenda Stevens’ Chapter 7 case was filed years ago. While it was pending, they were plaintiffs in state court litigation against their mortgage servicer, and that litigation was identified in the SOFAs under § 521(a)(1)(B)(iii), discussed in numerous meetings with the Chapter 7 trustee, and disclosed to the Chapter 7 trustee with all relevant litigation documentation. However, they did not list the litigation in their schedules under § 521(a)(1)(B)(i)(ii) despite its active status. In the end, the trustee certified that the case had been properly administered with no property available for distribution.
Section 554(c) of the Bankruptcy Code provides that all property that has not otherwise been administered at the close of a case is abandoned so long as the property was “scheduled.” For its part, Section 521(a) requires a debtor to file several schedules, as well as several statements.
Years later, after Debtors continued the litigation, the mortgage servicer contacted the trustee and sought reopening of the previous case to pursue settlement. The trustee agreed, and, upon reopening, the two settled the lawsuit. The trustee then moved for approval of the settlement. The bankruptcy court approved, holding that the debtors’ interest in the litigation had not been abandoned because it was not properly scheduled. The BAP affirmed on appeal.
The Ninth Circuit viewed the question presented as whether “‘scheduled’ in Section 544(c) ‘requires that property be listed on one of the literal schedules, or if listing it on one of the other statements [including SOFAs] can suffice.’” In re Stevens, 15 F.4th at 1215. Applying the plain language of the statute, Judge Ryan Nelson wrote for the court that “scheduled” in Section 544(c) means what it says, and that disclosure on the SOFAs, along with other disclosures to the trustee, is not sufficient to trigger abandonment. Id.
Despite the harsh result, the Ninth Circuit referenced a footnote in a recent Second Circuit opinion implying the panel there would have reached the same conclusion. See Ashmore v. CGI Grp., Inc., 923 F.3d 260, 282 n.16 (2d Cir. 2019). Moreover, the Ninth Circuit relied on various pronouncements that it is the debtors’ burden to properly list its assets and liabilities on the schedules. Further, as close readers of this space will appreciate, the panel was again somewhat persuaded by the Supreme Court’s reasoning in Law v. Siegel, 571 U.S. 415, 421 (2014), that bankruptcy courts cannot use equitable considerations to undermine or contravene plain language in the Bankruptcy Code.
Debtor’s State Taxes Not Dischargeable Absent a Tax Return or Payment[i]
In re Sienega, 18 F.4th 1164 (2021)
In another case of strict interpretation of the Bankruptcy Code’s terms leading to harsh results against a debtor, debtor Rudolf Sienega’s state tax debts were not dischargeable because he did not file “returns” within the meaning of Section 523(a)’s hanging paragraph. The Ninth Circuit held that following California’s permissible procedure to submit adjustments to tax bills was insufficient and did not meet the meaning of the word “return” in the Bankrkuptcy Code.
Debtor Sienega failed to file required California state income tax returns with the Franchise Tax Board (“FTB”) for the 1990, 1991, 1992, and 1996 tax years. In 2007, the IRS made upward adjustments in Debtor’s federal tax liability for those four years, and in January 2009, the U.S. Tax Court ruled that Debtor was also liable for accuracy-related penalties of approximately $9,688. Following the Tax Court decision, Debtor’s counsel notified FTB of the federal adjustments via fax. For each of the four tax years, counsel faxed a cover sheet and an IRS form (Form 4549-A) that listed the adjustments to the corrected taxable income and tax liability, interest and penalties, and the total balance due to FTB. The cover sheet purported to give notice “pursuant to California State law.” In re Sienega, 18 F.4th at 1167. Notably, FTB was never provided an actual tax return. In response, FTB issued a notice of proposed assessment to Debtor for each of the four tax years in question, noting that California had never received returns from Debtor in those years, and providing Debtor with the relevant period to submit formal protest. Under those notices, FTB’s assessments became final in October 2009.
Debtor filed a Chapter 13 petition in 2014 that was later converted to Chapter 7. FTB filed an adversary complaint seeking to have Debtor’s outstanding tax debts declared nondischargeable under Section 523(a)(1) of the Bankruptcy Code. Debtor argued that he had filed state tax returns within the meaning of 11 U.S.C. § 523(a) by faxing information about the adjustments to FTB and was thus entitled to discharge. The bankruptcy court granted California summary judgment, and the BAP affirmed.
The Ninth Circuit also affirmed, issuing two separate holdings. Debtor argued, unlike he had below, that the process he followed to report adjustments to FTB was “similar” to a return issued by the IRS under Section 6020 of the Tax Code. 11 U.S.C. 523(a).[ii]
Thus, first, the Chief Judge Sidney Thomas found that the California statute providing for how Debtor was to report changes or corrections on federal tax returns to a state taxing authority (i.e., via fax and then receiving a notice of adjustment from the State) is not “similar” to the Tax Code provision authorizing IRS to prepare tax returns when a taxpayer does not do so, within the meaning of the “hanging paragraph” of the Bankruptcy Code’s tax dischargeability provision. Second, and relatedly, faxes sent by Debtor’s counsel notifying a state taxing authority of federal tax adjustments, but without any accompanying formal state tax returns, did not constitute a “return” within the meaning of the “hanging paragraph” of the Bankruptcy Code’s tax dischargeability provision.
To get to both conclusions, the panel relied on the Ninth Circuit’s and Tax Court’s test for whether a document is a “return” in Beard v. Commissioner, 82 T.C. 766 (T.C. 1984). The four-part test for “a ‘return’ is a document that (1) ‘purport[s] to be a return’; (2) is executed under penalty of perjury; (3) contains enough data to allow computation of the tax; and (4) represents an ‘honest and reasonable attempt to satisfy the requirements of the tax law.’” In re Sienega. at 1168. California has a similar test, and Debtor’s faxes did not meet either. To sum it up, the panel stated that “one of these things is not like the other.” Id. at 1169.
Unfortunately, Sienega—not unlike the Stevenses above—might be punished for mistakes by their attorneys (in Sienega’s case, a former attorney rather than the bankruptcy lawyer). The Stevenses were decidedly less blameless—Sienega purposefully failed to file tax returns initially. Still, in both cases, the Ninth Circuit—for better or for worse, and in a win for predictability—has interpreted the Bankruptcy Code strictly by its plain language regardless of the “equities” of the outcome.
Trustee Can’t Avoid IRS Liens
In re Hutchinson, 15 F.4th 1229 (2021)
In another tax case, the Ninth Circuit again sided with the taxing authority, tossing out a debtor’s action to avoid tax liens on exempt property when the trustee had failed to bring the avoidance actions itself because such an action was meritless under binding circuit precedent.
In 2011, the IRS recorded liens for unpaid taxes, interest, and penalties against Chapter 7 debtors Leonard and Sonya Hutchinson’s residence in California. After Debtors filed for Chapter 7 bankruptcy in June 2017, they filed an adversary complaint naming both the trustee and the IRS as defendants seeking to avoid the tax liens under Section 724(a) as a “lien that secures” a claim for penalties, arguing they had standing to pursue the avoidance under Section 522(h) because the trustee had not yet sought to avoid the liens. The IRS then filed a proof of claim for both the secured and unsecured portions of its then-existing claim for unpaid taxes, interest, and penalties.
The trustee’s answer asserted a cross-claim against the IRS to avoid the portion of the lien attributable to penalties, claiming that the amount avoided should go to benefit of the estate and creditors. The IRS moved to dismiss Debtors’ complaint and succeeded. The trustee and the IRS then resolved the avoidance issue, stipulating that the portion of the lien on account of penalties—some $162,000 according to the proof of claim—was void and preserved for the benefit of creditors.
Debtors then appealed, arguing that they should have been allowed to pursue the claim under Section 522(h), which provides that debtors can avoid transfers that the trustee could have avoided but failed to attempt to do so, and if debtor could have exempted such property if the trustee had avoided the transfer. They also argued that the avoidance amount agreed by the IRS should go to their benefit, not the estate’s or creditors’, because Debtors were the ones who initially brought the action and who rightfully asserted it, and that the property (their homestead) subject to the lien was exempt.
However, the Ninth Circuit held that its previous decision in DeMarah v. United States (In re DeMarah), 62 F.3d 1248, 1250 (9th Cir. 1995) (citing In re Ridgley, 81 B.R. 65, 67 (Bankr. D. Or. 1987)) specifically stated that debtors could not exempt property from IRS tax liens, and debtors thus could not avoid liens for tax penalties on their homesteads. The panel acknowledged that DeMarah had created a schism where trustees might be able to avoid certain tax liens while debtors could not, but that difference made sense where Congress might permit avoiding a tax lien to benefit unsecured creditors while wanting to avoid a similar outcome only for the benefit of the debtor. The Ninth Circuit thus affirmed dismissal of Debtors’ first cause of action.
The panel next affirmed dismissal of Debtors’ cause of action seeking to benefit from the avoidance. The Ninth Circuit reasoned a transfer that is avoided by the trustee “under section … 724(a) … is preserved for the benefit of the estate but only with respect to property of the estate. 11 U.S.C. § 551. Because [the trustee] avoided the penalty portions of the tax liens pursuant to § 724(a), it follows that, under the plain language of § 551, those liens are preserved for the benefit of the estate.” In re Hutchinson, 15 F.4th. at 1234. The panel disagreed with Debtors’ argument that that part of § 551 is overridden by § 522(i)(2), which provides that, notwithstanding Section 551, an avoided transfer “may be preserved for the benefit of the debtor to the extent that the debtor may exempt such property under subsection (g) of this section or paragraph (1) of this subsection.” Id.
The panel determined that DeMarah’s holding prohibiting a debtor from exempting property from tax liens extended to § 522(i) as well. The court acknowledged that, if the provisions in question “existed in a vacuum,” they suggest that debtor could avoid a tax lien and recover the proceeds under § 522(h) and (i). However, the provisions do not exist in a vacuum, and any such lien-avoidance authority of the debtor under § 522(h) and (i) “could not be invoked to make an end-run around § 522(c)(2)(B)’s settled rule that tax liens apply to exempt property.” Id. at 1235.
Thus, rather than relying on plain language alone, the Ninth Circuit interpreted the various Code provisions at issue in context with one another (and provisions they reference) to score a victory for unsecured creditors and against absurd results that might benefit debtors. The court also continued its consistent history of supporting the IRS, as was Congress’s intent, against taxpayers who seek to use the Bankruptcy Code to evade their tax obligations.
State Tax Debt Arising After Initial Return Is Filed Is Not Discharged if a New Report or Return Is Required
In re Berkovich, 15 F.4th 997 (2021)
Dovetailing off In re Sienega, the Ninth Circuit adopted wholesale (with the exception of one footnote) the BAP’s decision in In re Berkovich, 619 B.R. 397 (B.A.P. 9th Cir. 2020), which held that debtor Dennis Berkovich’s tax debt to FTB was not discharged after a Chapter 13 bankruptcy because it derived from a “report or notice” “equivalent” to a tax return that he had failed to submit as required by California law.
Contrary to the Sienega above, the debtor here had submitted all his initial returns to the FTB. However, he was also subject to additional assessments from the IRS, and he failed to file the requisite “reports” of increased assessment with the FTB. Debtor filed a Chapter 13 petition and scheduled almost $800,000 in debts, including $100,000 to FTB. The confirmed plan contemplated payment of 0.9% of unsecured debts such as FTB’s, and Debtor made the payments and received the discharge under Section 1328(a). After receiving approximately $1,000 in payments from Debtor under the plan, the FTB filed a nondischargeability complaint, using largely the same argument that prevailed in Sienega—this time that without the requisite “reports” to the FTB, the Code forbade discharge under Section 523(a)’s hanging paragraph.
Following very similar reasoning to the Sienega panel, the court analyzed Section 523 in tandem with relevant California tax law to hold that the increased taxes owed since the original returns were filed were not “reported” and thus not dischargeable under Section 523. The court relied on a case from the Fourth Circuit analyzing a Maryland statute that is virtually identical to California’s to reach its conclusion. Maryland v. Ciotti (In re Ciotti), 638 F.3d 276 (4th Cir. 2011).
Critically for the debtor, the debts to FTB that had been properly noticed in the original return were dischargeable—it was only the adjusted amounts that were not discharged.
Interest Payment on Account of Short Sale Entitled to IRS Tax Deduction
Milkovich v. United States, 28 F.4th 1, 2022 WL 610295 (2022)
In the final case in our tax series, the Ninth Circuit disagreed with the IRS and ordered that a taxpayers’ claimed deduction for mortgage interest allowed after a short sale on the taxpayers’ home resulted in a large interest credit from their lender.
Plaintiffs, a married couple (Lisa Milkovich and Dang Nguyen), filed a joint Chapter 7 petition in 2009 when, among other things, they could not make their payments on their $744,993 mortgage with CitiMortgage on their home in Renton, Washington. The bankruptcy schedules listed the value of the home at $600,000, and the trustee quickly confirmed that there were no assets available for distribution to creditors.
Following the Plaintiffs’ discharge, the parties thus agreed that Citi lacked the ability to enforce the terms of the mortgage against the Plaintiffs personally (i.e., the mortgage was nonrecourse), and its only recourse was foreclosing on the home or working out some other arrangement. Citi therefore set about a short sale of the property for $555,005.92,[iii] which closed in July 2011. From that amount, Citi credited $114,688 toward the accumulated unpaid interest on the secured loan, while the remaining amount was credited toward paying off the loan principal. Citi issued a Form 1098-Mortgage Interest Statement (“Form 1098-MIS”) for 2011 indicating that it had received $114,688 in interest payments from Plaintiffs. Based on that statement, Plaintiffs claimed a $114,688 mortgage interest deduction that year.
In October 2014, the IRS issued a notice of deficiency, declaring that it intended to disallow the $114,688 interest deduction on the ground that Plaintiffs “did not establish that the amount … was (a) interest expense, and (b) paid.” Milkovich v. United States, 28 F.4th. at 5. However, the IRS mailed the notice to the property sold in 2011, and Plaintiffs had long since vacated, so they never received notice. After Plaintiffs finally found out about the disallowed deduction, they sought various administrative remedies with the IRS, but the agency’s appeals office issued a final order denying any relief in May 2018. Id.
Plaintiffs paid the assessed tax and sought a refund. After the IRS failed to respond, Plaintiffs filed a complaint against the IRS in the Western District of Washington seeking the refund under 28 U.S.C. § 1346(a)(1) and 26 U.S.C. §§ 6532(a)(1), 7422(a). The IRS moved to dismiss, and the district court granted the motion, holding that “although ‘interest deductions are generally allowed,’ Plaintiffs’ interest payments fell under an exception established in Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048–49 (9th Cir. 1976), for interest claimed in connection with purportedly debt-financed transactions that lacked economic substance.” Id. at 5-6. The district court extended Franklin despite, as the Ninth Circuit explained, the short sale here has valid economic substance because they related to properly issued mortgages where the nonrecourse liability exceeded the fair market value of the property.
After timely appeal, the Ninth Circuit reversed the district court, holding that, at least under the facts as pled in the Complaint, Plaintiffs were entitled to deduct the mortgage interest paid in connection with the short sale of their home and that Franklin did not apply because Plaintiffs had not acquired the interest in a transaction that lacked economic substance—to the contrary, the original transaction was a normal mortgage for a home.
The Ninth Circuit also rejected the IRS’s argument that Tax Code Section 265(a)(1), which precludes deductions that are “allocable to one or more classes of income … wholly exempt from the taxes imposed by this subtitle,” prevented Plaintiffs from claiming the interest deduction for two reasons. Id. First, where the short sale involved nonrecourse debt, the short sale did not give rise to cancellation-of-debt income that might trigger the application of § 265. Second, Plaintiffs’ bankruptcy discharge, which converted the mortgage from recourse to nonrecourse a year before the short sale, had no effect on the otherwise applicable tax treatment of the later short sale. In conclusion, the panel found that the rule for taxation of short sales of property backed by nonrecourse debts (such as those arising after a Chapter 7 discharge) in Commissioner v. Tufts, 461 U.S. 300, 317, (1983) (“’When a taxpayer sells or disposes of property encumbered by a nonrecourse obligation,’ he or she must ‘include among the assets realized the outstanding amount of the obligation,’… even ‘when the unpaid amount of the nonrecourse mortgage exceeds the value of the property transferred.’) was more apt than the Franklin case. Milkovich v. United States, 28 F.4th. at 8. quoting Commissioner v. Tufts, 461 U.S. 300, 317.
Thus ends our trip through the Tax Code and its myriad potential impacts on bankruptcies, debtors, and matters that might arise even after bankruptcy cases close and discharge is granted. Milkovich is a refreshing reminder that the IRS does not always get what it wants, and the power of the federal government will not go unchecked. All these cases present good things to keep in mind to warn clients about both while cases are pending and upon exit. The tax man is always watching and can rise from the dead if debtors and their counsel are not careful to dot every “i” and cross every “t.”
This article was originally published in the Spring 2022 issue of the Oregon State Bar Debtor-Creditor Newsletter.
[i] This summary and the three below are hard for me because my brain melts when it reads the word “taxes.” I’ve done my best.
[ii] Hanging paragraph at §532(a)(19) “The term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to Section 6020(a) of the Internal Revenue Code of 1986, or similar state or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to § 6020(b) of the Internal Revenue Code of 1986, or a similar state or local law.”
[iii] “A short sale is a real estate transaction in which the property serving as collateral for a mortgage is sold for less than the outstanding balance on the secured loan, and the mortgage lender agrees to discount the loan balance because of a consumer’s economic distress.” Milkovich v. United States, 28 F.4th 1, 5 (2022) quoting Shaw v. Experian Info. Sols., Inc., 891 F.3d 749, 752 (9th Cir. 2018).