“Auditing” an EDNY Decision with a Plethora of Tax Issues (Part Four)

Contributed by Yvanna Custodio and Max Goodman
Previously, in Parts One, Two, and Three of our four-part series on United States v. Bond, we investigated the factual genesis of the decision and the proper appellate standard of review, whether the Bankruptcy Code waived the IRS’s sovereign immunity with regard to a tax refund action filed by the trustee of the liquidating trust that succeeded to PT-1’s assets, and whether the bankruptcy court had jurisdiction to compel the IRS to accept a tax return filed by PT-1.  Part Four will focus on whether the bankruptcy court had jurisdiction to enjoin the IRS from its future exercise of setoff or recoupment rights against the trustee (which partially will involve a return to a discussion of sovereign immunity).  Particularly at issue was the offset of a postpetition tax refund against a purported postpetition tax liability.
The bankruptcy court had held that, because the IRS failed to object prior to confirmation to the provision of PT-1’s chapter 11 plan barring the exercise of setoff and recoupment rights, the IRS was barred from objecting after confirmation on the grounds of res judicata.
The district court, citing Malman v. United States, observed that, with respect to the government, “[s]overeign immunity protects the right to setoff and recoupment.”  According to the district court, the question thus is, “under what statute has the IRS waived sovereign immunity such that it can be enjoined from exercising its rights to setoff and recoupment?”  The district court then observed that the bankruptcy court and the liquidating trustee did not cite any statute under which the IRS could be said to have waived its immunity.  The IRS raised and distinguished section 106(a) of the Bankruptcy Code in conjunction with section 1141(a) of the Bankruptcy Code, which provides that a confirmed plan binds a creditor (among others).  The IRS argued, and the district court agreed, that the IRS was not a “creditor” for this purpose because all of its claims against PT-1 were postpetition (as discussed more fully in Part Two of this series).
The liquidating trustee, hinging his argument on the res judicata effect of confirmed plans, cited a number of cases in support of his argument.  The district court, however, after analyzing the applicability of such cases, observed that the cases either did not involve the government, or if they did involve the government, were otherwise distinguishable.  The district court thus, as a general matter, vacated the bankruptcy court’s order enjoining the IRS from exercising any future setoff or recoupment rights.
However, the district court agreed with the liquidating trustee that the IRS could not exercise setoff rights with respect to taxes allegedly owed by PT-1 for 2002.  PT-1 timely filed a federal income tax return for 2002 reporting a net operating loss, which filing included a request for a prompt determination of tax liability under section 505(b)(2) of the Bankruptcy Code.  Although the IRS examined this return, it did not assess any tax within 180 days after the request, as required by section 505(b)(2), and as a result, any liability of PT-1 for federal income tax for 2002 was discharged.  The IRS cited a number of cases for the proposition that its setoff rights were unaffected by discharge.  The district court, however, distinguished these cases as relying on section 553 of the Bankruptcy Code, which is limited to setoffs of mutual prepetition obligations.  The district court also rejected the IRS’s argument that section 505(b)(2) merely prevents the IRS from affirmatively seeking recovery from the taxpayer while leaving its setoff rights untouched.  Because section 505(b)(2) explicitly provides that the taxpayer is “discharged from any liability for such tax,” the district court concluded, “When one is no longer liable to another, it is only natural to conclude that he does not owe that party anything either.  And without anything owed to it, the IRS has nothing to setoff against the refund it owes to the Trustee.”  Consequently, the district court held that the IRS had no right of setoff for 2002.
For bankruptcy practitioners with a keen interest in setoffs of prepetition taxes or in section 505(b)(2), see Section 1006.1.1 or 1011, respectively, of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2013 ed.).