April/May 2004

Tax Cases Alan Barton Taxation Section Editor KPMG LLP Houston, TX abarton@kpmg.com .

Taxes

Bankruptcy Court

Was the Debtor a responsible person for a corporation’s unpaid trust fund taxes and therefore liable for trust fund tax penalties under IRC section 6672?

Debtor founded and financed Trailnor, Inc. (“Trailnor”), a trailer design and manufacturing business in mid-1995. Debtor negotiated and guaranteed working capital loans on behalf of Trailnor. Debtor was the sole shareholder and president of Trailnor, as well as the sole member of its board of directors.

Trailnor operated at a loss from inception. Trailnor filed its payroll tax returns for 1995 through 1997 and satisfied all of its payroll tax obligations for such years. During 1998, and for the first two quarters of 1999, Trailnor did not timely file its payroll tax returns. However, during the first quarter of 1998 and the first quarter of 1999, Trailnor made certain payroll tax deposits totaling approximately $13,400.

During the second and third quarters of 1999, Trailnor sold and refinanced certain of its assets, receiving cash proceeds totaling approximately $580,000. None of the cash proceeds were paid over to the IRS for payroll taxes.

During September and November 1999, Trailnor filed its payroll tax returns for all four quarters of 1998 and for the first three quarters of 1999. Such payroll tax returns reported total payroll taxes due of approximately $172,200.

Trailnor went out of business sometime in late 1999 and did not pay any of the additional amount of payroll taxes reported as due on the payroll tax returns.

IRC sections 3102(a) and 3402(a) require an employer to withhold the employees’ share of federal social security taxes and income taxes from the wages of their employees. The money withheld from each employee’s wages is then held by the employer in trust (“trust fund taxes”) for the benefit of the United States as provided by IRC section 7501(a).

To insure that an employer pays over such trust fund taxes, IRC section 6672(a) provides, in general, that any person required to collect and remit such payroll taxes who willfully fails to do so shall be liable for a penalty equal to the amount of such tax not withheld and remitted (i.e., the so- called “trust fund tax penalty”). IRC section 6671(b) defines a “person” for these purposes as an officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee, or member is under a duty to withhold and remit such taxes (i.e., a so- called “responsible person”).

The IRS sent notices to Debtor advising him that the IRS was attempting to collect the unpaid payroll taxes of Trailnor. Several of the notices mailed to Debtor were returned marked “unclaimed,” along with U.S. Postal Service notations indicating multiple attempts at delivery. Notices mailed directly to Debtor’s attorney on several occasions were received and, in some cases, acknowledged.

In late 2002, the IRS sent a final notice of intent to levy to Debtor’s address and it, too, was returned “unclaimed” with notations of multiple delivery attempts. In early 2003, Debtor filed for Chapter 13 bankruptcy protection and filed a Motion to Determine Tax Liability under Section 505 of the Bankruptcy Code contesting his liability for the trust fund tax penalty under IRC section 6672. In mid 2003, the IRS filed its proof of claim, listing the trust fund tax penalty as a claim against Debtor’s Chapter 13 estate.

The Court found that Debtor’s failure to receive his mail was not the IRS’ fault, and Debtor’s refusal to accept the notice under IRC section 6672(b) did not deem it invalid. The Court found that Debtor was a responsible person, because he was the business’ sole shareholder, was president and the sole member of the business’ board of directors, and had the corporate authority to perform all duties associated with being the senior executive in the company. The Court found that Debtor was a responsible person under IRC section 6672 who willfully failed to collect and pay over payroll taxes to the IRS. The Court held that Debtor was liable for Trailnor’s payroll taxes. In re Chabrand, 301 B.R. 468 (October 16, 2003).

Tax Court

Whether taxes due for tax years in which Debtor filed late returns are eligible for discharge?

Debtor failed to file timely Federal income tax returns for 1992 and 1993. On August 2, 2001, Debtor filed for Chapter 7 bankruptcy protection. On August 5, 2001, Debtor filed his 1992 and 1993 Federal income tax returns. On October 1, 2001, the IRS assessed Debtor’s tax liabilities for 1993. On November 6, 2001, the Court issued an order granting Debtor a discharge under Section 727 of the Bankruptcy Code. On November 26, 2001, the IRS assessed Debtor’s tax liabilities for 1992.

On April 15, 2002, the IRS sent notices of intent to levy with respect to Debtor’s 1992 and 1993 tax liabilities. On May 30, 2002, Debtor requested a collection due process hearing with the IRS, contesting the collection proceedings with respect to the 1992 and 1993 tax liabilities. Debtor asserted that his tax liabilities were discharged in the bankruptcy proceedings. On November 12, 2002, the IRS held an IRC section 6330 hearing with Debtor.

On January 17, 2003, the IRS sent Debtor a notice of deter-mination, stating that there was no record of Debtor’s tax liabilities being discharged in bankruptcy. The notice indicated the IRS’ intent to proceed with the levy with respect to the 1992 and 1993 tax liabilities. On February 26, 2003, Debtor filed an amended petition with the Court contesting the notice of determination. On July 25, 2003, the IRS filed a motion for summary judgment arguing that the Debtor’s tax liabilities were precluded from discharge under the Bankruptcy Code.

The IRS noted that Section 523(a) of the Bankruptcy Code excludes from discharge tax liabilities for which a return was not filed, or for which a return was filed after its due date and after the commencement of the two-year period immediately preceding the filing date of the bankruptcy petition.

Debtor argued that the IRS filed substitute-for-returns (“SFRs”) on behalf of Debtor for Debtor’s 1992 and 1993 tax years and that these SFRs were filed before the commencement of the two year period immediately preceding the filing date of the bankruptcy petition.

The Court held that prior case law dictates that SFRs do not constitute returns for purposes of Section 523(a)(1)(B) of the Bankruptcy Code unless signed by the taxpayer. Debtor presented no evidence that such SFRs were actually filed, and even if they were filed, Debtor presented no evidence that such SFRs were signed by him. As a result, the Court rejected Debtor’s argument. The Court concluded that, because Debtor’s late returns were filed on August 5, 2001, and the two-year period immediately preceding Debtor’s filing of the bankruptcy petition commenced on August 3, 1999, Debtor’s tax liabilities were not discharged in the bankruptcy proceedings. Ramsdell v. Comm’r, 86 T.C. Memo 2003-317 (November 17, 2003).

Tax Court

Can a debtor utilize a net operating loss generated by his Chapter 7 bankruptcy estate in post-bankruptcy tax years?

In 1991, Debtor, an individual, filed a voluntary petition in bankruptcy pursuant to Chapter 7 of the Bankruptcy Code. Upon the filing of the bankruptcy petition, a separate taxable entity came into existence, i.e., the bankruptcy estate. See IRC section 1398. Trustee was appointed to represent the bankruptcy estate, which included a $153,000 business receivable and two parcels of land. The business receivable became worthless subsequent to becoming an asset of the bankruptcy estate. Both parcels of land secured debts owed by Debtor to Creditor, and as of the bankruptcy filing Debtor was delinquent on his payments of those debts. Creditor did not file a proof of claim with respect to these items. Creditor moved the bankruptcy court to lift the stay prohibiting the foreclosure of Debtor’s interests in the real properties. The bank-ruptcy court granted the motion and Creditor foreclosed, resulting in the sale of the real properties. The amount still owed to Creditor following the liquidation of the properties totaled $197,500. Neither Trustee nor Debtor satisfied this remaining deficiency in any amount.

The bankruptcy court issued a final decree closing the bankruptcy case in 1995. Neither the bankruptcy estate nor Debtor reported any income from discharge of indebtedness on any Federal income tax return.

Debtor filed his 1994 and 1995 Federal income tax returns claiming a $153,000 net operating loss carryover, resulting from the worthlessness of the business receivable.

Income from the discharge of indebted-ness is includable in gross income under IRC section 61(a)(12). Pursuant to IRC section 108(a)(1)(A), gross income does not include such income where the discharge occurs pursuant to a bankruptcy proceeding. IRC section 108(b) provides that the amount of discharge of indebtedness income excluded from gross income must be applied to reduce certain tax attributes of the taxpayer, including net operating losses generated in, or carried over to, the taxable year of the discharge.

The Tax Court held that Creditor’s failure to file a proof of claim with respect to the amounts owed Creditor did not mean that the remaining deficiency was not discharged under bankruptcy law. The Court noted that Section 727(b) of the Bank-ruptcy Code specifically provides that debts arising before the order for relief is filed which are discharged by a bankruptcy court are discharged whether a proof of claim based on such debt is filed or not. Accordingly, the Court found that the discharge of the amounts owed Creditor gave rise to excludable discharge of indebtedness income of $197,500 and such excludable income eliminated the claimed net operating loss carryover. Johnson v. Comm’r, T.C. Memo 2004-37 (February 17, 2004).

Internal Revenue Service

Whether the discharge of an obligation to make a restitution payment results in cancellation of debt income under IRC section 61(a)(12)?

Corporation is owned and controlled by Taxpayer, who is also president of Corporation. The Department of Energy (“DOE”) determined that Corporation violated regulations imposing price controls on the resale of crude oil. The DOE ordered restitution of the over-charges and held Taxpayer jointly and severally liable for Corporation’s violation. The Federal Energy Regulatory Commission reviewed and affirmed the DOE order. Final judgment against Corporation and Taxpayer was entered by the District Court and affirmed upon appeal. The Supreme Court denied a writ of certiorari. The DOE subsequently released its judgment lien against Taxpayer and issued a Form 1099-C, Cancellation of Debt, to Taxpayer for the principal and interest to date.

Taxpayer did not include the amount reported on the Form 1099-C on his individual Federal income tax return. Upon examination, the IRS field auditor determined that the amount was income to the taxpayer under IRC section 61(a)(12). Taxpayer argued that the release from the liability for the restitution of the over-charges resulted from transactions that benefited Corporation and that the discharge should not result in taxable income to him. Alternatively, even if it did give rise to taxable income, Taxpayer argued that the payment of the restitution of the overcharges would have given rise to a deduction and therefore, the discharge should be excluded from gross income pursuant to IRC section 108(e)(2). IRC section 108(e)(2) provides that no income shall be realized from the discharge of indebtedness to the extent the payment of the liability would have given rise to a deduction. The IRS field auditor requested technical assistance from the IRS National Office on the question of whether the cancellation of the liability for the restitution is eligible for the exception under IRC section 108(e)(2).

The IRS National Office concluded that the release of Taxpayer from the obligation to make the restitution payments did not give rise to cancellation of debt income under IRC section 61(a)(12) and therefore the applicability of IRC section 108(e)(2) was moot. The IRS National Office noted that in general, when loan proceeds are received by a borrower, such proceeds are not taxable income to the borrower because of the borrower’s obligation to repay the loan. If the loan is cancelled or forgiven, the cancellation of such an obligation results in an increase in wealth with respect to the borrower and therefore the borrower should be taxed accordingly. See, United States v. Kirby Lumber Co., 284 U.S. 1, (1931). The IRS National Office noted that a different analysis applies where the guarantor of a loan is released from his obligation because a loan guarantor does not realize an increase in wealth when the loan is repaid or cancelled, such repayment or cancellation only prevents the guarantor’s wealth from being decreased. See, Hunt v. Commissioner, T.C. Memo 1990-248. See also, Whitmer v. Commissioner, T.C. Memo 1996-83.

Despite Taxpayer having sole authority and personal control over the operations of Corporation and participating in the transactions in which the overcharges occurred, the IRS National Office concluded that Taxpayer did not personally benefit from the overcharges. The IRS National Office held that the discharge of the restitution payment did not increase Tax-payer’s net worth and, thus, was not cancellation of debt income within the meaning of IRC section 61(a)(12). Chief Counsel Advice 200402004.