Law360, New York (May 5, 2016, 12:02 PM ET) -- A core principle of bankruptcy tax litigation holds that “bankruptcy courts have universally recognized their jurisdiction to consider tax issues brought by the debtor, limited only by their discretion to abstain.” IRS v. Luongo, 259 F.3d 323, 329-330 (5th Cir. 2001) (citing In re Hunt, 95 B.R. 442, 445 (Bankr. N.D. Tex. 1989). The Second Circuit recently departed from that generally accepted principle in United States v. Bond, 762 F.3d 255 (2d Cir. 2014). The Second Circuit held in Bond that the bankruptcy court did not have subject matter jurisdiction to adjudicate a tax refund claim that had been filed by a liquidating trustee, because that claim did not meet the prerequisites for a refund claim under 11 U.S.C. § 505(a)(2)(B), and therefore there was no waiver of sovereign immunity under 11 U.S.C. § 106(a). Bond has not been followed in any other circuit, and seems diametrically opposed to existing precedent in the Fifth and Sixth Circuits. Nonetheless, Bond raises new challenges for liquidating trustees seeking to litigate refund claims in bankruptcy proceedings in any jurisdiction.
In Bond, the debtor filed for a Chapter 11 bankruptcy in 2001, and a plan of reorganization was confirmed in 2004. A liquidating trustee was appointed to manage the liquidating trust. In 2005, that liquidating trustee counterclaimed in bankruptcy court against an IRS claim for post-petition penalties and interest by seeking a refund of post-petition taxes paid. Six months later, the liquidating trustee filed a request with the IRS for the same refund, which was not acted upon by the IRS.
I.R.C. § 6532(a)(1) requires six months to have elapsed from the filing of the refund claim with the IRS before a suit for refund can be brought. This requirement is altered in § 6532(a)(5) to 120 days for a bankruptcy proceeding with a cross reference to 11 U.S.C. § 505. The district court in Bond held that by filing the refund claim with the IRS shortly after the counterclaim for refund, the liquidating trustee had cured the jurisdictional defect arising from the lack of a proper request under Section 505, and by the time of its opinion, significantly more than 120 days had passed since the filing of the claim. United States v. Bond, 486 B.R. 9, 30 (E.D.N.Y. 2012).
The Second Circuit’s decision hinged on the use of the term “trustee” in § 505(a)(2)(B). While the term is not defined in Section 505, the Second Circuit interpreted “trustee” to mean only a bankruptcy trustee appointed before confirmation of a plan as described in 11 U.S.C. § 1104. Because by definition a liquidating trustee is only appointed after confirmation of a liquidation plan, the court found that a liquidating trustee could not be a “trustee” for purposes of Section 505(a)(2)(B). Because the refund claim had been filed by the liquidating trustee, the Second Circuit held that the bankruptcy court lacked jurisdiction to adjudicate that claim. Accordingly, while the liquidating trustee could still have filed a tax refund suit against the IRS, it had to do so in a parallel civil action in federal district court.
Before Bond, liquidating trustees had no reason to doubt the bankruptcy court’s jurisdiction over a suit predicated on a refund claim filed after confirmation. The only two circuits to address this issue rejected the IRS’ position. Both the Fifth and Sixth Circuits previously held that Section 505(a)(2)(B) was merely a timing requirement, not a jurisdictional bar, and permitted the adjudication of refund suits predicated on claims filed by persons other than a “trustee.” Gordon Sel-Way Inc. v. United States, 270 F.3d 280 (6th Cir. 2001); IRS v. Luongo, 259 F.3d 323 (5th Cir. 2001).
Gordon Sel-Way looked to the legislative history of Section 505 to find it was not intended to restrict jurisdiction only to claims brought by trustees because it “authorizes the bankruptcy court to rule on the merits of any tax claim involving an unpaid tax, fine, or penalty relating to a tax, or any addition to a tax, of the debtor or the estate.” Gordon Sel-Way Inc. v. United States, 270 F.3d at 285 (6th Cir. 2001) (quoting 124 Cong. Rec. H 11110 (daily ed. Sept. 28, 1978) (remarks of Rep. Edwards introducing the House amendments) (emphasis added), reprinted in 1978 U.S.C.C.A.N. 5787, 6436, 6490). The Fifth Circuit likewise rejected the argument that the Second Circuit adopted in Bond stating, “The IRS cites no case supporting its restrictive reading of the bankruptcy court's jurisdiction under § 505.” In re Luongo, 259 F.3d 323, 329 (5th Cir. 2001). Until such time as the US Supreme Court resolves this apparent circuit split, liquidating trustees who wish to prosecute potential refund claims against the IRS must proceed with caution.
The first question a liquidating trustee must consider is whether there is another ground for asserting that the IRS waived sovereign immunity, other than simply invoking Section 505. Bond’s holding only addressed the waiver of sovereign immunity with respect to Section 505 actions set forth in Section 106(a). Section 106 contains two other explicit waivers of sovereign immunity that Bond did not address. Section 106(b) waives sovereign immunity when the government files a prepetition proof of claim, thereby submitting itself to bankruptcy court jurisdiction over claims arising out of the “same transaction or occurrence.” United States v. Kearns, 177 F.3d 706, 711 (8th Cir. 1999) (“when claims of the IRS and a debtor involve the same tax liabilities, it is ‘without purpose and irrational’ to deny jurisdiction over refunds absent a formal request by the debtor”) (citation omitted); compare Bond, 762 F.3d at 263 n.7 (noting that the IRS had not filed a prepetition proof of claim so Section 106(b) did not apply). Similarly, Section 106(c) waives sovereign immunity as to offsets claimed against a governmental claim. Notably, the governmental claim need not be a tax claim — any federal agency’s claim would suffice to trigger the Section 106(c) waiver of sovereign immunity for offsets. In re Gibson, 176 B.R. 910 (Bankr. D. Or. 1994) (sovereign immunity does not bar setoff of debtor’s IRS tax debt against payments owed to debtor by the US Environmental Protection Agency and the US Department of Housing and Urban Development). If either of those conditions applies, a liquidating trustee could pursue a refund suit in bankruptcy court even in the Second Circuit.
Outside the Second Circuit, deciding where to file a tax refund suit based on a refund claim filed by a liquidating trustee is a more complex matter. At the time of this writing, no reported decision of a court has applied Bond to hold that a bankruptcy court lacked jurisdiction over a tax refund claim under § 505. Liquidating trustees have strong arguments in favor of bankruptcy court jurisdiction outside the Second Circuit. As the Fifth Circuit held in Luongo, Section 505(a)(2)(B) is a claims-processing rule intended “to prevent a refund claim from languishing in the administrative process, not to restrict the scope of the bankruptcy court’s jurisdiction over tax refunds to those benefitting the estate.” In re Luongo, 259 F.3d 323, 329 n.4 (5th Cir. 2001).
Further, as a policy matter, it makes no sense for Congress to grant bankruptcy courts broad jurisdiction over a tax refund suit filed by a liquidating trustee based on a refund claim of a debtor in possession or bankruptcy trustee, but deny jurisdiction over the same refund suit merely because the claim was filed by a liquidating trustee. The IRS position violates notions of judicial economy and the efficient use of government resources. A liquidating trustee would therefore seem to be on solid ground to argue that Bond was incorrectly decided and that a court outside the Second Circuit should reject Bond’s flawed reasoning.
That being said, the IRS continues to press the Bond argument in bankruptcy tax disputes, and indeed has sought to expand its reach. In a recent adversary proceeding in California, the IRS contended that Section 505(a)(2)(B) precluded the bankruptcy court from adjudicating a tax refund suit brought by a liquidating trustee. SLTNTRST LLC v. Dept. of Treasury, Case No. 6:13-ap-1437-MJ (Bankr. C.D. Cal.). While the court did not adopt the IRS’ argument in that proceeding, it is likely that the IRS will continue to press similar arguments aggressively in the future, and liquidating trustees must be prepared to deal with the issue.
Of course, the best course of action would be to ensure that a trustee or debtor in possession files all potential refund claims with the IRS before confirmation of a plan. Unfortunately, that is not always possible, and once a liquidating trustee has been appointed it is by definition too late to avoid the issue (obviously, there will never be a trustee and a liquidating trustee both in capacity at the same time, because the confirmation of the plan terminates the role of the trustee). Accordingly, it is imperative that liquidating trustees carefully consider the implications of filing a tax refund claim with the IRS, and prepare for a fight on this unsettled issue should they choose to file a refund suit in bankruptcy court based on such a claim.