Shareholder Beware: Don’t Let the Bankruptcy Estate Pay the IRS Without a Fight
by Marc D. Miceli
Carella, Byrne, Bain, Gilfillan, Cecchi, Stewart & Olstein, P.C.; Roseland, N.J.
The Second Circuit Court of Appeals in EDP Medical Systems Inc. v. United States, 2007 WL 706925 (2d Cir. March 9, 2007), held that a bankruptcy court order allowing an uncontested proof of claim constitutes a final judgment on the merits that can be a predicate for res judicata and thereby bar a taxpayer’s subsequent tax refund claim in the district court.
In EDP, the debtor filed a voluntary petition for chapter 11 reorganization in December 1992, which was later converted to a chapter 7 liquidation. The IRS filed an amended proof of claim in connection with certain pre-petition employment tax liabilities of the debtor, which included penalties and interest. Neither the trustee nor the debtor objected to the amended proof of claim. The trustee acceded to the amended proof of claim, and on Jan. 26, 2000, the bankruptcy court issued an order allowing the amended proof of claim amount.
On June 1, 2000, the shareholder of the debtor moved to intervene in the debtor's bankruptcy proceeding to object to the amended proof of claim, but later withdrew her motion. On Nov. 7, 2000, the trustee paid the U.S. Treasury the amount of the $195,001.23, satisfying the entire tax claim plus post-petition interest. Thereafter, on June 1, 2001, the trustee closed the bankruptcy case. At the time of the close of the bankruptcy case, the estate had a net worth of zero except for some post-petition interest. The court noted that if the amended proof of claim had been disallowed and not paid, the estate would have had a surplus of $195,001.23, which would have gone to the debtor.
A year later, the former debtor filed an action with the district court to have the $195,001.23 refunded. The United States moved for summary judgment and prevailed. The district court found that the former debtor lacked standing to pursue the tax refund claim because it remained property of the bankruptcy estate and that, even if the former debtor had standing, the claim was barred by res judicata based on the bankruptcy court's order allowing the amended proof of claim. The circuit court addressed only the latter issue and agreed with the district court in disallowing the tax refund claim.
In reaching its decision, the circuit court reviewed the application of res judicata as a doctrine that bars "later litigation of [an] earlier decision, [which] was (1) a final judgment on the merits, (2) by a court of competent jurisdiction, (3) in a case involving the same parties or their privies and (4) involving the same causes of action." EDP Medical Systems, 2007 WL at *2. In citing Allen v. McCurry, 449 U.S. 90 (1980), the court recognized that the policy rationale of the doctrine was, to wit, to "relieve parties of the costs and vexation of multiple lawsuits, [conserve] judicial resources and, by preventing inconsistent decisions, [encourage] reliance on adjudication," applied equally in the bankruptcy context and particularly in chapter 7 liquidations, where it is desirable that matters be resolved as expeditiously and economically as possible. EDP Medical Systems, 2007 WL at *3.
In applying this doctrine, the court cited the Fifth Circuit in Bank of Lafayette v. Baudoin, 981 F.2d. 736 (5th Cir. 1993), and the Ninth Circuit in Siegel v. Fed. Home Loan Mortgage Corp., 143 F.3d. 525, (9th Cir. 1998), and joined the two circuits in holding that an uncontested proof of claim constitutes a “final judgment” and thus a predicate for res judicata. EDP Medical Systems, 2007 WL at *3-4. The court, however, declined to follow the Fourth Circuit’s approach on this issue in County Fuel Co. v. Equitable Bank Corp., 832 F.2d. 290 (4th Cir. 1987), which expressed the view that it was “’doubtful’ that the ‘automatic allowance’ under Bankruptcy Code §502(a) of a claim not objected to constituted a ‘final judgment’ of the type that gives rise to ‘bar or ‘claim preclusion’ under strict res judicata principles.” EDP Medical Systems, 2007 WL at *3. Under the facts of EDP, the court found that although the amended proof of claim was uncontested, the claim was approved by the court order, and since the debtor received its discharge and the bankruptcy proceeding was closed, there was little doubt about the order’s finality. EDP Medical Systems, 2007 WL at *3-4.
Finally, the circuit court rejected the debtor's contention that res judicata was not available because the amended proof of claim was not litigated on the merits. EDP Medical Systems, 2007 WL at *3-4.The court held that res judicata “does not require the precluded claim to actually have them litigated; its concern, rather, is that the party against whom the doctrine is asserted had a full and fair opportunity to litigate the claim.” EDP Medical Systems, 2007 WL at *4 (citing Federated Dep’t Stores Inc. v. Moitie, 452 U.S. 394 (1981)). The court held that the debtor had an opportunity to litigate the validity of the claim since it was a “party in interest” as defined under Bankruptcy Code §502(a) because the disallowance of the amended proof of claim would have produced a surplus in the bankruptcy estate. EDP Medical Systems, 2007 WL at *4.