Consumer Bankruptcy Committee

Volume 5, Number 1 / January 2007

In This Issue:

• 910 Claim Litigation: Still in the Early Innings
• The IRS’ Policy of Refusing to Process Offers-in-Compromise Submitted by Taxpayers in Bankruptcy: A Roadblock to a Business Owner’s “Fresh Start” in Chapter 13
• Automatics, Stays, Dismissals and Ethical Traps for the Unwary
• Individual Cases under Chapter 11 of the Bankruptcy Code
• Agenda for the 2007 Annual Spring Meeting

• Committee Officers
• Upcoming Events
• Contribute to the Newsletter
• ABI World

The IRS’ Policy of Refusing to Process Offers-in-Compromise Submitted by Taxpayers in Bankruptcy: A Roadblock to a Business Owner’s “Fresh Start” in Chapter 13

by: Jeffrey A. Sandell
Tiffany & Bosco P.A.; Phoenix

The frequency with which small businesses fail gives rise to a common scenario: Former small-business owners finding themselves burdened with not only personally guaranteed trade payables, but also with significant amounts of business-related tax obligations, commonly in the form of tax penalties assessed personally against the business’ principals under 26 U.S.C. §6672.

Not surprisingly, facing significant tax obligations that are nondischargeable under the Bankruptcy Code,¹ many entrepreneurs will turn to chapter 13 of the Code in an effort to formulate a manageable plan through which they can not only eliminate much of their lingering business-related debt, but also repay nondischargeable tax obligations owed to the Internal Revenue Service, thereby forestalling most tax-collection efforts. Unfortunately, under the Code, the priority treatment² afforded to tax penalties assessed under §6672 can, in many instances, make full payment of such penalties an impossible task. This is because many entrepreneurs who find themselves attempting to regroup in chapter 13 before embarking upon their next business venture simply do not have the financial resources to pay a large priority obligation in full within the limited time period allowed under the Code. ³ In those instances, an offer-in-compromise submitted by the taxpayer to the IRS should be an effective tool to allow chapter 13 debtors to potentially settle their tax obligations for less than the full amount owed as part of a chapter 13 plan. The IRS, however, has adopted a policy of refusing to even process an offer-in-compromise submitted by a taxpayer if such taxpayer is a debtor in a pending bankruptcy proceeding.⁴

The General Mechanics of an Offer-in-Compromise

The IRS has the authority to compromise all tax liabilities under 26 U.S.C. §7122(a). That provision provides, in part, that:

The secretary may compromise any civil or criminal case arising under the internal revenue laws prior to reference to the Department of Justice for prosecution or defense, and the Attorney General or his delegate may compromise any such case after reference to the Department of Justice for prosecution or defense.

In order to facilitate the negotiation of a compromise of the kind described in §7122(a), the IRS has invited taxpayers to present it with an offer of settlement by way of the IRS’ development and dissemination of IRS “Form 656,” entitled “Offer in Compromise.” Form 656 invites taxpayers to list in a concise format all of the relevant information that would ever be needed by the IRS in evaluating a taxpayer’s settlement offer under the applicable criteria set forth in 26 C.F.R. 301.7122-1(b). Treas. Reg. §301.7122-1(b) delineates the criteria to be applied by the IRS in evaluating any taxpayer’s offer to compromise a civil or criminal tax liability. However, even when a taxpayer has properly completed form 656 and otherwise complied with the procedural rules attendant to an offer-in-compromise, the IRS will nonetheless summarily reject the same when the taxpayer is also a debtor under the Bankruptcy Code.

The IRS’ Policy of Summarily Rejecting Offers-in-Compromise Submitted by Taxpayers in Bankruptcy Violates the Bankruptcy Code’s Anti-Discrimination Provision

It was not until February 1997 that the IRS began refusing to process offers-in-compromise submitted by bankrupt taxpayers.⁵ Importantly, the IRS’ decision at that time to begin rejecting such offers was not based on any amendment to the Internal Revenue Code (IRC), the Treasury Regulations or the Bankruptcy Code; rather, it was based on nothing more than an amendment by the IRS to its own internal procedures manual, entitled “Internal Revenue Manual.”⁶ That manual now provides that the IRS will return to the taxpayer any offer-in-compromise submitted by a debtor in bankruptcy on the basis that such an offer is “nonprocessable.”⁷ The IRS normally argues that its authority to reject offers in that manner derives from Treas. Reg. §301.7122-1(b), which admittedly allows the IRS to return offers deemed to be nonprocessable, although neither the IRC or the Treasury Regulations define that term. In fact, it is precisely because the term nonprocessable is not defined that the IRS argues that it has the discretion to promulgate its own definition to include those offers submitted by taxpayers in bankruptcy. Importantly, however, such an argument misses the critical point. The IRS’ refusal to process an offer-in-compromise submitted by a bankrupt taxpayer does not involve a question of discretion, it involves a question of whether the IRS has the authority to exercise whatever discretion it may hold in a way that discriminates against a taxpayer based solely on the taxpayer’s status as a debtor in bankruptcy. Put another way, even assuming the IRS has the authority to promulgate the mechanics that control the actual processing of an offer-in-compromise, the question that must still be answered is whether the IRS’ policy of rejecting certain offers based solely on a bankruptcy filing violates the Bankruptcy Code’s anti-discrimination provision.

Section 525(a), provides, in pertinent part, the following:

A governmental unit may not deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise or other similar grant to, or…discriminate with respect to such a grant against…a person that is…a debtor under this title…solely because such…debtor is…a debtor under this title.

Given the protections afforded within that statute, certain debtors have sought to utilize §525(a) as a basis to seek the intervention of a bankruptcy court to redress the IRS’ rejection of a debtor’s offer-in-compromise based solely on such person or entity’s status as a debtor under the Bankruptcy Code. In those instances, the IRS normally argues that the act of returning, as nonprocessable, offers-in-compromise submitted by debtors in bankruptcy does not fall within the so-called “limited” scope of §525(a), i.e., that such an act does not constitute the denial of a “license, permit, charter, franchise or other similar grant.” On its face, such an argument initially has some appeal – at least until the statute’s legislative history and purpose is analyzed.

Indeed, in creating §525(a), Congress did not mince words. It went so far as to state its specific intent that courts would have not only the authority, but also the affirmative duty, to expand the acts enumerated within the statute to ensure that many other types of bankruptcy-based governmental discrimination were not allowed. Congress specifically said:

The section is not exhaustive. The enumeration of various forms of discrimination against former bankrupts is not intended to permit other forms of discrimination. The courts have been developing the Perez rule. This section permits further development to prohibit actions by governmental or quasi-governmental organizations that perform licensing functions, such as a state bar association or a medical society, or by other organizations that can seriously affect the debtors' livelihood or fresh start, such as exclusion from a union on the basis of discharge of a debt to the union's credit union… The courts will continue to mark the contours of the anti-discrimination provision in pursuit of sound bankruptcy policy.

H.Rept. No. 95-595 to accompany H.R. 8200, 95th Cong., 1st Sess. at p. 367, 1978 U.S. Code Cong. & Ad. News at pp. 5963, 6323 (1977).

Given Congress’ clear pronouncement that §525(a) was to be “further developed” to prohibit “other forms of discrimination” in addition to those enumerated, it is not surprising that the first bankruptcy court to address the issue of whether the IRS’ policy of rejecting offers-in-compromise submitted by taxpayers in bankruptcy violated §525(a) held that it did indeed. See In re Mills, 240 B.R. 689 (Bankr. S.D. W.Va. 1999). Accordingly, the Mills court ordered the IRS to process the debtors’ offer-in-compromise in the same manner the IRS would process an offer submitted by any non debtor.

Applicable Case Law Continues to Develop

In addition to Mills, there exists a handful of subsequent cases that have also addressed this very issue, but with varying results. Both In re Macher, 2003 WL 23169807 (Bankr. W.D. Va. June 5, 2003), and In re Holmes, 298 B.R. 477 (Bankr. M.D. Ga. 2003), aff'd, 309 B.R. 824 (M.D. Ga. 2004), also found the IRS’ conduct to be offensive; however, the Macher and Holmes courts did not find such conduct to fall within the scope of §525(a). Instead, those courts found that the IRS’ policy of returning offers-in-compromise submitted by taxpayers in bankruptcy frustrated the Bankruptcy Code’s general purpose of providing “fresh starts” and thus relied not on §525(a), but on their equitable authority codified under §105 as a basis to order the IRS to process the offers submitted in those cases. See, also, In re Peterson, 321 B.R. 259 (Bankr. D. Neb. 2004).

While employing some of the same reasoning set forth in Macher and Holmes, several other courts have declined to force the IRS to process an offer submitted by a debtor, regardless of the effect it may have on a debtor’s ability to confirm a plan. In In re 1900 M Restaurant, 352 B.R. 1 (D. D.C. 2006); In re Shope, 347 B.R. 270 (Bankr. S.D. Ohio 2006); and In re Uzialko, 339 B.R. 579 (Bankr. E.D. Pa. 2006), the respective courts not only agreed that the IRS’ conduct did not fall within the scope of §525(a), but went one step further and rejected the contention set forth in Macher and Holmes that a debtor’s right to a fresh start combined with the authority vested under §105 formed a basis to grant relief.
                                                                                                                       
While the handful of cases addressing this issue have produced a mixed bag of results, it would seem that the first court to address this matter, the Mills court, made the most analytically correct finding. As noted, Congress specifically instructed courts to “further develop” §525(a) in order to prohibit “other forms of discrimination,” not just those specifically enumerated. That mandate, when applied to well-settled canons of statutory construction,⁸ would suggest that it is proper to apply §525(a) to prohibit the IRS’ discriminatory policy discussed here, because that policy not only directly inhibits a debtor’s ability to obtain a fresh start, it also denies a privilege afforded to every taxpayer – at least every taxpayer that is not also a debtor in bankruptcy.