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UNITED STATES BANKRUPTCY COURT

SOUTHERN DISTRICT OF INDIANA

INDIANAPOLIS DIVISION

IN RE: )

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ERIC 8S. & CATHERINE E. )

RICHARDS ) CASE NO 18-3418-RLM-12

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Debtors )

a)

ORDER SUSTAINING, IN PART, DEBTORS’ OBJECTION

TO 224 AMENDED CLAIM FILED BY THE IRS

Eric and Catherine Richards (“Debtors”) objected to the amended Proof of

Claim filed by the Internal Revenue Service (“IRS”) in their chapter 12 bankruptcy.

The IRS filed a response to that objection and a hearing was held in the court on

February 18, 2020. For the reasons stated below, the Court sustains the Debtors’

objection to the extent the actions taken by the IRS were contrary to the provisions

of the confirmed plan. However, the objection is overruled to the extent it requests

additional relief.1

Among the far-reaching changes made to the Bankruptcy Code by BAPCPA 2

was the addition of §1222(a)(2)(A). That section dealt with the requirement a

chapter 12 plan must provide for full payment of §507 priority claims, but carved

out an exception for claims owed to a governmental unit that arose as a result of the

sale, transfer, exchange, or other disposition of any farm asset used in the debtor's

farming operation. If such a claim otherwise would have been entitled to §507

priority, the new §1222(a)(2)(A) provided, instead, that it would be treated as a

general unsecured claim subject to discharge. This was a huge advantage to

farmers who sought chapter 12 relief, as stated in , 430 B.R. 663, 666

(B.A.P. 10th Cir. 2010) , 433 Fed. Appx. 682 (10th Cir 2011):

The new provision attempts to mitigate the tax expense often incurred

by farmers who have significant taxable capital gains or depreciation

recapture when their low basis farm assets are foreclosed, sold, or

otherwise disposed of by their creditors. Formerly, these dispositions

created large priority tax claims that barred confirmation of Chapter 12

plans. By stripping these claims of their priority status and rendering

them unsecured claims for distribution and discharge purposes, the

drafters of BAPCPA sought to facilitate farmers' use of Chapter 12.

A split among the circuits arose as to whether §1222(a)(2)(A) covered taxes

from the post-petition sale of farm assets during the pendency of the chapter 12

case. See, , 581 F.3d 696 (8th Cir. 2009) (holding that §1222(a)(2)(A)

applied to post-petition sales); cf., , 652 F.3d 1236 (10th Cir. 2011) and

, 617 F.3d 1161 (9th Cir. 2010) (both holding that §1222(a)(2)(A) did not

apply to post-petition sales). That question was answered in the negative.

, 566 U.S. 506, 132 S. Ct. 1882, 182 L.Ed.2d 840 (2012). noted

that, for §1222(a)(2)(A) to apply, the tax first had to be a tax that otherwise would

be entitled to §507 priority. Of the several priority categories under §507, only two

1 This order constitutes findings of fact and conclusions of law to the extent required by Fed. R.

Bankr. P. 9014 and Fed. R. Bankr. P. 7052.

2 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

addressed taxes. Section 507(a)(8) covered pre-petition taxes and didn’t apply.

Section 507(a)(2) covered administrative expenses allowed under §503(b). Section

503(b)(1)(B)(i) covered administrative taxes, but a prerequisite to that section was

the tax had to be “incurred by the estate”. Unlike chapter 7 and chapter 11 cases3,

Section 1399 of the Internal Revenue Code (“IRC”) provided that no separate

taxable estate is created upon a chapter 12 filing, and thus, chapter 12

administrative taxes are not “incurred by the estate”. Consequently, taxes arising

from disposition of farm assets during the pendency of the chapter 12 case did not

enjoy §1222(a)(2)(A) treatment. , 566 U.S. at 512; 132 S.Ct. 1887. In October

2017, Congress enacted legislation that took out subsection (A) from §1222(a)(2) and

added new §1232.4 The “priority stripping” attributes of former §1222(a)(2)(A)

were carried over to §1232 and extended to taxes arising from post-petition sales,

thus effectively overruling .

Debtors filed their chapter 12 case in May 2018 after the enactment of §1232.

Their chapter 12 plan was confirmed in October 2018. The confirmed plan provided

the IRS’s priority claim for 2016 was $0 and its priority claim for 2017 was $5,681.

While the tax liability for 2018 had not yet become due, the plan provided that there

would be additional liquidation of farm assets in 2018 and occurring during the

pendency of the case that would qualify for treatment under §1232.

The plan also provided the exclusive means by which “any and all claims”

were to be paid post-petition, as follows:

Section 11.03. Exclusive Collection Action. The means of payment described

in this Plan are, absent an event of default of this Plan, the exclusive means

of post-petition payment of any and all claims, and no creditor shall take

action to collect on any claim, whether by offset or otherwise, unless

specifically authorized by this Plan. Any action taken on or between the

Petition Date and Confirmation Date shall be reversed and refunded to the

appropriate entity if such action is not specifically authorized by this Plan.

This paragraph does not curtail the exercise of a valid right of setoff

permitted under §553.

3 See I.R.C. §1398.

4 Additional Supplemental Appropriations for Disaster Relief Requirements Act of 2017, PL. 115-72,

effective October 26, 2017.

The IRS did not object to the plan and it was confirmed on October 22, 2018.

In March 2019, Debtors filed their 2019 federal tax return which included

taxes attributable to the sale of farms assets during 2018. To single out those §1232

taxes from other taxes incurred during 2018, Debtors filed both a 2018 pro forma

1040 federal tax return5 and a 1040 federal tax return. The pro forma return

indicated that Debtors were entitled to a $6414 refund for 2018 (the “2018 Refund”).

In October 2019, the IRS amended its claim (the “2nd Amended Claim”) which

indicated that it had offset the 2018 Refund against Debtors’ 2018 unsecured §1232

taxes. At the hearing on the objection, counsel for the IRS indicated that the 2018

Refund had been applied to the 2016 priority taxes and the §1232-related general

unsecured claim arising from the 2018 sale of farm assets. Debtors objected to the

2nd Amended Claim and their objection is in two parts: (1) asserting the setoff was

prohibited by the express terms of the confirmed plan and (2) seeking an order from

this Court directing the IRS to issue the 2018 Refund to Debtors.

Sovereign Immunity

Debtors’ objection to the 2nd Amended Claim recites that it is pursuant to

§502(b). To the extent the issue before the Court is a claims objection wherein the

Court has authority to determine and allow the amount of a claim under §502(b),

this Court has jurisdiction to do so. Sovereign immunity is abrogated as to

5 The pro forma return excluded the taxable income from the sale of farm assets qualifying for §1232

treatment in order to compute the taxes owed. This computation method is known as the “marginal”

method that was approved by the 8th Circuit Court of Appeals in and is applied by

calculating a return for all income, then a second “pro forma” tax return removing all qualifying

sales income, so that non-qualifying income would be taxed at lower marginal tax rates. The taxes

shown on the “pro forma” return would represent the portion of the tax claim entitled to priority

status, while the difference between the taxes shown on the return for all income and the taxes

shown on the “pro forma” return would represent the unsecured portion of the tax claim.

overruled only to the extent that then-§1222(a)(2)(A) did not apply to post-petition sales

but did not pass upon the appropriate method by which to compute taxes that included the sale

of farm assets. Paragraph 3.05 of the debtors’ confirmed plan here specifically provided that their

tax liability would be computed using the marginal method used in .

government units with respect to §502 matters under §106(a). Furthermore, Section

10.01(d) of the confirmed plan provides that the Court retains jurisdiction “to hear

and determine any objections to claims filed both before and after confirmation”.

Debtors’ claim objection is premised on the IRS’s violation of the terms of the

confirmed plan that spell out how the tax claims are to be paid. Section 10.01(i)

provides the Court retains jurisdiction to “hear and determine disputes arising from

the Plan or its implementation.” Furthermore, the IRS is bound by the terms of the

confirmed plan under §1227(a). Section 106(a) abrogates sovereign immunity as to

governmental units with respect to §1227, as well as §502.

IRS’s Right to Setoff under the Confirmed Plan

Section 553 preserves a creditor’s right to setoff that exists under

nonbankruptcy law. , 339 B.R. 504, 505 (Bankr. W.D. Mo. 2006).

Section 553 requires that only mutual, pre-petition obligations can be set off against

each other. , 516 U.S. 16, 116 S.Ct. 286, 289,

133 L.Ed.2d 258 (1995). 26 U.S.C. §6402 (a) (hereinafter “IRC”) is the

“nonbankruptcy law” that allows the IRS to set off tax overpayments against tax

liabilities.

Courts are divided as to whether a confirmed plan under §1141, §1227 or

§13276 bars the IRS from exercising its §553 setoff rights. Courts within the

Seventh Circuit have held that, absent an express plan provision extinguishing

such rights, a creditor’s §553 rights survive confirmation. Section 553 provides that

“this title does not affect any right of a creditor to offset a mutual debt” and courts

have reasoned that the “effect of confirmation” provisions are contained in “this

title” (Title 11) and thus, do not affect the creditor’s §553 rights. ,

6 These three sections are the “effect of confirmation” sections for chapter 11, 12 and 13 cases and

essentially provide that, except as otherwise provided for in the plan, the property dealt with by the

plan is free and clear of all claims and interests of creditors after confirmation of the plan. See,

§1141(c), §1227(c) (“except as provided in section 1228(a) of this title and except as otherwise

provided in the plan or in the order confirming the plan, the property vesting in the debtor under

subsection (b) of this section is free and clear of any claim or interest of any creditor provided for by

the plan”; §1327(c) (nearly identical language as §1227(c)).

248 B.R. 343, 346 (C.D. Ill. 2000 (§553 trumps §1327); , 284 B.R. 870, 874-

75 (Bankr. N. D. Ill. 2002) (“confirmation of a debtor’s plan…does not extinguish

prepetition setoff rights, especially …where the plan does not specifically treat

those setoff rights”). However, a creditor’s §553 setoff rights may be extinguished by

express provision under a confirmed plan.

., No. 02 Civ. 9629 (NRB), 2003 WL 21355214 at *4

(S.D.N.Y. 2003)(“[i]ndeed, where there is a specific provision in the confirmation

order prohibiting setoff claims, courts have indicated that the right to setoff may not

survive the confirmation plan”); , 185 B.R. 214, 215 (D Md. 1995);

., 217 B.R. 304, 310 (Bankr. M.D. Fla. 1997) (holding that

§1141 takes precedence over §553 where plan of reorganization specifically

prohibited setoff).

Debtors’ plan specifically provided that “no creditor shall take action to

collect on any claim, whether by offset or otherwise, unless specifically authorized

by this Plan”. That same paragraph later recites that “[t]his paragraph does not

curtail the exercise of a valid right of setoff permitted under § 553”. While this

paragraph contains incongruities, they need not be resolved here because the type

of setoff exercised by the IRS here was not of the kind “permitted under §553”. The

2018 Refund was a post-petition payment owed to Debtors and was applied against

the §1232 taxes arising from the 2018 sale of farm assets. Section 1232 taxes are to

be treated as a dischargeable, pre-petition tax under §1232(a)(1). Therefore, the

setoff was not among mutual, pre-petition obligations as required under §553.

What is left is a paragraph that clearly prohibits set off as a means for “post-

petition payment of any and all claims”. The setoff exercised by the IRS was in

derogation of section 11.03 of the plan.

Court’s Authority to Order IRS to Issue 2018 Refund

The solutions proposed by the Debtors to rectify the prohibited setoff is to (1)

order the IRS to issue the 2018 Refund to Debtors or (2) withhold distributions to

the IRS under the plan or pay those distributions to Debtors until the 2018 Refund

is issued. To the extent Debtors seek to alter payments to the IRS under the plan

by withholding distributions or having them paid to the debtors instead, Debtors

are free to move to modify their plan under §1229(a)(4). Otherwise, Debtors’

remedies require this Court to order the IRS to issue the 2018 Refund. That

remedy gives the Court pause, especially when the vehicle by which the remedy is

sought is a claims objection under §502(b).

Section 502(b) provides that a court may “determine the amount of such

claim in lawful currency of the United States as of the date of the filing of the

petition and shall allow such claim in such amount” but nowhere does that section

provide for anything beyond “determining” and “allowing”. Section 542(b) provides

for turnover by an entity that owes a debt, subject to the entity’s §553 setoff rights,

but the debt has to be “property of the estate”. , 432 B.R. 870, 887

(Bank. N.D. Ga. 2010) (“the affirmative duty to turnover (sic) property is limited to

property of the estate.”). A governmental unit that has filed a proof of claim in a

case is deemed to have waived sovereign immunity with respect to a claim against it

that is property of the estate and that arose out of the same transaction or

occurrence as the claim out of which the claim of such governmental unit arose

under §106(b). Thus, the 2018 Refund, at a minimum, must be “property of the

estate” if this Court is to have jurisdiction and the authority to direct its turnover.

Property of the Estate

Section 541(a) includes an expansive definition of “property of the estate” and

provides that the commencement of a case creates an estate. Section 541 falls

under “Chapter 5” (entitled “Creditors, the Debtor and the Estate”) and applies to

chapter 12 cases under §103(a). Section 1207 extends “property of the estate” to

include property that is of the kind described in §541 that the debtor acquires after

the commencement of the case but before the case is closed, dismissed or converted

to a case under chapter 7. Yet, §1227(b) provides that confirmation vests all

property of the estate in the debtor and Section 11.09 of the confirmed plan here

provides likewise.7

Chapter 13 contains nearly identical provisions in §1306 and §1327(b).

Courts that have attempted to reconcile these seemingly irreconcilable sections

have developed four distinct lines of cases which were summarized in ,

236 B.R. 156, 161 (Bankr. D. Vt. 1999). Suffice to say that the Seventh Circuit

follows the line of cases that hold that the only property that remains “property of

the estate” post confirmation is that property needed to fund the confirmed plan.

, 115 F.3d 521, 524 (7th Cir. 1997) (“We read the two sections, 1306(a)(2)

and 1327(b), to mean simply that while the filing of the petition for bankruptcy

places all the property of the debtor in the control of the bankruptcy court, the plan

upon confirmation returns so much of that property to the debtor's control as is not

necessary to the fulfillment of the plan.”). Nothing in the plan or confirmation order

here provides that post-petition tax refunds remain “property of the estate” and the

debtor has made no assertion that the 2018 Refund is needed to fund the plan. Nor

has the chapter 12 trustee sought turnover of the 2018 Refund to augment the plan.

Even assuming that the 2018 Refund qualifies as “property of the estate” under

§1207, it no longer is, as it vested in Debtors upon confirmation.

The IRS contends that the 2018 pro forma tax return does not accurately

reflect Debtors’ tax liability because the pro forma return “is used solely for the IRS

Insolvency Unit to submit an accurate proof of claim to the Court. It does not

entitle Debtors to a refund.” IRS Response, Doc. #33, pg. 7-8. Section §505(a)(2)(B)

(for which §106(b) abrogates sovereign immunity for governmental units) gives the

Court the power to determine to a tax refund. Section

505(a)(2)(B) provides that the bankruptcy court may not determine—

(B) any right of the estate to a tax refund, before the earlier of—

(i) 120 days after the trustee properly requests such refund from the

governmental unit from which such refund is claimed; or

(ii) a determination by such governmental unit of such request

7 Section 11.09 of the plan provides in part, that “[u]pon entry of the Confirmation Order, all

property of the Estate and that property treated under the Plan shall vest or re-vest in the Debtors”.

The intended purpose of subsection §505(a)(2)(B) is to prevent a refund claim from

languishing in the administrative processes, thus permitting the bankruptcy court

to make a determination of a refund if the taxing authority does not act upon a

refund claim within 120 days. , 259 F.3d. 323, 328, n4 (5th Cir. 2001).

rejected the notion that the §505(a)(2)(B) grant of jurisdiction is limited to

refunds that benefit the estate. . But see, ., 562 B.R. 632,

646 (Bankr. E.D. Va. 2016) (“the Trustee's allegations and supporting exhibits may

very well support an argument that he is entitled to the refunds claimed, but they

do not establish undisputed ownership as required for a §542 turnover

proceeding.”); , 572 B.R. 808, 811(Bankr. E.D. Va. 2017) (holding that

§505(a)(2)(B) did not apply because chapter 7 debtors were not “trustees” and were

not seeking the refund for the benefit of the bankruptcy estate). Fortunately, the

Court need not address this issue. Even if the 2018 Refund fell within the limits of

§505(a)(2)(B), nothing in the record indicates that Debtors followed the appropriate

administrative procedures in requesting a refund from the IRS. See, IRC §7422.

The Court lacks jurisdiction to make any determination with respect to the amount

or the turnover of the 2018 Refund. , Case No. CV 19-2849 FMO,

2020 WL 1317725 at *1 (C.D. Cal. March 20, 2020) (reversing judgment of

bankruptcy court and dismissing adversary proceeding, noting that “even assuming

the debtors/appellees have standing to pursue the tax refund, the court is persuaded

that the bankruptcy court did not have jurisdiction because the debtors/appellees

never filed an administrative claim for a refund as required by §505(a)(2)(B)”);

, 607 B.R. 794, 804 (D. Del. 2019) (where bankruptcy

court dismissed tax dispute regarding refund for failure to follow §505, district court

noted that appellant’s entitlement to refund of state property taxes must be

adjudicated in state court); , 574 B.R. 862, 875 (Bankr. D. Or. 2017)

(refund claim dismissed for failure to follow §505(a)(2)(B) requirements).

Accordingly, Debtors’ objection to the 2nd Amended Claim is SUSTAINED to

the extent the 2018 Refund was applied to the IRS’s claim in a manner other than

provided for under the confirmed plan. IT is OVERRULED as to all other relief

requested.

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