Walter S. Brown v. IRS

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No. 95-3173

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In re: Walter Steven Brown; *

Diane Kay Brown, *

*

Debtors. *

*

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*

Walter Steven Brown; *

Diane Kay Brown, *

*

Appellants, * Appeal from the United States

* District Court for the

v. * Southern District of Iowa

*

Internal Revenue Service, *

*

*

Appellee. *

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United States of America, *

*

Trustee. *

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Submitted: April 10, 1996

Filed: May 2, 1996

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Before McMILLIAN, FAGG and BURNS,* District Judge.

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McMILLIAN, Circuit Judge.

*The Honorable James M. Burns, United States

District Judge for the District of Oregon, sitting

by designation.

Debtors Walter Steven Brown and Diane Kay Brown appeal from a final

order entered in the District Court1 for the Southern District of Iowa

affirming the bankruptcy court’s2 dismissal of their Chapter 12 case

pursuant to 11 U.S.C. § 1208(c)(9). In re Brown, Civil No. 4-93-70804

(S.D. Iowa July 24, 1995), aff’g Bankr. No. 93-00070-C-J (Bankr. S.D. Iowa

Feb. 16, 1995). For reversal, the debtors argue the bankruptcy court erred

in (1) holding that certain presumptions were insufficient to rebut the

IRS’s proof of claim, (2) excluding the debtors’ answers to

interrogatories, certain documents produced in response to a discovery

request and debtor Walter Steven Brown’s affidavit, and (3) dismissing

their Chapter 12 case. For the reasons discussed below, we affirm the

order of the district court.

The debtors are farmers. At some point before the events at issue

in the present case, they had filed a voluntary petition in bankruptcy

under Chapter 12. One of their major creditors was the Farmers Home

Administration (FmHA). According to the debtors, their Chapter 12 petition

precipitated an investigation by the Office of the Inspector General of

them and their relatives, including scheduled examinations at distant

locations. The debtors asserted that they voluntarily dismissed their

Chapter 12 petition in order to spare their relatives from having to

undergo these examinations. According to the debtors, the Office of the

Inspector General continued the investigation and referred the matter to

the United States Attorney for presentation to a federal grand jury, which

did not indict the debtors.

In January 1993 the debtors filed a second Chapter 12 petition. This

petition is at issue in the present case. The

1

The Honorable Harold D. Vietor, United States District Judge

for the Southern District of Iowa.

2

The Honorable Lee M. Jackwig, United States Bankruptcy Judge

for the Southern District of Iowa

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debtors had $97,946 in assets but $639,305.07 in liabilities. Their major

creditor was the FmHA. According to the debtors, the Office of the

Inspector General had turned over the information obtained during the

course of its investigation to the Internal Revenue Service (IRS). The IRS

investigated the debtors’ tax liabilities. In April 1993 the IRS filed an

objection to the confirmation of the debtors’ proposed plan. In May 1993

the IRS filed a proof of claim for $604,251.89 for federal income taxes,

interest and penalties (for tax years 1987-1992). The debtors’ proposed

plan did not provide for payment of these tax liabilities.

The debtors had filed a federal income tax return only for 1987. On

June 4, 1993, the bankruptcy court ordered the debtors to file their

delinquent tax returns within 7 days and to file either an objection to the

IRS proof of claim or an adversary proceeding within 3 weeks.

On June 23, 1993, the debtors filed an objection to the IRS proof of

claim. The debtors stated that they had filed their tax returns as ordered

and that the tax returns showed that they did not owe any federal income

taxes at that time. The government filed an objection and argued that its

proof of claim was entitled to a presumption of validity and that the

debtors had “the burden of presenting evidence to rebut the prima facie

evidence of the validity and amount of the claim.” The government also

filed a motion to dismiss the debtors’ case because the debtors reported

annual employment income of less than $20,000 in 1991 and 1992 and the IRS

and the FmHA had each filed a proof of claim for more than $600,000. The

government argued that the debtors’ “financial history did not reflect a

farming operation from which a plan of reorganization could feasibly be

developed” and that the debtors would probably not change the type of

farming they did in order to produce more income.

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In September 1993 the government filed a memorandum in support of its

objection and attached the declaration of the IRS agent assigned to the

debtors’ case. In this declaration the IRS agent stated that he

investigated the debtors’ income tax liabilities for 1987-1991 for the

purpose of preparing the IRS proof of claim. The IRS agent reviewed the

debtors’ income tax returns and many of the invoices for goods purchased

by various customers of 3-S Farming, 3-S, Inc., and M & B Farms, three Iowa

corporations operated by the debtor Walter Steven Brown. He also analyzed

the endorsements on the checks used to pay for the goods purchased by

customers of these corporations. The IRS agent discovered that “large

amounts” of money had been paid to these corporations for various

agricultural commodities. He also discovered that these corporations had

never filed federal corporate tax returns and that many of the checks used

to pay for the commodities sold by these corporations had been endorsed by

the debtor Walter Steven Brown. In addition, the IRS agent discovered that

the debtors did not maintain any known bank accounts in their own names and

that they attempted to deal in cash as often as possible. He concluded

that income which had nominally been paid to the corporations should be

attributed to the debtors personally and that this income had not been

reported on the debtors’ tax returns. The IRS agent attached his work

sheets to his declaration.

On September 16, 1993, the bankruptcy court held a hearing on the

debtors’ objection to the IRS proof of claim. The debtors did not testify

or appear in person. The IRS agent testified at the hearing and explained

how he had calculated the debtors’ unreported income and that he had

obtained the checks, receipts and other documents from the FmHA. The

bankruptcy court refused to allow counsel for the debtors to ask the IRS

agent whether he knew how the FmHA had obtained the documents (the debtors

alleged the FmHA had obtained the documents in violation of federal privacy

laws and the fourth amendment) because the only issue was the validity of

the claim. The IRS agent also testified that articles of

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incorporation had been filed for the three corporations but that he did not

know who controlled the corporations. He also testified that two of the

corporations, 3-S, Inc., and 3-S Farming, had never filed federal corporate

income tax returns and that the third corporation, M & B Farms, had filed

tax returns for 1987 and 1990-1992, but that none of the income attributed

to the debtors for the years at issue had been reported by M & B Farms.

The debtors’ tax preparer testified that she had prepared the

debtors’ 1987-1992 tax returns on the basis of information provided by the

debtors but that she had not seen most of the documents that the IRS agent

had used to calculate the debtors’ income. According to the tax preparer,

the debtors by 1992 had no farm income other than agriculture programs and

had what she described as “negative income.” The tax preparer also

testified that she had prepared corporate tax returns for the three

corporations in the past on the basis of information provided by the

debtors.

The debtors then sought to admit into evidence their answers to

interrogatories, certain documents produced in response to a discovery

request and an affidavit of the debtor Walter Steven Brown. The bankruptcy

court refused to admit these items because they were hearsay.

The government filed a motion for judgment as a matter of law on the

ground that the debtors had failed to carry their burden of proof. The

debtors opposed the motion on the basis of the presumptions in favor of the

separateness of the corporations and the validity of their tax returns.

The bankruptcy court concluded that the debtors had failed to carry the

ultimate burden of proof that the IRS proof of claim was erroneous and

dismissed the debtors’ case. On appeal the district court reversed and

remanded because the bankruptcy court erroneously placed the ultimate

burden of proof on the debtors. The district court decided that the

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debtors only had to present sufficient evidence to rebut the prima facie

validity of the IRS proof of claim.

On remand the debtors relied on the existing bankruptcy court record,

including the presumption in favor of “corporate separateness.” The

bankruptcy court placed the ultimate burden of proof (the burden of

persuasion) on the IRS, concluded that the debtors had failed to present

sufficient evidence to rebut the prima facie validity of the IRS proof of

claim, and dismissed the debtors’ case. On appeal the district court

agreed and affirmed the bankruptcy court order dismissing the debtors’

case. This appeal followed.

STANDARD OF REVIEW

We review the bankruptcy court’s factual findings under the clearly

erroneous standard; however, we review the bankruptcy court’s legal

conclusions de novo. We also review the determination that a party has

failed to satisfy its burden of proof under the clearly erroneous standard.

See, e.g., In re Placid Oil Co., 988 F.2d 554, 557 (5th Cir. 1993).

ALLOCATION OF BURDENS OF PERSUASION AND PRODUCTION

The debtors first argue the bankruptcy court erred in holding the

presumptions in favor of corporate separateness and the validity of their

tax returns were insufficient to rebut the presumed validity of the IRS

proof of claim. The debtors also argue that the testimony of IRS agent

Widelski attributing nominally corporate income to the debtors personally

was not inherently more reliable than their tax returns, which did not

report any of the corporate income, and that the IRS had failed to prove

that the corporations were alter egos of the debtors. We disagree.

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[In this type of case] the proper allocation of

the burdens of [persuasion] and production may be

decisive. A proof of claim which comports with the

requirements of Bankruptcy Rule 3001(f) constitutes

prima facie evidence of the validity and amount of the

claim. The interposition of an objection does not

deprive the proof of claim of presumptive validity

unless the objection is supported by substantial

evidence. Once the [debtor] manages the initial burden

of producing substantial evidence, however, the ultimate

risk of nonpersuasion as to the allowability of the

claim resides with the party asserting the claim [here,

the government].

In re Hemingway Transport, Inc., 993 F.2d 915, 925 (1st Cir.) (citations

omitted), cert. denied, 114 S. Ct. 303 (1993); In re Placid Oil Co., 988

F.2d at 557 (IRS has ultimate burden of proof by preponderance of

evidence). The presumption of the validity of the proof of claim is a

procedural device that places the burden of producing evidence to rebut the

presumption on the debtors. Cf. Portillo v. Commissioner, 932 F.2d 1128,

1133 (5th Cir. 1991) (tax refund action). In the present case the issue

is whether the debtors met their burden of producing sufficient evidence

as to the attribution of income to rebut the government’s prima facie case.

We hold the debtors did not provide enough information to meet their

burden of producing sufficient evidence to shift the burden of producing

evidence to the IRS. The debtors failed to rebut the claim with

“substantial evidence,” that is, evidence sufficient to rebut the IRS’s

prima facie case that the income nominally received by the three

corporations should be attributed to the debtors personally. The debtors

failed to produce any financial information other than the testimony of

their tax preparer, which was very limited and did not address the issue

of the attribution of income, and their tax returns, which were not

sufficient to prove the true amount of the debtors’ income for the years

at issue. Cf. Mays v. United States, 763 F.2d 1295, 1297 (11th Cir.) (per

curiam) (tax returns insufficient to substantiate taxpayer’s

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claim for refund), cert. denied, 474 U.S. 998 (1985). The debtors failed

to present any evidence showing that their income was what they claimed it

was, that the checks payable to the corporations but endorsed by the debtor

Walter Steven Brown were corporate income, or that the corporations were

entities wholly separate from the debtors and not their alter egos. The

presumptions in favor of corporate separateness and in favor of tax returns

prepared in good faith were not equal in probative force to the IRS proof

of claim and the declaration and testimony of the IRS agent.

Because this was a claim proceeding (as opposed to an adversary

proceeding), the government was entitled to establish its prima facie case

on the basis of the IRS proof of claim and was not required to plead

specially, give notice or produce evidence that the corporations were the

alter egos of the debtors in order to “pierce the corporate veil.” The

government could have relied only on the proof of claim to force the

debtors to come forward with sufficient evidence in rebuttal. However, the

government also produced specific and detailed evidence in support of its

claim through the declaration and testimony of the IRS agent.

The debtors also argue the bankruptcy court improperly treated the

proof of claim as raising a conclusive presumption of validity. We

disagree. The bankruptcy court’s analysis was inconsistent with a

conclusive presumption. The bankruptcy court concluded that the debtors’

allegations were not entitled to much, if any, weight because they were not

supported by any evidence and for that reason decided that the debtors had

failed to rebut the IRS proof of claim.

EXCLUSION OF EVIDENCE

The debtors also argue the bankruptcy court erred in excluding the

debtors’ answers to interrogatories, certain documents and the debtor’s

affidavit. We hold the bankruptcy court did not abuse its

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discretion in excluding this evidence on hearsay grounds. The debtors were

not present at the hearing (either initially or on remand) and thus were

not available to authenticate the documents or for cross-examination. The

debtors’ answers to interrogatories were not admissions by a party and thus

not hearsay because they were not offered against the debtors. Rather, the

debtors sought to use the answers to interrogatories in their favor. Fed.

R. Evid. 801(d)(2).

The debtors also argue the bankruptcy court erred in refusing to

allow counsel for the debtors to ask the IRS agent whether he knew how the

FmHA had obtained the documents he used to calculate their unreported

income and tax liability. The debtors argued that the FmHA had obtained

these documents illegally. The bankruptcy court did not abuse its

discretion in refusing to allow this line of inquiry because the only issue

in this claim proceeding was the validity and amount of the claim. How the

FmHA had obtained the documents in question was irrelevant to that issue

or to the sufficiency of the debtors’ evidence in rebuttal.

DISMISSAL OF THE DEBTORS’ CASE

The debtors also argue the bankruptcy court erred in summarily

dismissing their case because Chapter 12 is to be liberally construed in

favor of the debtor. The bankruptcy court did not abuse its discretion in

dismissing the debtors’ case. Once the bankruptcy court denied the

debtors’ objection to the IRS claim, the debtors’ proposed 3-year plan did

not present a reasonable likelihood of rehabilitation. 11 U.S.C. §

1222(a)(2) (Chapter 12 plan must provide for full payment of all claims

entitled to priority). The debtors’ proposed plan and schedules reflected

assets of less than $100,000, annual income from employment of less than

$20,000 in 1991 and 1992, and liabilities of approximately $640,000, not

including the IRS claim in excess of $600,000 and other timely-filed

claims.

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Accordingly, the order of the district court is affirmed.

A true copy.

Attest:

CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.

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