Feshbach v. U.S. Dep't of Treasury & Internal Revenue Serv. (In re Feshbach)

• Decision Date: 17 October 2017
• Docket Number: Case No. 08:11–ap–00803–CPM,Case No. 08:11–bk–12770–CPM
• Citation: 576 B.R. 660
• Parties: IN RE: Matthew L. FESHBACH and Kathleen M. Feshbach, Debtors. Matthew L. Feshbach and Kathleen M. Feshbach, Plaintiffs, v. United States Department of Treasury and Internal Revenue Service, Defendants.
• Court: U.S. Bankruptcy Court — Middle District of Florida

576 B.R. 660

IN RE: Matthew L. FESHBACH and Kathleen M. Feshbach, Debtors.Matthew L. Feshbach and Kathleen M. Feshbach, Plaintiffs,

v.United States Department of Treasury and Internal Revenue Service, Defendants.

Case No. 08:11–bk–12770–CPM

Case No. 08:11–ap–00803–CPM

United States Bankruptcy Court, M.D. Florida, Tampa Division.

Signed October 17, 2017

Luis Salazar, Salazar Jackson, LLP, Coral Gables, FL for Debtor.

Suzy Tate, Attorney for Trustee, Suzy Tate, P.A., Tampa, FL, for Trustee.

Cynthia Burnette, United States Trustee, Tampa, FL, for U.S. Trustee.

AMENDED ¹ MEMORANDUM DECISION ON COMPLAINT TO DETERMINE DISCHARGEABILITY OF DEBT FOR TAXES AND TO SET ASIDE TAX LIENS

Catherine Peek McEwen, United States Bankruptcy Judge

In providing an exception to a discharge in bankruptcy for debtors who do not "make an honest and reasonable effort to comply with the tax laws,"² the Bankruptcy Code evinces public policy favoring payment of taxes. The Plaintiffs in this proceeding are Matthew L. and Kathleen M. Feshbach, chapter 7 debtors. They seek a determination that their chapter 7 discharge extends to their substantial 2001 federal income tax debt. But their alleged inability to pay this debt resulted from a conscious decision to spend their considerable income to support an excessive lifestyle based on a conviction that it takes money to make money. While such a conviction may in some instances prove true, it cannot excuse the Plaintiffs' intentional failure over the course of more than a decade to pay their tax debt while at the same time realizing in excess of $21 million in income ($13 million of that from tax years 2002–2010) and living what most would consider a luxurious life. Consequently, they are not entitled to a discharge of any of their tax debt.

Jurisdiction

The Court has jurisdiction over this proceeding pursuant to 28 U.S.C. §§ 1334, 157(a), and the Standing Order of Reference issued by the United States District Court for the Middle District of Florida. This is a core proceeding arising under 28 U.S.C. § 157(b)(2)(I) and procedurally governed by Rule 4007, Federal Rules of Bankruptcy Procedure.

The Feshbachs filed their dischargeability complaint against United States of America, naming the United States Department of Treasury and the Internal Revenue Service (the "IRS" or "Service") as Defendants and seeking a determination of the dischargeability of substantial federal income tax liability and the avoidance of tax liens.³ After an unsuccessful run at a summary judgment, the Feshbachs proceeded to trial on the complaint.

Discussion

I. Facts

For most of his adult life, Mr. Feshbach has worked as an investment professional, both as a money manager and a private investor.⁴ But he hasn't gone at it alone. Essentially since they married, Mrs. Feshbach has been, in her words, an extension of Mr. Feshbach's professional ventures, albeit at their home.⁵ Beginning in the 1980s, Mr. Feshbach began using an investment strategy known as "selling short against the box." This strategy served one primary purpose: delaying the recognition of taxable income. And unlike selling short generally—which involves an investor's selling stock that he (or a broker on his behalf) borrows from another with the hope that the stock price will fall before the investor is required to buy identical stock to return to the person whose stock the investor sold—selling short against the box is in one way a far safer bet.

An investor who sells short against the box borrows matching shares of an appreciated stock that the investor presently owns. The investor then sells the borrowed shares and posts the owned shares as collateral, thereby creating a long and short position in the same security. (Days long ago, the investor would place the owned, collateralized shares in a safe-deposit box—hence the phrase "against the box."⁶ ) This maneuver creates a neutral position, whereby any change in one position is always offset by an opposite, but balanced, change in the other position. "You can't lose; you can't win," Mr. Feshbach explained.⁷ And here's the upside: selling short against the box locks in the built-in gain on the owned shares. Of course, an investor could similarly capture the same gain by merely selling the owned shares. But that would create taxable income. Selling short against the box, on the other hand, at one time allowed investors to liquidate stock without having to report the gain as income, often delaying the taxable event until the subsequent tax year—or even longer.

Although it is unclear exactly how much money Mr. Feshbach made in the 1980s and 1990s by selling short against the box, one thing is certain: Mr. Feshbach was a successful investment professional. This success allowed him and his family to lead an unusually comfortable life. But it is important to note that Mr. Feshbach did not support the family through traditional means. Instead, Mr. Feshbach borrowed against the gains that he locked in by selling short against the box.⁸ In the first part of the 1990s, Mr. Feshbach invested a significant portion of the borrowed funds in real property, spending $14 million to construct a new house on a parcel of land that he purchased near Silicon Valley.⁹

Because selling short against the box allowed investors to defer gain recognition, Mr. Feshbach was not required to immediately pay taxes on the borrowed funds. He could defer that obligation until he returned the borrowed stock or closed the short position. This, no doubt, was the peril of selling short against the box. An imprudent or unlucky investor who years ago borrowed locked-in gains for other investments could find himself empty handed when the tax bill came due.

New legislation made things even more complicated for investors who sold short against the box. In his 1997 budget proposal, President Bill Clinton, who was poised to "to kill ‘selling short against the box’ and similar strategies to lock in gains while deferring or even eliminating taxes,"¹⁰ suggested several amendments to the Internal Revenue Code. Congress agreed with the proposed changes and subsequently enacted the Taxpayer Relief Act of 1997,¹¹ adding (among other things) § 1259 to Title 26. This new provision, titled "Constructive sales treatment for appreciated financial positions," closed the loophole that made selling short against the box so appealing. Under the provision, still in effect today, a taxpayer is treated "as having made a constructive sale of an appreciated financial position [when] the taxpayer ... enters into a short sale of the same or substantially identical property."¹² And where "there is a constructive sale of an appreciated financial position," taxpayers are required to "recognize gain as if such position were sold."¹³

But this legislative fix favoring the federal government's coffers did not deter Mr. Feshbach from this investment strategy. He "embraced volatility and ... believed [that he] was smarter than the market."¹⁴ In 1999, Mr. Feshbach heavily invested in a home improvement and remodeling company, again selling short against the box.¹⁵ In relatively quick order, the company collapsed and entered bankruptcy.¹⁶ This event, under the new tax laws, closed out Mr. Feshbach's investments in the company and triggered significant income recognition, on which he owed $1,950,827.00 in taxes.¹⁷ At that time, the Feshbachs did not have sufficient liquid assets to cover the debt. Luckily, Mr. Feshbach still had a strong securities portfolio. So in 2001, he liquidated other short-against-the-box positions to help cover the 1999 tax debt.¹⁸ Unsurprisingly, this again triggered income recognition. This time the stakes were higher. On their 2001 tax return, the Feshbachs reported $8,601,748.00 in taxable income.¹⁹ This resulted in a $3,247,839.00 tax liability.²⁰ Things looked bleak for the Feshbachs. Changing circumstances and bad bets left them deeply indebted to the federal government.

Faced with this mounting problem, the Feshbachs approached the IRS with a plan to settle the 1999 and 2001 tax debts for less than what they owed. This is known as an "offer-in-compromise."²¹ In deciding on whether to accept any given offer—evidently, an altogether complex process—the IRS considers what it refers to as a taxpayer's "reasonable collection potential," which is a function of two things: (1) a taxpayer's assets and (2) a taxpayer's ability to pay (a calculation that is essentially a taxpayer's monthly income reduced by reasonable expenses).²² According to a revenue officer²³ who, for a period of time, handled the Feshbachs' case, "the government is allowed to take less than full payment of the tax, penalty, and interest due if it's in the interest of the government and the taxpayer [and] if the taxpayer is going to offer [his] equity in assets and a portion of his future ability to pay."²⁴ The Service also takes into account whether accepting a particular offer would "be unfair to the taxpaying public at large."²⁵

The Feshbachs presented their first offer-in-compromise in June 2001, proposing to settle the 1999 tax debt for $1 million, paid over the course of five years.²⁶ At the time, taking accrued interest and penalties into account, the Feshbachs' $1 million offer represented roughly half of what they owed on the 1999 tax debt. Two months later, generally consistent with the offer, the Feshbachs submitted an initial $200,000.00 payment to the IRS.²⁷ Nevertheless, after an initial review, the Service simply didn't feel that the Feshbachs' half-price offer was the right price, in part because the documents that the Feshbachs' submitted along with this first offer established that the Feshbachs were living "way over allowable living expenses" and that Mr. Feshbach personally believed that his income would continue to rise in the coming years.²⁸ The Service believed the Feshbachs' offer to be a "nonstarter," primarily because their reasonable collection potential exceeded their entire tax...