In re Industrial Commercial Electrical, Inc., No. 04-40038-WGY.

• Court: United States District Courts. 1st Circuit. United States District Courts. 1st Circuit. District of Massachusetts
• Writing for the Court: YOUNG
• Citation: 319 B.R. 35
• Decision Date: 04 January 2005
• Docket Number: No. 04-40038-WGY.
• Parties: In re INDUSTRIAL COMMERCIAL ELECTRICAL, INC., I.C.E. Management Corp., and I.C.E.-Conn, Inc., Debtors. United States Internal Revenue Service, Appellant, v. Official Committee of Unsecured Creditors of Industrial Commercial Electrical, Inc., I.C.E. Management Corp., and I.C.E.-Conn, Inc., Appellee.

319 B.R. 35

In re INDUSTRIAL COMMERCIAL ELECTRICAL, INC., I.C.E. Management Corp., and I.C.E.-Conn, Inc., Debtors.
United States Internal Revenue Service, Appellant,
v.
Official Committee of Unsecured Creditors of Industrial Commercial Electrical, Inc., I.C.E. Management Corp., and I.C.E.-Conn, Inc., Appellee.

No. 04-40038-WGY.

United States District Court, D. Massachusetts.

January 4, 2005.

319 B.R. 36

COPYRIGHT MATERIAL OMITTED

319 B.R. 37

COPYRIGHT MATERIAL OMITTED

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Carl D. Aframe, Aframe, Barnhill & Von Timroth, P.A., Worcester, MA, for I.C.E. Management Corporation, I.C.E.-Conn, Inc., Industrial Commercial Electrical, Inc., Appellee.

Michael J. Fencer, Jager Smith, P.C., Boston, MA, for Official Committee of Unsecured Creditors, I.C.E. Management Corporation, I.C.E.-Conn, Inc., Appellee.

Barry E. Reiferson, U.S. Department of Justice, Trial Attorney, Tax Division, Washington, DC, for United States of America, Appellant.

Michael J. Sullivan, United States Attorney's Office, Boston, MA, for United States of America.

MEMORANDUM AND ORDER

YOUNG, Chief Judge.

This is an appeal, brought under 28 U.S.C. § 158(a)(1), from an order disallowing an administrative claim by the United States Internal Revenue Service ("IRS") in the joint Chapter 11 proceedings regarding Industrial Commercial Electrical, Inc. ("ICE"), I.C.E. Management Corp. ("Management"), and I.C.E.-Conn., Inc. (ICE-Conn.) (collectively "debtors"). After filing for bankruptcy, Management filed an amended tax return seeking (and by operation of law receiving) a tentative carryback adjustment tax refund pursuant to 26 U.S.C. § 6411 (also called a "quickie refund"), based on Management's reported net operating loss, and an appointed examiner's determination that $450,000 in management fees that Management had received from ICE in prior years should be reversed, because Management had mismanaged ICE's accounts receivable. The IRS filed an administrative claim under 11 U.S.C. § 503(b)(1)(B)(ii) to preserve its rights, should it determine that the adjustment was not justified. The debtors and the Official Committee of Unsecured Creditors ("Creditors' Committee")¹ challenged the claim, and after an evidentiary hearing, the Bankruptcy Court disallowed the claim. The IRS argues on appeal that the Bankruptcy Court abused its discretion in disallowing the IRS's motion to continue, that its factual findings were erroneous, and that it erred in applying the burden

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shifting framework for determining the validity of the adjustment in question

1. FACTUAL BACKGROUND AND PROCEDURAL HISTORY

A. The Debtors' Pre-petition History

The following facts are essentially undisputed or were found by the Bankruptcy Court and are not clearly erroneous. ICE (incorporated in 1989, Appellant's App. Doc. No. 3 at 319 (income tax return)) and Management (incorporated in 1995, id. at 337 (income tax return)) were related companies, with Management functioning as a management company for ICE and ICE-Conn., who functioned as operating companies. Id. at 247 (transcript of 11/19/03 hearing). The three related companies were under common management, with Daniel Kennedy ("Kennedy") serving as Chief Financial Officer and David Le-Blanc ("LeBlanc") serving as President for each company. Id. Kennedy and LeBlanc each own fifty percent of the stock in the respective companies. Id. at 083 (copy of Examiner's Report). According to the debtors, only Management paid Kennedy and LeBlanc's salaries. Id. at 291, 295 (transcript of 11/19/03 hearing). The Examiner's Report (the "Report"), filed with the Bankruptcy Court on October 10, 2002, stated the following with regard to intercompany transactions: "Known irregularities in financial reporting and revenue recognition don't provide ample comfort that related party transactions were accounted for according to the substance of the transaction." Id. at 097 (copy of the Report).

The debtors' tax returns since 1997² reveal inter-company transactions that the IRS claims were designed to evade federal income tax liability. See Appellant's Br. Doc. No. 3 at 12-14 & nn. 18-21. Management did not deduct manager salaries on its tax return for tax year 1997, when it only reported taxable income of $351. Appellant's App. at 357 (tax return). During the more profitable years from 1998 through 2001, however, manager salaries were deducted, reducing Management's reported taxable income by $1,500,416.00 for that period. Id. at 359, 361, 363-64, 366, 370, 374, 379 (tax returns). For the 2002 year (the claimed loss year), Management deducted $105,603 each in salaries for Kennedy and LeBlanc, id. at 375 (tax return), as opposed to the $302,380 deducted for each in 2001.³ The 2002 return reports zero gross income and zero cash at the beginning of the year, id. at 329, 335 (tax returns), and the only recorded income is from the affiliates, so either the operating companies paid the remainder of the salaries, or no one did.

Management claimed $319,785 in depreciation in the 1999 tax return, but had not claimed any depreciation in prior returns, and then claimed another $232,211 for the 2000 tax year. Id. at 363, 366 (tax returns). Management's Schedule L for 2000 indicates accumulated depreciation as of the beginning of the year of $561,768 (on $1,133,360 in depreciable assets). Id. at 369. The IRS argues that because this figure is larger than the reported 1999 depreciation, and Management did not report any depreciation prior to that, that

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the extra depreciation was reported on one of the affiliate's tax returns, presumably to shelter income. Appellant's Br. at 13. Management deducted $267,663 in depreciation in 2001 and $373,998 in 2002. Although Management's 2002 tax return reported $1,699,162 in depreciable assets as of June 30, 2002, Appellant's App. at 340, the bankruptcy schedules report, as of the September 6, 2002, bankruptcy filing, only a loan receivable from one of its officers and various vehicles of "unknown value." Schedules, Doc. No. 5 in Case No. 02-45453

Management's sole source of income was the fees it received from the related operating companies. Appellant's App. at 284 (transcript of 11/19/03 hearing). The following table shows Management's gross income and reported income (after deductions) for fiscal years 1997-2002:

 Taxable Income as
                Fiscal Year Gross Income Originally Reported
                1997 $ 1,000 $ 351
                1998 $ 309,455 $182,802
                1999 $ 966,559 $211,787
                2000 $1,021,000 $287,049
                2001 $1,618,147 $385,589
                2002 $ 0 ($610,135)
                Total $3,916,161 $457,443
                

Appellant's Br. at 14-15 (citing Appellant's App. at 329, 349, 357, 359, 363, 366, 374 (copies of Management's tax returns)). Management's 2002 tax return asserts that it experienced a net operating loss of $610,135 in 2002.

B. The Bankruptcy Case, the Examiner, and the Tentative Federal Income Tax Refund

Management filed for Chapter 11 protection on September 6, 2002, and its bankruptcy case was ordered jointly administered with those of ICE and ICConn. Id. at 001, 067 (copies of the case docket and of the Bankruptcy Court's 9/6/02 consolidation order, respectively). It is important to note that administrative consolidation, where the cases are managed under one docket but assets and debts of individual companies are separated, is different from substantive consolidation, where all the debtors' collective assets and debts are combined. See id. at 067 (copy of the Bankruptcy Court's 9/6/02 consolidation order); see also In re Babcock & Wilcox Co., 250 F.3d 955, 958 & nn. 5-6 (5th Cir.2001), and sources cited (explaining the differences between the two kinds of consolidation). The debtors continued in the possession of their assets as debtors-in-possession, pursuant to 11 U.S.C. §§ 1107 and 1108, which means that the debtors have the powers and duties of a trustee. Appellee's Br. Doc. No. 7 at 5. Flagship Bank & Trust Co. ("Flagship") asserted a secured claim against ICE's estate for roughly $1,919,902. Appellant's App. at 045 (copy of claims register).

On September 11, 2002, after a motion by Flagship to appoint a Chapter 11 Trustee and upon agreement by Flagship and the debtors, the Bankruptcy Court ordered that an examiner be appointed under 11 U.S.C. § 1104, with powers specified in the court's order, Id. at 070 (copy of 9/11/02 appointment order). See Samuel R. Maizel, "Examiners on the rise," The National Law Journal, Nov. 22, 2004, at 18. The Bankruptcy Court approved the United States Trustee's appointment of Stephen Wentzell, CPA (the "Examiner") as examiner on September 13, 2002. Id. at 072 (copy of 9/13/02 appointment order). On September 18, 2002, the United States Trustee appointed the members of the Creditors' Committee. Id. at 078 (copy of 9/18/02 notice of appointment).

The Examiner's primary responsibilities were to investigate the debtors' affairs and to supervise "all aspects of the debtors'

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business." Id. at 082 (copy of Examiner's Report). Pursuant to that mandate, he began an investigation of the debtors' finances, and produced an Examiner's Report on October 10, 2002. Id. During that investigation, he determined that roughly $600,000 in ICE's accounts receivable were uncollectible, essentially due to mismanagement on Management's part. See id. at 296 (transcript of 11/19/03 hearing)

He therefore determined that a reversal of certain management fees that Management had charged ICE in past years would be appropriate, and after consultation with Paul E. Rogers ("Rogers"), a certified public accountant and tax professional, he determined that the reversal should be in the amount of $450,000. Id. at 263-67 (transcript of 11/19/03 hearing); id. at 404 (1/27/04 decision). When testifying about these matters before the Bankruptcy Court, Rogers first stated that the reversal was for fees charged by Management in fiscal year 2002, but on cross-examination he admitted that the reversal was actually for $450,000 paid in prior...