In re Kreidle, Bankruptcy No. 86-B-5540-M

Citation145 BR 1007
Decision Date23 June 1992
Docket NumberBankruptcy No. 86-B-5540-M,Adv. No. 90-1579 PAC.
PartiesIn re James KREIDLE, Debtor. James D. KREIDLE, Plaintiff, v. DEPARTMENT OF the TREASURY, INTERNAL REVENUE SERVICE, Defendant.
CourtUnited States Bankruptcy Courts. Tenth Circuit. U.S. Bankruptcy Court — District of Colorado



Harry M. Sterling, Denver, Colo., for plaintiff.

Mark Nebergall, U.S. Dept. of Justice, Washington, D.C., for defendant.


KAREN M. SEE, Visiting Judge.

Pending is a Motion for Attorney Fees and Costs pursuant to 26 U.S.C. § 7430, arising from Debtor's Complaint for Determination of Tax Liability and for Equitable, Injunctive and Declaratory Relief. After judgment was entered for Debtor and against the IRS in the action, Debtor moved for $227,152.04 in attorney fees and costs. The court finds that Debtor is a prevailing party and that the IRS' position on the most significant issue was not substantially justified, and awards $192,817.23 for fees and costs. The court has jurisdiction pursuant to 28 U.S.C. § 157(b)(2)(O).


Debtor James Kreidle was a 50% partner in Titsch & Associates, a general partnership, and an officer and director of related corporations. In 1986 Debtor was personally liable for $8,000,000 in partnership debt and guarantees of corporate debt. On June 20, 1986, an involuntary petition was filed. On September 26, at the hearing on the involuntary petition, petitioning creditors and Debtor agreed to a Chapter 11 Order for Relief. On October 2, the Order was inadvertently entered in Chapter 7, rather than Chapter 11 as agreed, so on November 25, 1986, the error was corrected by an Order Converting Case to Chapter 11.

The facts in the tax litigation underlying this fee dispute began when Debtor sent the IRS an election to terminate his 1986 calendar tax year on October 1, 1986, pursuant to IRC § 1398, which allows a Chapter 11 Debtor to terminate the tax year upon commencement of the bankruptcy.

On June 9, 1987, a Notice of Bar Date for filing proofs of claim was mailed to all creditors, including the IRS. Before the bar date, another creditor filed a proof of claim on behalf of the IRS in an unknown amount for FICA, Federal Withholding Taxes "and/or other taxes in an undetermined amount." On July 21, 1987, the IRS received notice of the filing of the proof of claim along with a notice the IRS could amend the proof of claim if desired.

The court approved Debtor's Disclosure Statement on September 14, 1987. November 13 was the last day to file objections to the Plan. The Disclosure Statement provided Debtor would pay $203,518 in estimated unpaid 1986 taxes. On October 9, the IRS received the Disclosure Statement, Plan, notice of deadline to file objections, and a ballot for voting on the Plan. The IRS did not file a ballot or object to the Plan. On November 16, 1987, an Order Confirming Debtor's First Amended Plan of Reorganization was entered.

Debtor and his spouse determined their actual tax liability for the tax year ending October 2, 1986 to be $166,275, and $2,513 for the tax year ending December 31, 1986. They paid the taxes when they submitted the returns on October 15, 1987. The first inkling of trouble was three years later, on October 5, 1990, when after an audit of Debtor's tax returns for the 1986-88 tax years, the IRS issued a Statutory Notice of Deficiency claiming additional taxes due of $1,510,964, including interest and penalties, in excess of the amounts previously paid. The IRS based the deficiency, in part, on an alleged untimely filing of the § 1398 election.

Debtor was current on Plan payments to that point but did not pay the interest payment scheduled for December, 1990 after receipt of the Notice of Deficiency. The parties agreed in the Amended Joint Pretrial Statement that Debtor and his Plan creditors would be injured as a result of allowing the IRS to collect a $1,500,000 claim at that late stage in Debtor's rehabilitation.

On December 7, 1990, Debtor filed an adversary complaint in bankruptcy court pursuant to 11 U.S.C. § 505(b)(1). Debtor and his spouse each also filed a petition with the United States Tax Court for redetermination of the liability deficiencies claimed by the IRS within 90 days from the issuance of the Notice of Deficiency. The Tax Court petitions, filed in January, 1991, were not heard before this court's hearing of Debtor's adversary action.


Debtor filed a Complaint for Determination of Tax Liability pursuant to 11 U.S.C. § 505(b), presenting several issues for trial. The first issue was whether Debtor made a timely § 1398 election and was entitled to file short year tax returns for 1986. The timeliness issue turned on whether an involuntary bankruptcy case commences upon filing of the petition or upon entry of the Order for Relief for purposes of Section 1398.1

The second issue was the amount of Kreidle's and the estate's available net operating loss carrybacks and whether NOL carrybacks and carryforwards were sufficient to offset any tax liability for 1986 and 1987, specifically liability arising from cancellation of debt income as a result of the bankruptcy discharge. This involved a determination whether losses were capital or ordinary losses.

The IRS argued the bankruptcy estate, as a separate taxpayer under the Tax Code, used up all favorable tax attributes, so Debtor was not entitled to take carryback net operating losses to offset the alleged increase in income taxes for 1986. Debtor argued that regardless of disposition of other issues raised in the complaint, the IRS incorrectly eliminated the net operating losses based on an incorrect calculation of cancellation of indebtedness income. The IRS objected to inclusion of this issue at trial, claiming surprise. The issue of cancellation of debt was not directly raised in Debtor's Complaint, but the parties were on notice the issue was pending. It was discussed in pretrial conferences and included in the Pretrial Statement filed three weeks before trial.

The third issue was whether there was substantial authority to support Debtor's position on his submitted tax returns for 1986 and 1987, or whether Debtor was liable for penalties pursuant to I.R.C. § 6661 for substantial understatement of income.

The fourth issue was whether Debtor was entitled to a charitable contribution carryover deduction for 1987. This required determination of the amount and nature of the estate's tax attributes, and whether they were consumed by the estate's tax liability or flowed out to Debtor upon confirmation of the Plan.

The fifth issue was whether the IRS was estopped from collecting the alleged deficiency based on reliance by Debtor and his creditors on the amount of tax liability shown in the First Amended Disclosure Statement, in confirming the Plan, and making payments under the plan for several years before issuance of the Notice of Deficiency.


The result of the prior litigation will be summarized. To the extent issues overlap with those in the fee dispute, the Findings entered July 1, 1991 are incorporated. The court concluded that for purposes of § 1398, an involuntary bankruptcy commences when the Order for Relief is entered, and that Debtor's § 1398 election was timely filed on January 15, 1987, thus creating two short tax years in 1986: from January 1 to October 1, and from October 2 to December 31, 1986. It was also concluded that even if the § 1398 election was untimely, the IRS should be estopped from assessing or collecting the alleged deficiency due to actions and statements by IRS representatives which led Debtor, his wife, and creditors to believe, to their detriment, that the § 1398 election was valid, and that the IRS had no claims against Debtor's estate.

Before trial, the IRS claimed the cancellation of indebtedness income was $5,300,000; Debtor claimed it did not exceed $423,957. At trial, the cancellation of indebtedness income figure used by the IRS turned out to be erroneous because the person responsible for the audit failed to take into account the effect of § 108(e)(2) which provides that cancellation of debt, which if paid would give rise to a deduction, does not result in taxable income. On the second day of trial, the parties stipulated the amount of cancellation of debt income was $1,054,757, which was significantly less than the $5,300,000 originally alleged by the IRS.

Based on the Stipulation and the conclusion that Debtor's § 1398 election was valid, the court entered the following findings of fact and conclusions of law in its calculation of Debtor's correct income tax liability for the 1986 and 1987 tax years:

1) The amount of charitable contribution carryover deduction flowing out of the bankruptcy estate for use by debtor was $41,135.
2) The characterization of the loss occurring from Debtor\'s partnership interest in Titsch & Associates becoming worthless by reason of its bankruptcy was an issue properly before the court despite the IRS\' contention that it lacked sufficient notice. The court reached this conclusion based on discussions of this issue by the IRS with debtor and with the court prior to trial.
3) The loss resulting from the worthlessness of debtor\'s partnership interest was an ordinary loss and therefore the entire $2,092,090 loss was available for carryback along with other NOLs incurred by Debtor. The loss flowed out to debtor on November 16, 1987 when the bankruptcy estate terminated and increased Kreidle\'s available NOL carrybacks.
4) Debtor was not subject to penalties under § 6661 of the Tax Code based on its conclusion that Debtor made a proper § 1398 election which resulted in Debtor\'s tax return being correct as filed. In addition, debtor adequately disclosed the relevant facts that identified potential controversy over the § 1398 election on his 1986 tax return form.
5) Debtor was not liable for

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