Landbank Equity Corp., In re

• Decision Date: 27 October 1992
• Docket Number: No. 91-1780,91-1780
• Citation: 973 F.2d 265
• Parties: -5524, 61 USLW 2140, 92-2 USTC P 50,464, 23 Bankr.Ct.Dec. 507, Bankr. L. Rep. P 74,796 In re LANDBANK EQUITY CORPORATION, a Virginia Corporation, Debtor. INTERNAL REVENUE SERVICE, Plaintiff-Appellant, v. Laurence H. LEVY, Trustee, Defendant-Appellee, Debera F. Conlon, Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 265

973 F.2d 265

70 A.F.T.R.2d 92-5524, 61 USLW 2140,

92-2 USTC P 50,464,

23 Bankr.Ct.Dec. 507, Bankr. L. Rep. P 74,796

In re LANDBANK EQUITY CORPORATION, a Virginia Corporation, Debtor INTERNAL REVENUE SERVICE, Plaintiff-Appellant, v. Laurence H. LEVY, Trustee, Defendant-Appellee Debera F. Conlon, Appellee.

No. 91-1780.

United States Court of Appeals Fourth Circuit.

Argued May 4, 1992.

Decided Aug. 14, 1992.

As Amended Oct. 27, 1992.

Janet Kay Jones, Tax Div., U.S. Dept. of Justice, Washington, D.C., argued (James A. Bruton, Acting Asst. Atty. Gen., Gary R. Allen, Gary D. Gray, Tax Div., U.S. Dept. of Justice, Washington, D.C., Richard Cullen, U.S. Atty., Norfolk, Va., on brief), for plaintiff-appellant.

David Huntington Adams, Clark & Stant, P.C., Virginia Beach, Va., argued (Donna J. Hall, Michelle P. Burchett, on brief), for defendant-appellee.

Before PHILLIPS and NIEMEYER, Circuit Judges, and KAUFMAN, Senior United States District Judge for the District of Maryland, sitting by designation.

OPINION

NIEMEYER, Circuit Judge:

In this appeal we are asked to decide whether the fact that a dispute over a tax deduction for bad debt losses under 26 U.S.C. § 166 arises in the context of a bankruptcy proceeding reverses the long-established requirement that the taxpayer bears a burden of proving that the debt became worthless in the particular year in which the deduction was taken. See Belser v. Commissioner, 174 F.2d 386, 389 (4th Cir.), cert. denied, 338 U.S. 893, 70 S.Ct. 240, 94 L.Ed. 549 (1949). Because we conclude that Congress, by merely providing for the consideration of tax claims in the bankruptcy courts, did not intend implicitly to alter established interpretations of the tax laws, we reverse the decision of the district court insofar as it permits the trustee to deduct bad debt losses in years for which the trustee could not meet his burden.

I

From 1981 through 1985, William and Marika Runnells owned and operated the Landbank Equity Corporation and its wholly owned subsidiary, Richmond Equity Corporation. Landbank was in the business of making loans secured by second mortgages which were then sold on the secondary market to institutions such as the Federal National Mortgage Association, banks, and savings and loan associations. In doing so, however, Landbank falsified loan histories to make them look more attractive for sale. It also agreed to and did service or buy back loans that went into default to hide the nature of its scheme from the potential buyers of what in many cases turned out to be worthless loans. Probably because its business success depended on its loan purchasers' belief that the loans were of high quality, Landbank did not accurately maintain its financial records with respect to loan delinquencies, nor did it report bad debt losses on its corporate tax returns.

In September 1985, Landbank and Richmond Equity petitioned for bankruptcy protection under Chapter 11. Shortly thereafter their cases were converted to Chapter 7 liquidation proceedings and Laurence H. Levy was appointed bankruptcy trustee for the estate. The true nature of the debtors' "business" surfaced soon after the initiation of the bankruptcy proceedings, eventually leading to the criminal fraud convictions of both the Runnells and their accountant and to the suicide of a vice president.

In December 1985, the Internal Revenue Service (IRS) submitted a proof of claim against the bankruptcy estate for an estimated $4.4 million in owed taxes, interest, and penalties for the tax years 1982-85. After conducting an audit, the IRS revised its assessment, asserting deficiencies for these years totalling approximately $879,000 plus interest and penalties. In determining the amount of taxes owed for the tax years 1982-85, the IRS allowed as deductions the reasonable additions to bad debt reserves that it estimated Landbank could have claimed for each year, amounting to $6.4 million in total deductions for the four years.

Under the tax law in place at that time, a corporation could take deductions for bad debts using either an "actual method" of accounting, in which the taxpayer was allowed to deduct bad debts in the tax year in which they actually became worthless or a "reserve method" which allowed deductions for "reasonable additions" to a bad debt reserve. See Act of Aug. 16, 1954, ch. 736, 68A Stat. 1, 50, repealed by Tax Reform Act of 1986, § 805(a), 100 Stat. 2085, 2361. Under the reserve method, the corporation would later "charge off" against the reserve the actual losses as they occurred and any reserve ultimately remaining after all "charge offs" would be returned to income.

In conducting its audit, the IRS used the reserve method because, in the absence of accurate financial records, the actual amounts of bad debt losses incurred by Landbank could not be determined for each year. Based on its audit for the tax years 1982-85, the IRS submitted to the trustee a Form 870 (Consent to Assessment of Deficiencies) which the trustee signed on the advice of his accountant. By signing a Form 870, the taxpayer gives consent to the IRS's assessment of taxes as shown on the form. The form also serves as the taxpayer's tax return for the years indicated on the form.

When the trustee filed Landbank's 1986 tax return, which was not covered by the Form 870, he added $2.8 million to the bad debt reserve as a deduction, so that as of that time the reserve totaled over $9.2 million. The trustee then charged off $9.1 million against the reserve as if that amount of bad debt losses occurred in 1986. Because that method of accounting, however, would still leave the estate liable to pay taxes owed for the years 1982-85, as shown on the Form 870, the trustee filed an objection to the IRS's proof of claim. Along with several other objections not the subject of this appeal, he requested that he be allowed to revert to an "actual method" of accounting for bad debts during these earlier years and allocate the $9.1 million in losses over those years in proportion to the income reported in them. By this method, the trustee claims that the taxpayer would owe no taxes.

The bankruptcy court, as a matter of equity, sustained all of the trustee's objections, disallowed the IRS's claim, and thus relieved the bankruptcy estate of all tax liability for the years in question. Recognizing the efforts of the trustee in uncovering the taxpayer's fraud and preserving an estate for creditors, the bankruptcy court stated:

If there had not been the bankruptcy of Landbank Equity Corporation, in my opinion, having presided over the case, [it is] quite unlikely that the Internal Revenue Service would have gotten much, if anything, from this case.

* * * * * *

So I think the IRS is requiring in this case a line, hard line, statutory line, whatever it may be, that makes it extremely difficult when so many things do not later come to light.

* * * * * *

There are times when justice and equity would require--and this is in accord with that--would require that something else be done. And the Court feels that the trustee, relative to allocation, should be entitled to refile, to refile anything if there is a clearer picture at this time.

The IRS appealed this decision, and others not raised here, to the district court, which affirmed the bankruptcy court. 130 B.R. 28. The district court concluded that the IRS, by failing to object to the taxpayer's 1986 return, admitted to bad debt losses of $9.1 million, which were charged off against the reserve. The court stated, "The IRS has not claimed that Landbank did not incur these bad debt losses. It merely claims that because the trustee cannot prove exactly when Landbank incurred the bad debt losses, he cannot take deductions for them in any particular year...." Indeed, the court recognized that "it would be impossible" for the trustee to prove when specific debts actually became worthless. Recognizing that "[t]he burden would normally be on the taxpayer" to prove the tax year in which the bad debt losses occurred, the district court held that in a bankruptcy proceeding, Bankruptcy Rule 3001(f) shifts the burden of proof from the trustee to the claimant once the trustee adduces some evidence supporting his objection to the claim filed. The court concluded that the IRS did not meet its burden of demonstrating that the losses were not properly allocated as proposed by the trustee and that the IRS's creation of a bad debt reserve for the taxpayer in the Form 870 was "a fiction devised by the IRS after the fact." The district court therefore permitted the taxpayer to reallocate its bad debt losses over the tax years 1982-85 "in proportion to the year's share of total net income for the four years," thereby avoiding any tax liability.

This appeal followed.

II

The sole question presented to us on this appeal is whether, in the context of a bankruptcy proceeding, the burden of showing entitlement to a deduction for bad debts shifts from the taxpayer to the IRS. The trustee, readily acknowledging that the records maintained by Landbank are not adequate to prove the year, or years, in which the $9.1 million in bad debt losses occurred, claims that as a matter of equity he ought to be able to allocate the losses over four years in proportion to the income reported. Accepting the trustee's claim, the district court decided that "[b]ankruptcy courts are essentially courts of equity" and to deny bad debt losses because the actual years in which they were sustained cannot be proved would "exalt form and technical considerations over substance and substantial justice." Confronted with the risk of failing to meet the traditional burden imposed on taxpayers to prove deductions claimed, the court relied on Bankruptcy Rule 3001(f) to require the IRS to prove its claim for taxes, including the proper allocation of deductions to be given the taxpayer.

On this appeal the IRS argues that the courts below erred by...