Levinson v. U.S.

• Decision Date: 15 July 1992
• Docket Number: No. 91-1899,91-1899
• Citation: 969 F.2d 260
• Parties: -5303, 92-2 USTC P 50,463, Bankr. L. Rep. P 74,771 Melvin E. LEVINSON, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 260

969 F.2d 260

70 A.F.T.R.2d 92-5303, 92-2 USTC P 50,463,

Bankr. L. Rep. P 74,771

Melvin E. LEVINSON, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 91-1899.

United States Court of Appeals Seventh Circuit.

Submitted Jan. 23, 1992.

Decided July 15, 1992.

Melvin E. Levinson, Wilmette, for plaintiff-appellant.

Sharon J. Coleman, Asst. U.S. Atty., Office of the U.S. Atty., Criminal Div., Chicago, Gary R. Allen, William S. Estabrook, Bridget Rowan, John A. Lindquist, III, Dept. of Justice, Tax Div., Appellate Section, Washington, D.C., for defendant-appellee.

Before COFFEY, FLAUM, and RIPPLE, Circuit Judges.

COFFEY, Circuit Judge.

Once again, we attempt to untangle the web of Melvin Levinson's past deceit. ¹ This time, the issue is whether unpaid income taxes from 1966 to 1969 should be included in Levinson's discharge in bankruptcy. The bankruptcy court and the district court held that they were not, and we affirm.

BACKGROUND

Levinson, a former attorney, embezzled money from his clients but did not declare it as income on his tax returns between 1966 and 1969. In 1978 the Internal Revenue Service sought to recover the tax on this income by asserting deficiencies against the plaintiff for each of these years. Plaintiff responded by challenging these deficiencies, except for 1969, in tax court. Pursuant to an agreed-upon stipulation, the parties settled the case, with Levinson agreeing to pay $74,815.27, comprising back taxes and penalties for negligence, 26 U.S.C. § 6653(a), and failure to file a return in 1968, 26 U.S.C. § 6651(a). The government, in turn, agreed that Levinson did not have to pay any penalties for fraud under 26 U.S.C. § 6653(b).

As to the 1969 taxes, plaintiff allowed judgment to be entered against him in the district court for $44,840.23, including a negligence penalty. In order to reach this accord, the government again agreed not to seek a fraud penalty.

In 1982 Levinson filed a Chapter 7 bankruptcy petition, and in 1985 he received his discharge in bankruptcy, releasing him from all dischargeable debts. Soon thereafter he filed suit in the bankruptcy court to determine whether his 1966-69 tax debts to the government were dischargeable. The government argued that the debts were not dischargeable because Levinson's returns for those years were fraudulent, and therefore his debt could not be expunged by bankruptcy. 11 U.S.C. § 523(a)(1)(C). ² The bankruptcy court agreed with the government, finding the debts nondischargeable, and the district court affirmed.

ISSUES

Levinson raises two main issues on appeal. First, should res judicata, collateral estoppel, or judicial estoppel have barred the government from arguing that his tax debts were nondischargeable because of fraud? Second, if these doctrines were inapplicable, did the government either fail to give adequate notice of its intent to argue fraud or fail to prove that the returns were fraudulent?

DISCUSSION

Normally, tax debts over three years old are dischargeable in bankruptcy. 11 U.S.C. § 523(a)(7)(B). Such debts are not dischargeable, however, if the debtor made a "fraudulent return or willfully attempted to evade or defeat such tax." 11 U.S.C. § 523(a)(1)(C). The government relied on this exception before the bankruptcy court, arguing that plaintiff's debts were not dischargeable because he knew that the money he embezzled had to be declared as income, but intentionally and fraudulently neglected to report it.

Levinson, however, contends that res judicata should apply to prevent the government from claiming fraud. Res judicata "prevents litigation of all grounds for, or defenses to, recovery that were previously available to the parties, regardless of whether they were asserted or determined in the prior proceeding." Brown v. Felsen, 442 U.S. 127, 131, 99 S.Ct. 2205, 2209, 60 L.Ed.2d 767 (1979). Because the government could have asserted that his returns were fraudulent when determining his tax liability, Levinson argues, res judicata prevents it from now claiming fraud as a defense to his discharge in bankruptcy. In short, the argument is that the government had its chance to allege fraud and did not do so, and therefore the issue must be treated as having been resolved in Levinson's favor.

The Supreme Court's decision in Brown v. Felsen rejected this very argument, and controls here. In Brown the parties settled a suit by consenting to a judgment based on a stipulation, but neither the stipulation nor the judgment revealed the basis for the debtor's liability. When the debtor later filed for bankruptcy the creditor claimed the debt was nondischargeable, having been the result of the debtor's fraud. The debtor responded by claiming that the consent judgment, which made no mention of fraud, was res judicata on the issue because the creditor could have increased his recovery by arguing fraud in the collection proceeding, but declined to do so. The Supreme Court disagreed, finding that applying res judicata in such circumstances would neither protect the interests served by res judicata (e.g., encouraging reliance on judicial decisions, barring vexatious litigation, and freeing courts to resolve other disputes, id. at 131, 99 S.Ct. at 2209), nor serve the policies of bankruptcy law, one of which is to give a "fresh start" to the honest debtor. Id. at 128, 99 S.Ct. at 2208. Central to the Court's decision was the fact that the creditor was not presenting some new ground for recovery, or seeking to increase his recovery, or challenging the validity of a prior judgment. Rather, he was simply trying to defend his pre-existing rights against the debtor's attempt to evade the debt by means of the Bankruptcy Act. In such circumstances, it is the debtor who "has upset the repose that would justify treating the prior ... proceeding as final, and it would hardly promote confidence in judgments to prevent [the creditor] from meeting [the debtor's] new initiative." Id. at 133-34, 99 S.Ct. at 2211. So it is here. The government is not trying to increase Levinson's tax debt by tacking on fraud penalties; if it were, res judicata would apply. Instead, it is simply responding to Levinson's bankruptcy petition and attempting to prevent a legitimate debt from being discharged. The Brown court refused to apply res judicata on nearly identical facts, and we follow suit.

Furthermore, the fact that the government could have claimed fraud in the earlier proceedings does not mean that it was obliged to do so in order to protect its award from a bankruptcy discharge. Such a rule would lead to inefficiency and unnecessarily complicated litigation. As the Brown court said in rejecting the debtor's res judicata argument,

The rule proposed by respondent would force an otherwise unwilling party to try [dischargeability] questions to the hilt in order to protect himself against the mere possibility that a debtor might take bankruptcy in the future. In many cases, such litigation would prove, in the end, to have been entirely unnecessary[.]

Id. at 135, 99 S.Ct. at 2211. This is especially true in collection cases, where flexibility and compromise are essential to the speedy resolution of disputes. See id. at 137 n. 8, 99 S.Ct. at 2212 n. 8. ("Default and consent judgments are common in collection proceedings. For the creditor, the prospect of increased attorney's fees and the likelihood of driving the debtor into bankruptcy may offset the advantages of exemplary damages or other extraordinary remedies.") For example, the government may have received more from Levinson if it had sought fraud penalties in the earlier proceedings, but it chose not to in order to effect a settlement and insure some recovery. Res judicata ought not be applied so as to inhibit such compromises. We would not want the government, or any creditor, to feel compelled to bring every conceivable charge against a debtor lest that debtor should declare bankruptcy and use the creditor's spirit of compromise as a bar to its right to defend its award.

Finally, application of res judicata in cases like the one at bar would run contrary to the underlying purpose of the Bankruptcy Code, which is to provide a "fresh start" to the "honest but unfortunate debtor." Local Loan Co. v. Hunt, 292 U.S. 234, 244, 54 S.Ct. 695, 699, 78 L.Ed. 1230 (1934); see also Grogan v. Garner, --- U.S. ----, 111 S.Ct. 654, 659, 112 L.Ed.2d 755 (1991). As one court recently recognized, the parties to a non-bankruptcy proceeding may often be unconcerned with issues, such as fraud, that only become significant when the debtor files for bankruptcy. Applying res judicata to such proceedings could prevent the bankruptcy court from ever discerning whether the debtor is in fact honest and deserving of the Code's shelter.

At the time of a pre-bankruptcy proceedings [sic], a debtor may not foresee the possibility of, or need for, filing a petition for protection under the Bankruptcy Code. Therefore, it would be inconsistent with the "fresh-start" policy of the Bankruptcy Code to permit a pre-bankruptcy proceeding in a tax court in which the debtor could have contested the issue of "fraud," but for whatever reason did not, to foreclose that debtor from actually litigating the fraud issue in the bankruptcy court for the purpose of determining the dischargeability of tax liabilities.

In re Graham, 131 B.R. 275, 279 (E.D.Pa.1991). Just as the debtor in Graham, who agreed to a stipulation including penalties for fraudulent underpayment of taxes, was allowed to deny fraud in his discharge proceeding, so must the government, which agreed to a stipulation precluding fraud penalties, be allowed to claim fraud in Levinson's discharge proceeding. By refusing to apply res judicata in either case, the bankruptcy court has the opportunity to determine the truth, and so implement the policies behind the Code, rather than binding the parties to strategic decisions made in a different context.

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