Rochelle v. U.S.

• Decision Date: 24 October 1975
• Docket Number: No. 74-1639,74-1639
• Citation: 521 F.2d 844
• Parties: 75-2 USTC P 9792 William J. ROCHELLE, Jr., Trustee, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 844

521 F.2d 844

75-2 USTC P 9792

William J. ROCHELLE, Jr., Trustee, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 74-1639.

United States Court of Appeals Fifth Circuit.

Oct. 24, 1975.

Linda N. Coffee, Philip I. Palmer, Jr., Dallas, Tex., for plaintiff-appellant.

Frank D. McCown, U. S. Atty., Martha Joe Stroud, Asst. U. S. Atty., Ft. Worth Tex., Karl Schmeidler, Atty., Lawrence R. Jones, Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks, Chief, Appellate Sec., Tax Div., Dept. of Justice, Washington, D. C., Charles G. Barnett, Tax Div., Dept. of Justice, Michael D. Cropper, Dallas, Tex., Joseph M. McManus, Attys., Tax Div., Dept. of Justice, Washington, D. C., for defendant-appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before RIVES, GODBOLD and GEE, Circuit Judges.

GODBOLD, Circuit Judge:

This case involves the interplay of two sections of the Bankruptcy Act. Section 5g, 11 U.S.C. § 23g, ¹ gives priority in the allocation of the assets of a bankrupt partner to creditors of the partner over creditors of the partnership. Section 68a, 11 U.S.C. § 108a, ² permits a creditor of a bankrupt who also is in debt to the bankrupt to set off the two debts against each other, claiming or paying only the balance.

In this case the United States is a creditor of a bankrupt partnership, Wynne-Compass Fair, Inc. The United States seeks to set off against the claim running to it as a partnership creditor a claim asserted on it by the bankruptcy estate of a partner of Wynne-Compass Fair, Inc. ³

We hold that the claim of the United States against the estate of the partner, based upon the partnership obligation, is subordinated by § 5g to the claims of creditors of the partner in his individual capacity. But we further hold that this subordination of the United States' claim under § 5g does not bar the United States from utilizing the set-off provision of § 68a, which is available for provable claims even though they are not allowable.

An individual, Wynne, and a New York corporation, Compass Fair, Inc., formed a New York partnership, Wynne-Compass Fair, Inc., to operate the Texas pavilion at the 1964 New York World's Fair. The partnership proved unsuccessful. It filed for a Chapter XI arrangement in July 1964 and was adjudicated a bankrupt in August 1964. In September an involuntary petition in bankruptcy was filed against Wynne, and in November he was adjudicated a bankrupt. The United States filed against the estates of both the partnership and of Wynne, the general partner, proofs of claim for the partnership's unpaid federal employment (withholding, FUTA and FICA) and excise taxes.

In November 1967 Wynne and his wife, who had filed a joint federal income tax return in 1962, claimed a refund of $326,947.92 of their 1962 income tax by a carryback of the 1964 partnership loss. The claim was allowed in full by IRS. Rochelle, the trustee of Wynne's bankruptcy estate, now claims the refund on behalf of Wynne's individual creditors. The United States resists, asserting under § 68a a right to set off the refund against the unpaid tax liability of the partnership. Put in practical terms, the trustee would have the United States pay the tax refund into Wynne's individual estate and wait in line with other creditors in either or both of the partner and partnership bankruptcy proceedings to collect the unpaid tax debts of the partnership. Presumably the United States would not be able to recoup even the amount of the tax refund paid in, let alone the total tax debt of the partnership. The District Court held that the government had the right to set off the two debts and trustee Rochelle has appealed. ⁴

This appeal presents the following questions:

(I) What is the effect of § 5g on the United States' tax claim against the individual estate of the partner Wynne?

(II) Does § 68a authorize offset between the government's claim against the bankrupt as affected by § 5g and its liability for a tax refund?

(A) Are the claims "mutual"?

(B) Is the United States' claim "provable" and is it "allowable" under § 57g, 11 U.S.C. § 93g?

(C) Does § 68a allow offset of subordinated claims?

I. Section 5g

The United States argues that § 5g "relates to priorities of payment between classes of creditors, and provides a rule of distribution; it does not alter the status of one who is a creditor of both the partnership and the partner." And, the government says, since it enjoys the status of creditor of both partner and partnership, it may, under § 5g, share in the partner's estate as a creditor of that estate.

We agree with the government that its tax claim against the partnership is also a personal liability of the partner. But the claim did not begin that way. The partnership was formed in New York, and under New York partnership law, N.Y.P.L. § 26(1) (McKinney's, 1948), partners are jointly and severally liable only for partnership liabilities under N.Y.P.L. §§ 24 and 25. These include liability for wrongful acts in the course of business or with the partners' authority under § 24 and liability for breaches of trust by misapplication of funds under § 25. All other liabilities of the partnership including tax debts are only joint liabilities of the individual partners, N.Y.P.L. § 26(2) (McKinney's, 1948). The partners' individual or several liability arises when "the property held jointly is insufficient to pay the firm debts, or it appears that there can be no effective remedy without resort to individual property. . . . The theory of the law was that the joint liabilities should be paid from the joint property if possible, and not until that remedy was exhausted, or resort thereto shown to be useless, could payment from the individual property be exacted." Seligman v. Friedlander, 199 N.Y. 373, 376, 92 N.E. 1047, 1048 (1910) (citations omitted). ⁵ It is in this sense, then, that when a partnership is adjudicated a bankrupt or its assets are exhausted that all partnership creditors become creditors of the individual partners.

The United States cites cases to illustrate that tax liabilities of a partnership are also the individual liabilities of each partner. It further asserts that its tax claim against the partner is "not solely derivative upon its failure to obtain satisfaction of its claim against the partnership, instead, Wynne . . . is individually liable . . . whether there are sufficient assets available in the partnership estate." We take it that the government is suggesting that its tax claim, insofar as assertable against the partner's estate, enjoys a better status than the claims of other partnership creditors. But every case cited by the government for this argument relies on the syllogism that partners are liable for the debts of the partnership, tax liabilities are debts of the partnership, therefore the partners are liable for the tax debts. ⁶ Moreover, in every case the government's claim against the individual partner was pressed only after the bankruptcy of the partnership or its failure to pay the taxes due. In Adams the court refers to the partner's joint not joint and several liability, 228 F.Supp. at 232, and in Ross the court noted the creditor's duty to pursue the partnership assets before turning to a retired partner, 176 F.Supp. at 935. Indeed, the government lost in Ross exactly because the partner, then retired but active when the tax debt was incurred, was only a surety, and the government failed to protect his interest by retaining a lien for his benefit on the principal debtor's assets. Thus these cases not only do not support the government's claim that Wynne was liable even if there were sufficient partnership assets, they actively refute it. ⁷ Whatever the status of the United States' claim against the bankrupt individual partner for the purposes of § 5g, it is no different than that of any other creditor of the bankrupt partnership.

Section 5g draws only one distinction, that between partnership creditors and individual creditors. It permits all individual creditors as a class to share on an equal basis in the individual estate while relegating all partnership creditors as a class to a subordinate position in claiming against the individual estate. We think the drafters would not have drawn this balanced, logical distinction if they meant one class individual creditors to include as well every member of the other class partnership creditors.

This circuit has already ruled squarely on this proposition. In In re Hurley Mercantile Co., 56 F.2d 1023 (CA5, 1932), we held that although "each partner is individually liable for every partnership debt," for bankruptcy act purposes

the partnership with its property and debts is considered a separate entity from the partners with their several estates and creditors. The Bankruptcy Act requires them to be kept separate for administration, and that partnership assets be first applied to partnership debts, and individual assets to individual debts. Bankr.Act § 5 (11 U.S.C.A. § 23).

56 F.2d at 1025. See Farmers' & Mechanics' Nat. Bank of Phila. v. Ridge Ave. Bank, 240 U.S. 498, 36 S.Ct. 461, 60 L.Ed. 767 (1916). To the same effect, see, E. g., In re Janes, 133 F. 912 (CA2, 1904); In re Knowlton & Co., 202 F. 480, 482 (CA3, 1913); Bank of Reidsville v. Burton, 259 F. 218, 219 (CA4, 1919); Cutler Hardware Co. v. Hacker, 238 F. 146, 147 (CA8, 1916). We know of no case to the contrary. See 1A Collier on Bankruptcy § 5.26 at 734.2-736. Even reducing a partnership claim to judgment against the partner does not alter the result, Id. at 736 n. 6. Thus the government's tax claim on the partnership, like every other partnership debt, is subordinated to the claims of individual creditors by § 5g.

In support of its argument that partnership debts on which the individual partner's liability has matured are to be treated as individual debts under § 5g, the government says it should be...