U.S. v. Frontone

• Decision Date: 09 September 2004
• Docket Number: No. 04-1051.,04-1051.
• Citation: 383 F.3d 656
• Parties: UNITED STATES of America, Creditor-Appellant, v. John F. FRONTONE and Kathleen M. Frontone, Debtors-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 656

383 F.3d 656

UNITED STATES of America, Creditor-Appellant, v. John F. FRONTONE and Kathleen M. Frontone, Debtors-Appellees.

No. 04-1051.

United States Court of Appeals, Seventh Circuit.

Argued June 7, 2004.

Decided September 9, 2004.

Appeal from the United States District Court for the Central District of Illinois, Jeanne E. Scott, J Kenneth W. Rosenberg, Thomas J. Clark (argued), Washington, DC, for Appellant.

John S. Narmont (argued), Springfield, IL, for Debtor-Appellee.

Before POSNER, RIPPLE, and ROVNER, Circuit Judges.

POSNER, Circuit Judge.

The question presented by this appeal is whether a claim by the Internal Revenue Service to recover an erroneous refund is dischargeable in bankruptcy even if as a consequence of the refund the debtor underpaid his taxes. The bankruptcy court, seconded by the district court, said yes, it is dischargeable, and the IRS appeals.

When it reviewed the Frontones' 2000 tax return, the IRS determined that they had overpaid the taxes they owed by more than five thousand dollars, and it mailed them a refund. Within a couple of months the IRS discovered its mistake and made a supplemental assessment. What was assessed was a "deficiency" — the amount by which the tax owed by a taxpayer exceeds the amount reported on his return plus the amount of any "rebates." 26 U.S.C. § 6211(a). Rebates are refunds or credits awarded when the IRS determines that the taxpayer owed less than what the return reported as the amount due from him. § 6211(b)(2). If a rebated refund (or credit) is made in error, this may increase the amount of taxes that the recipient of the refund owes, in which event the IRS is entitled to issue a supplemental assessment, as it did here. (See § 6204(a), discussed below.) If, for example, the tax owed by the taxpayer was $10,000, the amount reported on his return was $7,000, and he had received an erroneous rebate-refund of $1,000, the deficiency would be $4,000 ($10,000 — $7,000 + $1,000). The refund that the Frontones had received was a rebate, as they concede, so if the refund was in error it could have given rise to a deficiency; the IRS believed it had — hence the supplemental assessment.

The IRS notified the Frontones of the supplemental assessment. Their response was to pay only a small part of it ($492), instead filing for bankruptcy under Chapter 7 of the Bankruptcy Code the following year and receiving from the bankruptcy court a discharge of their (dischargeable) debts. Three days before receiving the discharge, they had filed another petition for bankruptcy, this one under Chapter 13 of the Code (reorganization). That is a common sequence (nicknamed "Chapter 20"). For after receiving a discharge of dischargeable unsecured debts in his Chapter 7 proceeding, the debtor may still be burdened with debts — non-dischargeable unsecured debts, plus secured debts — and Chapter 13 enables him to work them off in accordance with an installment payment schedule approved by the bankruptcy court. Johnson v. Home State Bank, 501 U.S. 78, 87-88, 111 S.Ct. 2150, 115 L.Ed.2d 66 (1991); 2 Thomas D. Crandall, Richard B. Hagedorn & Frank W. Smith, Jr., The Law of Debtors and Creditors § 17:4 (2004); Lex A. Coleman, "Individual Consumer `Chapter 20' Cases After Johnsorr. An Introduction to NonBusiness Serial Filings under Chapter 7 and Chapter 13 of the Bankruptcy Code," 9 Bankr.Development J. 357 (1992).

The IRS filed a claim for the supplementally assessed taxes in the Frontones' Chapter 13 case, contending that the tax liability reflected by the assessment had not been discharged by the discharge granted them in their Chapter 7 case. Section 523(a)(1)(A) of the Bankruptcy Code exempts from discharge a tax "of the kind and for the periods specified in section 507(a)(2) or 507(a)(8)" of the Code. Section 507 lists the kinds of claim given priority in the distribution of a bankrupt's assets, and one of them, which section 523(a)(1)(A) incorporates by reference, is a claim for unpaid income taxes for (roughly speaking) the three years before the taxpayer filed his petition for bankruptcy. 11 U.S.C. § 507(a)(8)(A)(i). Not only are such claims not dischargeable in a Chapter 7 bankruptcy, but a Chapter 13 plan must provide for their payment in full. § 1322(a)(2). If when the plan expires the claim still hasn't been paid, it remains payable even if the debtor is granted an unconditional — a purportedly "full" — discharge. § 1328(c)(2).

Before coming to the main issue, we must smooth a procedural wrinkle. The Internal Revenue Service is forbidden, with immaterial exceptions, to assess a deficiency until it has issued the taxpayer a notice of deficiency. 26 U.S.C. § 6213(a). It failed to do that here (the errors mount up!). The notice of assessment that the IRS sent the Frontones can't be treated as a notice of deficiency, because it followed rather than preceded the assessment, which therefore was invalid. Singleton v. United States, 128 F.3d 833, 838-39 (4th Cir.1997); Philadelphia & Reading Corp. v. United States, 944 F.2d 1063, 1072 (3d Cir.1991); Russell v. United States, 774 F.Supp. 1210, 1213-16 (W.D.Mo.1991). It might seem to follow that the government has no tax claim. It does not follow. The IRS had three years from the filing of the Frontones' 2000 tax return in which to issue the notice of deficiency, and it finally did issue it, earlier this year, the month before the three-year reach-back deadline expired. It could have issued a new assessment but it didn't have to. All that matters is that, the notice of deficiency having been timely, the deficiency was assessable. For though assessment is a prerequisite to certain remedies that the IRS might seek, it is not a prerequisite to the IRS's making a claim in a bankruptcy proceeding, because the Bankruptcy Code gives priority to a tax claim that is "assessable" as well as to one that is actually assessed. 11 U.S.C. § 507(a)(8)(A)(iii); see In re Hillsborough Holdings Corp., 116 F.3d 1391, 1394-96 (11th Cir.1997); In re Pacific-Atlantic Trading Co., 64 F.3d 1292, 1301-04 (9th Cir.1995); In re L.J. O'Neill Shoe Co., 64 F.3d 1146, 1149-51 (8th Cir.1995). And remember that it is priority claims that are exempt from discharge.

So the question here is whether a claim for taxes based on an erroneous refund is — a claim for taxes. Clearly the general answer is yes. Section 6204(a) of the Internal Revenue Code authorizes the IRS, "at any time within the period prescribed for assessment, [to] make a supplemental assessment whenever it is ascertained that any assessment is imperfect or incomplete in any material respect." That describes this case. The initial assessment was "imperfect or incomplete in [a] material respect" because it understated the Frontones' tax liability. So the IRS made a new, accurate assessment, which showed that they owed additional income tax for the year 2000. It is true that they had paid this amount (with some discrepancies that we needn't get into) when they first filed their return; but the money had been returned to them by mistake, and so they had to pay it again. The additional payment due was a payment of taxes due, as the case law recognizes in allowing the IRS to use its deficiency procedures, which are intended for the recovery of taxes, to recapture erroneous refunds. Brookhurst, Inc. v. United States, 931 F.2d 554, 555-57 (9th Cir.1991); Beer v. Commissioner, 733 F.2d 435 (6th Cir.1984) (per curiam); Warner v. Commissioner, 526 F.2d 1 (9th Cir.1975); United States v. C & R Investments, Inc., 404 F.2d 314 (10th Cir.1968). This is provided, however, that the error affects the tax liability of the person who received the refund; the significance of this qualification will appear shortly.

The Frontones argue that while it may be true in general that the IRS can treat an erroneous rebate-refund as an underpayment of taxes, it is false in bankruptcy — and "characterizations in the Internal Revenue Code are not dispositive in the bankruptcy context." United States v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213, 224, 116 S.Ct. 2106, 135 L.Ed.2d 506 (1996). Had the IRS not given the Frontones an erroneous refund, they wouldn't have a nondischargeable tax debt facing them, because they wouldn't have owed taxes. And having a nondischargeable debt, as both the bankruptcy judge and the district judge noted, makes it harder for the debtor to get back on his feet after bankruptcy.

The judges believed that both "equity" (bankruptcy proceedings are part of the equity jurisdiction of the federal courts) and the "fresh start" rationale of bankruptcy supported the Frontones' claim. The appeal to equity rings a little hollow. The IRS's error did not "cause" the Frontones to emerge from their Chapter 7 bankruptcy with a nondischargeable tax debt. Had they paid the supplemental assessment — which, remember, they had been notified of before they declared bankruptcy — they would have emerged from Chapter 7 with no dischargeable debts, though the record is silent on whether their assets when they were notified were sufficient to enable them to pay it in full.

And while the Bankruptcy Code is indeed a code of debtors' rights (hence the "fresh start" rationale), it is equally a code of creditors' remedies. Bankruptcy maximizes the repayment of an insolvent debtor's debts by overcoming the collective-action (or musical-chairs) problem that arises when each of the debtor's unsecured creditors races to seize the debtor's assets, when a more orderly liquidation, or a reorganization, would yield a larger total recovery. Aiello v. Providian Financial Corp., 239 F.3d 876, 879 (7th Cir.2001); In Matter of Milwaukee Cheese Wisconsin, Inc., 112 F.3d 845, 847-48 (7th Cir.1997); Covey v. Commercial Nat'l Bank, 960 F.2d 657, 661-62 (7th Cir.1992).

But what is most important is that it is the Code itself — not bankruptcy judges, district judges, circuit judges, or even Supreme Court Justices,...