Contributed by Yvanna Custodio and Max Goodman
The third installment of our four-part series on the tax issues raised in United States v. Bond centers on the Prepetition 2001 Period. As discussed in Part One, the debtors (collectively referred to as “PT-1” in this series) had filed a tax return for the Postpetition 2001 Period reporting and paying tax. PT-1 later filed two late, unsigned tax returns: one for the Prepetition 2001 Period reporting net losses and one covering all of 2001 (presumably showing a refund). The IRS refused to accept both returns on the ground that PT-1 was part of the Star Group during the Prepetition 2001 Period and should have been included in the Star Group’s consolidated return. Because the Star Group did not file a return for 2001, the IRS argued that it could not determine whether PT-1’s reported net losses for the Prepetition 2001 Period should have offset net income of the Star Group as required by the consolidated return rules (in which case such losses would not be available for carry forward to PT-1’s postpetition periods). The liquidating trustee responded that the Star Group had been liquidated, and neither he nor PT-1 had access to its records. The bankruptcy court ordered the IRS to accept PT-1’s tax return for the Prepetition 2001 Period and to pay a refund of approximately $3.8 million for the Postpetition 2001 Period based in part on losses carried forward from the Prepetition 2001 Period.
On appeal, the IRS argued that the Administrative Procedures Act did not provide a basis for the bankruptcy court to compel the IRS to accept PT-1’s Prepetition 2001 Period return. Moreover, according to the IRS, the Tax Anti-Injunction Act proscribed the bankruptcy court from compelling the IRS to accept the return. Even if jurisdiction existed, the IRS argued that it did not act arbitrarily and capriciously when it refused to accept the return, and thus the bankruptcy court’s order was improper.
The district court first addressed the Administrative Procedures Act, which provides for judicial review of the actions of administrative agencies, subject to certain exceptions set forth in the statute. Specifically, judicial review applies “except to the extent that – (1) statutes preclude judicial review; or (2) agency action is committed to agency discretion by law.” The IRS asserted that each of these exceptions applied, thereby precluding the bankruptcy court from compelling the IRS to accept the Prepetition 2001 Period return. The district court cited the U.S. Supreme Court case Heckler v. Chaney, where the Supreme Court “describes the agency discretion exception to judicial review as applying to Congressional statutes drawn so broadly that they can be taken to have committed the decisionmaking to the agency’s judgment absolutely.” The district court observed that the rule upon which the IRS relied in giving the IRS discretion over whether to accept the return is a regulation enacted by the Secretary of the Treasury, and not a statute as in Heckler, and thus concluded that the IRS could not, by its own regulation, insulate its decisions from judicial review unless the governing statute grants the IRS absolute discretion. Turning to the governing provision of the Internal Revenue Code, which gives the Secretary of the Treasury authority to promulgate regulations governing the making of consolidated tax returns, the district court observed that the statute directed such regulations to provide that such returns “clearly  reflect the income tax liability” of the consolidated tax group and its members. Because the statute provided a standard against which the IRS’s actions could be judged, the district court concluded that the statute did not preclude judicial review.
The district court then turned to the Tax Anti-Injunction Act, which the IRS asserted as another reason why the bankruptcy court lacked jurisdiction to compel the IRS to accept PT-1’s Prepetition 2001 Period return. The Act provides that, except for certain exceptions not relevant here, “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person.” Agreeing with the bankruptcy court’s reasoning, the district court held that the Tax Anti-Injunction Act does not apply because requiring the IRS’s acceptance of PT-1’s Prepetition 2001 Period return does not affect the IRS’s ability to collect taxes. Instead, the liquidating trustee was attempting to obtain a refund of tax already paid for the Postpetition 2001 Period, and the net losses reported on the Prepetition 2001 Period return were a predicate to this refund.
Having found that the bankruptcy court had jurisdiction to consider whether the IRS exceeded its discretion, the district court agreed with the bankruptcy court’s conclusion that the IRS’s refusal to accept PT-1’s Prepetition 2001 Period return was arbitrary and capricious. The district court stated that, among other reasons, the IRS could not refuse to accept the return based on the “remote possibility” that the Star Group would absorb PT-1’s losses for the Prepetition 2001 Period, particularly because the Star Group lost millions of dollars in 2000, filed for bankruptcy in 2001 and thus likely lost more money during the Prepetition 2001 Period. As additional support for its holding that the IRS acted arbitrarily and capriciously, the district court noted that the Star Group did not file a return for 2001 and had since liquidated, the IRS withdrew its claim against the Star Group for Prepetition 2001 Period taxes in the Star Group bankruptcy, and, according to uncontradicted statements of the liquidating trustee’s counsel, two members of the IRS district counsel stated that the Star Group did not have any tax liability during the Prepetition 2001 Period.
For a further discussion of the issues raised in this Part, see Section 1013.3 of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2013 ed.). Stay tuned for Part Four of our series, where we will focus on whether the bankruptcy court had jurisdiction to enjoin the IRS from its future exercise of setoff or recoupment rights against the liquidating trustee.