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Bankruptcy Headlines

The IRS Can Offset Post-petition Tax Overpayments Against Pre-petition Tax Liabilities

By: Kyle J. TumSuden

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in In re Pugh, the Bankruptcy Court for the Eastern District of Wisconsin modified the automatic stay to allow the IRS to offset the debtor’s post-petition claim for tax overpayment against the debtor’s pre-petition tax liability due to the IRS. In Pugh, the chapter 13 debtor confirmed her plan, which provided that she would be able to keep any federal or state tax refunds received during the term of the plan. Sometime after the debtor had filed, the IRS audited her pre-petition tax returns and discovered a tax liability for 2011. The debtor then filed a proof of claim on behalf of the IRS for the tax liability for 2011, and the IRS subsequently filed an amended proof of claim. In early 2014, the debtor filed her 2013 federal income tax return, claiming a refund based on an overpayment. The IRS did not remit the refund to the debtor and instead moved for an order modifying the automatic stay to allow the IRS to offset the debtor’s post-petition claim to a tax overpayment against pre-petition tax liabilities. The debtor responded that, pursuant to section 541(a)(7) of the Bankruptcy Code, the right to the refund was property of the estate because the 2013 tax refund did not exist at the time of the bankruptcy filing. In addition, the debtor argued that the 2011 tax obligation arose post-petition because, at the time of filing, she did not owe any taxes for 2011. The IRS, however, maintained that the overpayment for 2013 was not property of the debtor or the estate because under section 6402 of the Internal Revenue Code, the IRS was entitled to offset such funds against the tax liability for 2011. Therefore, the IRS argued that the debtor was entitled to a refund only if there was a net amount remaining after offset. Ultimately, the court granted the IRS’ order modifying the automatic stay, thereby allowing the IRS to offset the debtor’s post-petition tax overpayment for 2013 against the debtor’s pre-petition 2011 tax liability.

Breach of the Covenant of Good Faith Leads to Equitably Subordinated Debt and the Possibility of Losing Millions

By: Lauren Casparie

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re LightSquared, Inc.,[i] a bankruptcy court recently equitably subordinated the claim of an entity that the founder, chairman of the board, and controlling shareholder of a competitor of the debtor created in order to circumvent a credit agreement’s restrictions on transferring the debt to certain parties. In particular, the LightSquared court determined that the entity breached the implied covenant of good faith by effectively acquiring the debt on behalf of the competitor’s controlling shareholder.[ii] In LightSquared, the debtor entered into a credit agreement that restricted transferring the debt to certain disqualified companies and all natural persons.[iii] When a competitor company inquired about purchasing the debt, it discovered that the agreement’s schedules listed competitor as a disqualified company.[iv] Since the competitor could not purchase the debt directly, its controlling shareholder formed an investment vehicle for the exclusive purpose of buying the debt, thereby circumventing the credit agreement’s restrictions on transferring the debt, in order to give the competitor effective control over the debtor’s reorganization.[v] The investment vehicle was under capitalized, resulting in the creditor funding multiple purchases by transferring money from his personal account.[vi] Eventually, the investment entity purchased enough debt to give it a blocking position and the power to enforce certain rights during the debtor’s subsequent bankruptcy.[vii] After this purchase, rumors started to circulate that the controlling shareholder of the competitor was behind the purchasing.[viii] After hearing of these rumors, the debtor’s management strongly suspected that the controlling shareholder was behind the investment vehicle’s acquisition of the debt but never inquired into this suspicion.[ix] A month after obtaining a blocking position, the controlling shareholder made presentations to the competitor’s board of directors, informed them that he was behind the purchases of the debt, and proposed that the competitor submit a bid seeking to acquire the debtor’s assets.[x] Later, without informing the board of directors, the controlling shareholder submitted a bid on the competitor’s behalf for the debtor’s assets.[xi] This bid would have resulted in the investment entity being paid in full on the debt with an additional $140 million profit.[xii] Subsequently, the debtor filed for bankruptcy under chapter 11 of the Bankruptcy Code.[xiii]

A Non-Attorney Can Be Subject to Bankruptcy Code’s Requirements for Both a Bankruptcy Petition Provider and a Debt Relief Agency

By: Sharon Basiratmand

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in Jonak v. McDermott,[i] a federal district court in Minnesota affirmed a bankruptcy court’s ruling that an individual and his companies functioned as bankruptcy petition preparers, regardless of what they actually called themselves.[ii] In particular, the district court affirmed the bankruptcy courts order enjoining the individual and his companies from “providing any bankruptcy assistance within the meaning of section 101(4A) to an assisted person for compensation, without giving all disclosures required by sections 527 and 528(a).”[iii] The district court also held that the bankruptcy court’s order disgorging the fees paid to the individual and his companies was proper.[iv] In Jonak, Edward Jonak was sole shareholder, president, and operating principal of Affordable Legal Services (“ALC”). [v] He advertised ALC as providing “low cost legal aid,” including services by “program attorneys.”[vi] Acting through ALC, he provided forms for clients to complete, assisted in preparing bankruptcy petitions on their behalf, answered questions about how to complete forms, and provided completed firms to a service to type into completed bankruptcy petitions and schedules.[vii] After investigating Mr. Jonak’s conduct in the underlying bankruptcy cases the United States Trustee (the “UST”) filed a complaint against Jonak and his companies, alleging that Mr. Jonak violated five provisions of section 110 of the bankruptcy code, all of which are applicable to petition preparers.[viii] The complaint also alleged that Mr. Jonak violated section 527 by failing to provide required notices and section 528 by failing to identify his company as a debt relief agency.[ix] In response, Mr. Jonak denied that section 110 applied, asserting that he did not physically prepare the bankruptcy documents and therefore was not a bankruptcy petition preparer.[x] He further contended that sections 526 to 528 did not apply, arguing that his company, ALC, was not a debt relief agency.[xi] After the UST moved for summary judgment, the bankrupty court found that Jonak and ALC functioned as bankruptcy petition preparers and that ALC qualified as a debt relief agency.[xii] Therefore, the bankruptcy court enjoined him from committing any future violations of section 110, ordered forfeiture and turnover of fees received, and awarded the UST liquidated damages.[xiii] On appeal, the district court affirmed.[xiv]