A September 20 opinion from the Seventh Circuit reads like a suspense novel: For nine pages, Circuit Judge Frank H. Easterbrook sounded as though he was rejecting a test for “related to” jurisdiction adopted by nine other circuits.
Then, on page 10, Judge Easterbrook abruptly announced that the Seventh Circuit would adopt the position taken everywhere else. He found “related to” jurisdiction when there appears to be a conceivable effect on a bankruptcy estate at the time the proceeding commences.
Despite finding jurisdiction, Judge Easterbrook ended his opinion by directing the bankruptcy court to abstain because resolution of the tax dispute would have no effect on creditors or the estate at the time the appeal was decided. The ruling in that regard is curious because an abstention decision is not reviewable in the court of appeals under 28 U.S.C. § 1334(d).
The case was argued in May 2017; the appeals court took 28 months to issue a decision.
The Tax Dispute
Although Judge Easterbrook did not say so directly, the debtors may have committed tax fraud and were forum-shopping, facts that may have influenced the outcome.
The Internal Revenue Service had assessed $107,000 in taxes plus $80,000 in penalties for fraud. The debtors sought review in the Tax Court and later agreed with the IRS that they owed $100,000 in taxes. However, they did not agree on the amount of penalties.
The IRS was seeking 75% in penalties for fraud, while the debtors thought $20,000 was the correct amount for negligence. On the day of trial in Tax Court, the husband and wife debtors filed a chapter 13 petition. After the bankruptcy court denied a motion by the IRS to modify the automatic stay, the debtors converted the case to chapter 7.
The IRS did not appeal denial of a stay modification. However, the IRS did file a priority proof claim for the taxes and penalties, alleging that the penalties were nondischargeable. The debtors filed an objection to the claim. Contending that they were not liable for fraud penalties, the debtors filed a motion about three months into the bankruptcy case, asking the bankruptcy court to determine the amount of the debt under Section 505(a)(1).
The IRS moved to dismiss the Section 505 proceeding, contending there was no subject matter jurisdiction to determine the amount of the tax debt. The bankruptcy court denied the motion to dismiss and declined to abstain about 10 months into the bankruptcy case.
The IRS sought and obtained permission for an interlocutory appeal. The district court disagreed with the bankruptcy court and found no subject matter jurisdiction. Because the district court’s order was final, the debtors were entitled to appeal to the circuit.
The trustee did not sell the largest chunk of estate property until almost two years after the bankruptcy court’s ruling on jurisdiction, about the same time that the jurisdiction appeal was being argued in the Seventh Circuit. The trustee did not file the final report until about two years after the appeal was argued in the circuit court.
Section 505 Isn’t Jurisdictional
The debtors argued that Section 505 grants jurisdiction. The section provides that the court “may determine the amount or legality of any tax . . . .”
Judge Easterbrook said it was “unfortunate” that other circuits have referred to Section 505 as jurisdictional. He said, “we do not see what Section 505 has to do with jurisdiction, a word it does not use.” Provisions in the Bankruptcy Code like Section 505 “are unrelated to jurisdiction,” he said.
Instead, Judge Easterbrook said, grants of jurisdiction appear in Title 28, the Judicial Code. Quoting Section 105(c) of the Bankruptcy Code, he ruled that the jurisdiction depends on 28 U.S.C. § 1334, the statute granting general bankruptcy jurisdiction.
Jurisdiction under Section 1334
Having won round one, the IRS next argued there was no jurisdiction under Section 1334(b).
Judge Easterbrook found no “arising in” jurisdiction because a “proceeding to determine taxes and penalties does not arise in bankruptcy in this sense,” because “[m]ost tax disputes are resolved outside of bankruptcy.”
Similarly, Judge Easterbrook said there was no “arising under” jurisdiction because there was no “substantive question of bankruptcy law.” Rather, the dispute turned on the IRS Code.
Turning to “related to” jurisdiction, Judge Easterbrook found no constitutional constraints of the Stern variety because concerns about “jurisdiction for state-law disputes are not salient for federal tax disputes.” If the bankruptcy court did not fix the amount of tax owing, the dispute would be resolved by a judge in Tax Court, another Article I tribunal.
The Effect on Creditors
The government contended there was no “related to” jurisdiction given the lack of an effect on creditors or the estate.
In response, Judge Easterbrook asked whether “related-to jurisdiction really depends on how things look at the end of the bankruptcy.” On the other hand, he said, “one of the most fundamental rules of federal jurisdiction is that judicial authority depends on the state of affairs when a case begins . . . rather than on how things turn out.”
When the debtors filed their motion for the bankruptcy judge to determine their tax liability, Judge Easterbrook said there could have been an effect on creditors.
Nonetheless, the IRS contended that there was no effect on creditors at the later time when the bankruptcy court would have ruled on tax liability. In other words, Judge Easterbrook asked, is jurisdiction decided “in light of how things turn out”?
To answer the question, Judge Easterbrook cited Celotex Corp. v. Edwards, 514 U.S. 300, 308 n.6 (1996), where he said the Supreme Court “favorably quoted” a rule adopted in nine circuits to the effect that “related to” jurisdiction turns on a conceivable effect on the estate. He said that Celotex “avoids making a jurisdictional decision only after the merits have been resolved and the effect can be known with certainty.”
“Under [the Celotex] approach,” Judge Easterbrook said, the debtor’s motion to determine tax liability “is within the related-to jurisdiction.”
Judge Easterbrook observed that nine circuits addressing the question “unanimously conclude that ex ante perspective is the right one,” not “ex post perspectives.” The Seventh Circuit, he said, has not ruled on the issue.
To “align this circuit with the view widely held by our colleagues elsewhere,” Judge Easterbrook ruled that “related-to jurisdiction must be addressed at the outset of the dispute, and is satisfied when the resolution has a potential effect on other creditors.”
Judge Easterbrook therefore reversed the district court because the bankruptcy court did have subject matter jurisdiction over the tax dispute.
Abstention
Although the bankruptcy court did have subject matter jurisdiction, Judge Easterbrook said that the “exercise [of] that authority was “a distinct question.”
By the time the Seventh Circuit issued its decision, Judge Easterbrook gleaned from the bankruptcy court’s docket that the estate’s assets had been distributed, the final report had been filed, and the automatic stay had “lapsed by its own terms.” He therefore found “no reason why this residual dispute about tax penalties should stick with the bankruptcy judge, who otherwise is done with the case, rather than the specialized judges in the Tax Court.”
Judge Easterbrook vacated the district court’s finding of no jurisdiction but remanded the case with instruction for the bankruptcy court to abstain under Section 1334(c)(1).
Observations
Beyond the holding that Section 505(a) is not jurisdictional, courts elsewhere might disagree with other aspects of the opinion.
Judge Easterbrook tersely rejected the idea of “arising in” or “arising under” jurisdiction. But even though tax disputes are ordinarily decided in Tax Court under the IRS Code, is there an argument that Section 505(a) results in a contested matter that arises in the bankruptcy case or arises under the Bankruptcy Code?
At the time of oral argument in the Seventh Circuit, May 2017, the bankruptcy case was active. The trustee would not file the final report until February 2019, showing that the priority claim of the IRS would consume all assets after payment of administrative expenses.
Would abstention have been the proper result if the appeals court had issued its opinion soon after argument when it was unclear whether unsecured creditors would receive a distribution?
And how could the appeals court in substance overturn the bankruptcy judge’s ruling on abstention when Section 1334(d) provides that a decision to abstain or not to abstain “is not reviewable by appeal or otherwise by the court of appeals . . . .”?
A September 20 opinion from the Seventh Circuit reads like a suspense novel: For nine pages, Circuit Judge Frank H. Easterbrook sounded as though he was rejecting a test for “related to” jurisdiction adopted by nine other circuits.
Then, on page 10, Judge Easterbrook abruptly announced that the Seventh Circuit would adopt the position taken everywhere else. He found “related to” jurisdiction when there appears to be a conceivable effect on a bankruptcy estate at the time the proceeding commences.
Despite finding jurisdiction, Judge Easterbrook ended his opinion by directing the bankruptcy court to abstain because resolution of the tax dispute would have no effect on creditors or the estate at the time the appeal was decided. The ruling in that regard is curious because an abstention decision is not reviewable in the court of appeals under 28 U.S.C. § 1334(d).
The case was argued in May 2017; the appeals court took 28 months to issue a decision.
Although Judge Easterbrook did not say so directly, the debtors may have committed tax fraud and were forum-shopping, facts that may have influenced the outcome.