United States v. Frontone , 383 F.3d 646 ( 2004 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 04-1051
UNITED STATES OF AMERICA,
Creditor-Appellant,
v.
JOHN F. FRONTONE and
KATHLEEN M. FRONTONE,
Debtors-Appellees.
____________
Appeal from the United States District Court
for the Central District of Illinois.
No. 03-3196—Jeanne E. Scott, Judge.
____________
ARGUED JUNE 7, 2004—DECIDED SEPTEMBER 9, 2004
____________
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 bank-
ruptcy 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
2 No. 04-1051
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 defi-
ciency 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 as-
sessment. 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 proceed-
ing, 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 bank-
No. 04-1051 3
ruptcy court. Johnson v. Home State Bank, 501 U.S. 78, 87-88
(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 Johnson: 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 dis-
charged 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 spe-
cified 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 pro-
cedural 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
4 No. 04-1051
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 assess-
ment 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 pre-
scribed for assessment, [to] make a supplemental asses-
sment whenever it is ascertained that any assessment is
imperfect or incomplete in any material respect.” That de-
scribes 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 in-
come 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
No. 04-1051 5
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 sig-
nificance 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 “char-
acterizations 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
(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 pro-
ceedings are part of the equity jurisdiction of the federal
courts) and the “fresh start” rationale of bankruptcy sup-
ported 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 nondis-
chargeable tax debt. Had they paid the supplemental as-
sessment—which, remember, they had been notified of
before they declared bankruptcy—they would have emerged
from Chapter 7 with no dischargeable debts, though the
6 No. 04-1051
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 deb-
tors’ 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
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, exercising a free-wheeling
“equitable” discretion—that strikes the balance between
debtors and creditors. Cohen v. de la Cruz, 523 U.S. 213, 222
(1998); Grogan v. Garner, 498 U.S. 279, 286-87 (1991); In re
Kmart Corp., 359 F.3d 866, 871 (7th Cir. 2004); In re Stoecker,
179 F.3d 546, 551 (7th Cir. 1999); In re Mayer, 51 F.3d 670,
673-74 (7th Cir. 1995); cf. Raleigh v. Illinois Dept. of Revenue,
530 U.S. 15, 24-25 (2000). “The fact that a [bankruptcy] pro-
ceeding is equitable does not give the judge a free-floating
discretion to redistribute rights in accordance with his
personal views of justice and fairness, however enlightened
those views may be.” In re Chicago, Milwaukee, St. Paul &
Pacific R.R., 791 F.2d 524, 528 (7th Cir. 1986).
So it is critical that nothing in the Bankruptcy Code pro-
vides the slightest footing for the Frontones’ position. On
the contrary, it is apparent from section 523(a)(1)(A) that the
IRS—that most importunate of creditors—has won from
No. 04-1051 7
Congress a broad exemption from the dischargeability of tax
claims. The result is that if a debtor lacks sufficient assets to
cover his tax debts, those debts will follow him out of
bankruptcy and impede his “fresh start.”
That is what Congress has decreed and how likely is it
that Congress would have wanted the courts to carve an
exception for the case in which the IRS had mistakenly
refunded a portion of the taxes due from the debtor? Such
cases are common, given the enormous volume of refunds.
Warner v. Commissioner, supra, 526 F.2d at 2. Congress knew,
moreover, and did not object, that the IRS would sometimes
attempt to recover in a bankruptcy proceeding an erroneous
refund, for it provided in section 507(c) of the Bankruptcy
Code that “a claim . . . arising from an erroneous refund or
credit of a tax has the same priority as a claim for the tax to
which such refund or credit relates.” The preferred status of
tax claims, including claims based on an erroneous refund,
is not an inference from the Internal Revenue Code; it is
express in the Bankruptcy Code.
The Frontones argue that their supplemental debt to the
IRS arose not from their 2000 income but from the IRS’s
mistake. There is no either-or; it is both-and. The ultimate
source of the debt is the Frontones’ 2000 income. It is as
truthful to say that the claim for those taxes is based on the
Frontones’ 2000 tax return as it is to say that it is based on
the IRS’s error in making a refund to them. Nor was the IRS
the only maker of mistakes in this case; the Frontones made
a serious mistake in not paying the supplemental assess-
ment before they declared bankruptcy, assuming they had
some assets beyond the $492 that they did send to the IRS in
(very) partial payment of the assessment.
What is true—though not in this case—is that a mistaken
refund can give rise to a claim that is not a tax claim and so
8 No. 04-1051
would not enjoy the priority that the Bankruptcy Code gives
such claims and would therefore be dischargeable. Thus in
United States v. Reorganized CF & I Fabricators of Utah, Inc.,
supra, the Supreme Court ruled that a “tax” on employers
who underfund pension plans is really a fine, and similarly
the IRS’s claim for the erroneous rebate issued to someone
who actually owed no taxes would be a claim for restitution
rather than a tax. Suppose the Frontones had no income and
therefore paid no income taxes, but the IRS made a mistake
and mailed them a check. The government would be
entitled to the return of the money, but not because the
Frontones owed it any taxes. The ground would be unjust
enrichment, since the Frontones would have no right to
retain money paid them by mistake. Lawyers Title Ins. Corp.
v. Dearborn Title Corp., 118 F.3d 1157, 1163-65 (7th Cir. 1997);
First Wisconsin Trust Co. v. Schroud, 916 F.2d 394, 400-01 (7th
Cir. 1990); Leasing Service Corp. v. Hobbs Equipment Co., 894
F.2d 1287, 1291-92 (11th Cir. 1990). The government would
proceed by suing for restitution under federal common law,
United States v. Wurts, 303 U.S. 414, 415-16 (1938); Old
Republic Ins. Co. v. Federal Crop Ins. Corp., 947 F.2d 269, 275
(7th Cir. 1991); United States v. Domino Sugar Corp., 349 F.3d
84, 88 (2d Cir. 2003); Bechtel v. Pension Benefit Guaranty Corp.,
781 F.2d 906 (D.C. Cir. 1985) (per curiam), rather than
proceeding by assessing a deficiency; there would be no
deficiency.
In a case such as the present, however, in which the
ultimate source of the IRS’s claim is a tax owed—the refund
or credit having resulted in the taxpayer’s underpaying his
taxes—the IRS can proceed either by the assessment route,
as it did here, which would enable it if it wanted to utilize
the summary procedures for tax collection authorized by 26
U.S.C. §§ 6320, 6330, or by a suit under 26 U.S.C. § 7405,
which, in the subsection that would be applicable to such a
case, authorizes the government to sue to recover “any
No. 04-1051 9
portion of a tax imposed by this title which has been
erroneously refunded.” § 7405(b). Either way, the govern-
ment would be prosecuting a tax claim. Only if the refund
went to someone who owed no tax would the government
be able to proceed only by suing for restitution, because in
that case the refund would not have resulted in the recipi-
ent’s paying less than his full taxes.
To vary the case slightly, suppose the taxpayer requests a
refund on the basis of a deduction and the IRS sends him
the requested refund but later discovers that the taxpayer
isn’t entitled to it. The mistaken refund would still be a
rebate because it would have been “made on the ground
that the tax imposed by [the Tax Code] was less than the
excess of the amount specified in subsection (a)(1) over the
rebates previously made,” § 6211(b)(2), after the error was
noticed. And so in United States v. C & R Investments, Inc.,
supra, 404 F.2d at 315-16, an erroneous-refund case in which
the error was based on the taxpayer’s claiming a credit to
which he was not entitled, the court held that the IRS was
entitled to recover the refund either by a suit under section
7405 or by the assessment route.
The case on which the Frontones principally rely, O’Bryant
v. United States, 49 F.3d 340 (7th Cir. 1995), was similar to C
& R Investments insofar as the IRS had credited the tax
payment of the taxpayers twice and as a result had errone-
ously refunded them the entire payment. But there was a
critical though subtle difference, which led us to conclude
that the assessment route was closed to the IRS. “[T]he
money the O’Bryants have now is not the money that the
IRS’ original assessment contemplated, since that amount
was already paid. Rather, it is a payment the IRS acciden-
tally sent them. They owe it to the government because they
have been unjustly enriched by it, not because they have not
paid their taxes.” 49 F.3d at 346. In C & R Investments, the
10 No. 04-1051
taxpayer had received a refund on the ground that by virtue
of its claimed tax credit it owed less tax than would other-
wise have been due. In O’Bryant, the refund was based not
on any calculation of tax due, but rather on an accounting
error, the double posting of the credit. See Michael I.
Saltzman, IRS Practice & Procedure ¶ 10.03[1][c], pp. 19-20
(2004). Remember that a deficiency is the difference between
the amount of tax due and (1) the amount of tax due that is
reported on the taxpayer’s return plus (2) the amount of any
rebates awarded because the IRS has determined that the
taxpayer owed less than his return showed him as owing. A
deficiency can thus arise as a result of a determination that
the rebate in (2) was in error. But in O’Bryant there was no
recalculation of the taxpayer’s liability. The IRS’s accounting
error was akin to writing a refund check to the wrong
person, 49 F.3d at 345-46, an example we gave earlier of a
refund that is not a rebate.
A different conclusion would, by extending the availa-
bility of supplemental-assessment procedures to cases in-
volving posting errors, create tension with 26 U.S.C. § 6204.
That section, as we know, authorizes “a supplemental
assessment whenever it is ascertained that any assessment
is imperfect or incomplete in any material respect”; and a
posting error does not involve an imperfect or incomplete
assessment. We acknowledge the tension between O’Bryant’s
conception of when assessment is available and the broader
conception suggested by Bilzerian v. United States, 86 F.3d
1067, 1069 (11th Cir. 1986), and Clark v. United States, 63 F.3d
83, 88 and n. 7 (1st Cir. 1995), but this case is unlike
O’Bryant; it is on the C & R Investments side of the ledger.
The Frontones point finally to a change Congress made in
1984 in section 507(c) of the Bankruptcy Code, the section
that gives a claim arising from an erroneous refund “the
same priority” as a claim for the tax to which such refund
relates. Before 1984, the section provided that a claim arising
No. 04-1051 11
from an erroneous refund “shall be treated the same” as a
claim for the underlying tax, and the Frontones argue that
the effect of the change is that a claim arising from an
erroneous refund affects only priority and not discharge. (A
similar argument was accepted in In re Jackson, 253 B.R. 570
(M.D. Ala. 2000), though in the context of a nonrebate
refund.) The legislative history, however, describes the
change as “stylistic and clarifying,” S. Rep. No. 65, 98th
Cong., 1st Sess. 79 (1983), and the description is apt. Section
507 is about priorities, and the point of section 507(c) is that
the priority of a claim based on a refund is the same as that
of the underlying tax. Thus when Congress in the earlier
version of the section said that the claim based on the
refund “shall be treated the same” as a claim for the un-
derlying tax, it meant “shall be treated the same for the
purpose of determining priority.” Our case has nothing to
do with priority. Section 507 is about the order in which
claims are paid when, as is usually the case, the bankrupt’s
liabilities exceed his assets. Section 523(a)(1)(A) incorporates
the list of tax claims from section 507 and pronounces them
nondischargeable, but the conferral by the latter section of
priority upon those claims is irrelevant to this appeal, which
is about whether the IRS has a claim in the Frontones’
Chapter 13 bankruptcy or whether the claim has already
been discharged in their Chapter 7 bankruptcy. We have
just held that IRS does have a claim in the Chapter 13
bankruptcy, and so section 507 will determine its priority
vis-à-vis the other claims in that bankruptcy; but, to repeat,
that has no bearing on this appeal.
In sum, we cannot find any legal basis for the Frontones’
contention that the IRS’s tax claim founded on the mistaken
refund is dischargeable and was therefore discharged in the
Chapter 7 proceeding. The judgment affirming the dismissal
of the claim is therefore reversed and the case is remanded
12 No. 04-1051
to the bankruptcy court with directions to reinstate the
claim in the current, Chapter 13 proceeding.
REVERSED AND REMANDED, WITH DIRECTIONS.
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—9-9-04