7th Circuit Explains Bankruptcy Court Jurisdiction to Address Tax Claims

7th Circuit Explains Bankruptcy Court Jurisdiction to Address Tax Claims

Prior to filing bankruptcy, the Debtors were involved in a tax dispute with the IRS. The IRS demanded the Debtors pay $107,000.00 in taxes plus $80,000.00 in fraud penalties for tax years 2009-2011. The Debtors petitioned the Tax Court for review. Shortly before the trial, the parties agreed the Debtors owed $100,000.00 but were split over calculation of the penalties.   The IRS sought a 75% fraud penalty under 26 U.S.C. §6663(a), while the Debtors argued for a 20% negligence penalty under 26 U.S.C. §6662(a).

On the day of trial before the Tax Court, the Debtors filed a chapter 7 bankruptcy. The Debtors filed an adversary proceeding against the IRS asking the Bankruptcy Court to set the penalty at 20% of their unpaid taxes. The IRS contested the Bankruptcy Court’s jurisdiction.

The Debtors argued that Section 505 of the Bankruptcy Court gives the Bankruptcy Court jurisdiction to determine tax claims. This section states

Except as provided in paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.

11 U.S.C. § 505(a)(1). The IRS argued that Section 505 does not grant subject-matter jurisdiction and that only a potential effect on distributions to creditors justify jurisdiction.

The Bankruptcy Court agreed with the Debtors, but the District Court did not. Prior to the decision on appeal, the debtors received a discharge and the trustee filed his final notice of distribution.

On appeal, the Seventh Circuit discussed whether Section 505 supplies jurisdiction, bases for jurisdiction under 28 U.S.C. § 1334 (those “arising in” bankruptcy litigation, those “arising under” the Bankruptcy Code, and those “related to” the resolution of the bankruptcy proceeding), as well as when the Bankruptcy Court should relinquish jurisdiction under 28 U.S.C. § 1334(c)(1).

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