The Debtors filed their dischargeability complaint against United States of America, naming the United States Department of Treasury and the Internal Revenue Service (the “IRS” or “Service”) as Defendants and seeking a determination of the dischargeability of substantial federal income tax liability and the avoidance of tax liens.
Beginning in the 1980s, Husband began using an investment strategy known as “selling short against the box.” This strategy served one primary purpose: delaying the recognition of taxable income. And unlike selling short generally—which involves an investor’s selling stock that he (or a broker on his behalf) borrows from another with the hope that the stock price will fall before the investor is required to buy identical stock to return to the person whose stock the investor sold—selling short against the box is in one way a far safer bet.
An investor who sells short against the box borrows matching shares of an appreciated stock that the investor presently owns. The investor then sells the borrowed shares and posts the owned shares as collateral, thereby creating a long and short position in the same security. (Days long ago, the investor would place the owned, collateralized shares in a safe-deposit box—hence the phrase “against the box.”) This maneuver creates a neutral position, whereby any change in one position is always offset by an opposite, but balanced, change in the other position. “You can’t lose; you can’t win,” Husband explained. And here’s the upside: selling short against the box locks in the built-in gain on the owned shares. Of course, an investor could similarly capture the same gain by merely selling the owned shares. But that would create taxable income. Selling short against the box, on the other hand, at one time allowed investors to liquidate stock without having to report the gain as income, often delaying the taxable event until the subsequent tax year—or even longer.
In his 1997 budget proposal, President Bill Clinton, who was poised to “to kill ‘selling short against the box’ and similar strategies to lock in gains while deferring or even eliminating taxes,” suggested several amendments to the Internal Revenue Code. Congress agreed with the proposed changes and subsequently enacted the Taxpayer Relief Act of 1997, adding (among other things) § 1259 to Title 26. This new provision, titled “Constructive sales treatment for appreciated financial positions,” closed the loophole that made selling short against the box so appealing. Under the provision, still in effect today, a taxpayer is treated “as having made a constructive sale of an appreciated financial position [when] the taxpayer . . . enters into a short sale of the same or substantially identical property.”12 And where “there is a constructive sale of an appreciated financial position,” taxpayers are required to “recognize gain as if such position were sold.”
On their 2001 tax return, the Debtors reported $8,601,748.00 in taxable income. This resulted in a $3,247,839.00 tax liability. Things looked bleak for the Debtors. Changing circumstances and bad bets left them deeply indebted to the federal government.
Faced with this mounting problem, the Debtors approached the IRS with a plan to settle the 1999 and 2001 tax debts for less than what they owed. This is known as an “offer-in-compromise.”21 In deciding on whether to accept any given offer—evidently, an altogether complex process—the IRS considers what it refers to as a taxpayer’s “reasonable collection potential,” which is a function of two things: (1) a taxpayer’s assets and (2) a taxpayer’s ability to pay (a calculation that is essentially a taxpayer’s monthly income reduced by reasonable expenses).22 According to a revenue officer who, for a period of time, handled the Debtors’ case, “the government is allowed to take less than full payment of the tax, penalty, and interest due if it’s in the interest of the government and the taxpayer [and] if the taxpayer is going to offer [his] equity in assets and a portion of his future ability to pay.” The Service also takes into account whether accepting a particular offer would “be unfair to the taxpaying public at large.”
Soon after the filing of their bankruptcy petition, the Debtors filed this adversary proceeding against the IRS, seeking a determination that the balance of the 2001 tax debt is dischargeable. The Service has taken the opposite position and contends that the Debtors’ remaining debt is nondischargeable under § 523 of the Bankruptcy Code. At the time their chapter 7 case commenced, the Debtors’ debt to the United States exceeded $3.8 million.