Wathen v. Commissioner
T.C. Memo. 2021-100

On August 11, 2021, the Tax Court issued a Memorandum Opinion in the case of Wathen v. Commissioner (T.C. Memo. 2021-100). The primary issues presented in Wathen v. Commissioner were whether the petitioner failed to report income, whether the petitioner is entitled to deductions on Schedule C, whether the petitioner is liable for the failure to file penalty for 2010 and 2011, and whether the petitioner is liable for the substantial understatement accuracy-related penalty.

Background to Wathen v. Commissioner

During the years in issue, the petitioner was a bankruptcy lawyer; he listed legal services as his principal business or profession on his Schedules C. During those years he lived and worked in Houston, Texas; he listed Houston as his home-address city on his Forms 1040 and as his business-address city on his bank accounts.

In 2009, the petitioner’s bankruptcy practice expanded to Austin and San Antonio, Texas, and throughout the years in issue he would travel to both cities to attend court hearings or meet with clients. The U.S. Bankruptcy Court for the Western District of Texas has locations in both cities.

The petitioner’s bank statements for the years in issue show filing fees paid to U.S. bankruptcy courts in Texas but do not indicate any client. These filing fees totaled $15,000 for 2010 and $10,000 for 2011. The bank statements also show charges for PACER and LexisNexis. PACER expenses totaled $233 for 2010 and $246 for 2011. LexisNexis expenses totaled $1,100 for 2010 and $1,500 for 2011.

Petitioner did not keep any records—such as records of travel expenses or office expenses—of how much he spent on any given bankruptcy case as counsel for the debtor. When he submitted his fees for bankruptcy court approval, he included filing fees and other charges and was reimbursed for those fees.

The Irony is Thick: A Debtor’s Attorney Turned Debtor

Wathen v. CommissionerIn August 2012, the petitioner filed for Chapter 13 bankruptcy. That month, the IRS filed a proof of claim for tax years 2010 and 2011. It later amended its proof of claim on February 27, 2013, two days after petitioner untimely filed his 2010 and 2011 Forms 1040. In June 2014 petitioner proposed a chapter 13 plan, which listed the IRS’ priority claim.

The bankruptcy court entered an order confirming the plan in August 2014. However, the order confirming the plan did not cite 11 U.S.C. § 505(a)(1) or otherwise state that it was issued pursuant to the bankruptcy court’s authority to determine taxes under that section. Nor did it include any factual recitations of petitioner’s income, deductions, and credits or otherwise state his total Federal tax liability for any year.

In December 2017 petitioner was granted a discharge of debts under 11 U.S.C. § 1328(a). The order of discharge noted that “[s]ome debts are not discharged” and listed as “[e]xamples of debts that are not discharged” debts for taxes specified in 11 U.S.C. § 523(a)(1)(B). There is no indication that the IRS agreed to waive any of its rights with respect to tax debts excepted from discharge under the Bankruptcy Code (Title 11 of the U.S. Code).

The Returns

The petitioner reported $100,000 gross receipts in 2010 and $150,000 in 2011. He listed substantial expenses, yet the petitioner did not keep a set of books and records computing his gross receipts or classifying his expenses. In his post-trial brief, the petitioner reconstructed his travel and office expenses using these bank statements.

He grouped the office expenses into categories, including telecommunications, bar dues and professional organization memberships, equipment, advertising and marketing, printing, shipping and mailing, office supplies, bankruptcy court filing fees (those noted generally as “COURTS/USBC-TX”), outside services (including PACER), and legal research and legal and professional services (including LexisNexis).

The Notice of Deficiency

In the notice of deficiency, the IRS increased the petitioner’s reported Schedule C gross receipts by $59,726 for 2010 and $15,833 for 2011.  He stated that “[i]n the absence of adequate records, your taxable income for the taxable years shown above [2010 and 2011] has been computed by reference to bank deposits and cash payments, plus personal and other nondeductible expenditures if any.”

These adjustments were based on the examining agent’s analysis of the petitioner’s bank statements, which calculated the difference between the petitioner’s bank deposits (less payroll, transfer from other bank accounts, refunds, or other nontaxable deposits) and the petitioner’s reported gross receipts. The IRS disallowed the petitioner’s claimed deductions for Schedule C travel and office expenses for both years in issue because the expenses “ha[d] not been adequately substantiated (as to amount or deductibility).”

Preclusive Effect of Prior Bankruptcy Proceeding

The petitioner argues that respondent is precluded from pursuing this deficiency case by res judicata, collateral estoppel, and judicial estoppel because his chapter 13 plan—which included the IRS’ priority claim for the years in issue—was confirmed by the bankruptcy court. He does not dispute that the taxes at issue are non-dischargeable under the Bankruptcy Code.

Res judicata prevents repetitious suits involving the same cause of action and is rooted in “considerations of economy of judicial time and public policy favoring the establishment of certainty in legal relations.” Commissioner v. Sunnen, 333 U.S. 591, 597 (1948). However, where the subsequent cause of action or demand is different, the principle of res judicata may be applied “much more narrowly,” as collateral estoppel. Id. at 597-598.

Collateral estoppel precludes litigation of issues in a second cause of action if those issues were actually litigated and necessary to the outcome of the first action. Hambrick v. Commissioner, 118 T.C. 348, 353 (2002) (citing Parklane Hosiery Co. v. Shore, 439 U.S. 322, 326 (1979)).

Judicial estoppel prevents parties in subsequent judicial proceedings from asserting positions contradictory to those they previously have persuaded a court to accept. Huddleston v. Commissioner, 100 T.C. 17, 26 (1993) (citing United States ex rel. American Bank v. C.I.T. Constr. Inc. of Tex., 944 F.2d 253, 257-259 (5th Cir. 1991)). Judicial estoppel “seeks to protect the integrity of the judicial process by preventing a party from successfully asserting one position before a court and thereafter asserting a completely contradictory position before the same or another court merely because it is now in that party’s interest to do so.” Id.

The Tax Court’s 2019 Breland Case

In Breland v. Commissioner, 152 T.C. 156, 157-60 (2019), a bankruptcy court had entered a consent order in the taxpayer’s prior chapter 11 proceeding, resolving the IRS’ objection to a plan of reorganization that settled the amount of the IRS’ priority claim and setting out procedures for resolving the IRS’ unsecured general claim for the relevant tax years. The IRS later issued a notice of deficiency for tax years covered by the consent order, and the taxpayer argued that the consent order and the principle of res judicata precluded the IRS from collecting any additional tax. Id.

In Breland, the Tax Court held that res judicata did not apply because the redetermination of a taxpayer’s total Federal tax liability for the years covered by a notice of deficiency and the resolution of the IRS’ objection in a bankruptcy plan confirmation proceeding were not the same cause of action. Id. at 161-162. The Wathen v. Commissioner court would come to the same conclusion.

Notably, the facts that gave rise to the deficiency proceeding were the taxpayer’s income, deductions, and credits, whereas those that gave rise to the consent order and plan confirmation were the viability of the proposed plan of reorganization and the disposition of the debtor’s assets. Id. at 162 (noting that causes of action are the same for purposes of res judicata if they arise out of the same nucleus of operative fact (citing Kaiser Aerospace & Elecs. Corp. v. Teledyne Indus., Inc. (In re Piper Aircraft Corp.), 244 F.3d 1289, 1297, 1299 (11th Cir. 2001))).

Failure to execute. Gets them every time.

The Tax Court also held in Breland that collateral estoppel did not apply because there was no indication that the taxpayer’s total Federal tax liability was ever actually litigated or even at issue before the bankruptcy court. Id. at 171-72. Notably, the consent order failed to cite or otherwise mention the bankruptcy court’s authority to determine taxes under 11 U.S.C. § 505(a)(1).

Further, the consent order failed to include any factual recitations of the taxpayer’s income, deductions, and credits or otherwise state his total Federal tax liability for any year before the bankruptcy court. Id. at 166-167 (stating that there was “no indication that the IRS agreed to waive any of its unique rights under the Bankruptcy Code with respect to the tax debts that were excepted from discharge”).

The present Wathen v. Commissioner case is analogous to Breland on both issues. Here, the facts underlying the deficiency proceeding—petitioner’s tax items for each year—were not raised or litigated in the plan confirmation proceeding. Rather, the plan confirmation focused on the reorganization and disposition of petitioner’s assets pursuant to 11 U.S.C. § 1325.

Further, the three indicia that a taxpayer’s total Federal tax liability was actually litigated or at issue in the bankruptcy proceeding—reference to the bankruptcy court’s authority to determine taxes under 11 U.S.C. § 505(a)(1), factual findings related to tax items, waiver of rights by the IRS— that were absent in Breland are also absent in Wathen v. Commissioner. The causes of action are not the same and the Wathen v. Commissioner petitioner’s total Federal tax liability was not at issue before the bankruptcy court, and therefore res judicata and collateral estoppel do not apply.

As for the Wathen v. Commissioner petitioner’s argument that judicial estoppel bars respondent from pursuing this case, he does not identify how the IRS’ proof of claim in his chapter 13 bankruptcy is completely contradictory to its determination of deficiencies in this case. He merely states that respondent would “gain the advantage of not being bound by its proofs of claim in bankruptcy.”

However, that is an outcome contemplated by the Bankruptcy Code, particularly when the taxpayer has failed to timely file certain returns, see 11 U.S.C. § 523(a)(1)(B), and one that the petitioner was made aware of in the order discharging his debts. Therefore, the petitioner’s prior bankruptcy proceeding does not bar the IRS’s deficiency determination.

Wathen Make It So

A Short Note on Substantiation

It’s necessary.

Because the petitioner failed to keep adequate books and records of his travel and office expenses, the only expenses that the Tax Court allowed were the court filing fees and the PACER and LexisNexis fees. Ouch.

(T.C. Memo. 2021-100) Wathen v. Commissioner

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