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October 1, 1970

In the Matter of Abner MICHAUD and Alyce E. Michaud, Bankrupts

Gerald J. Weber, District Judge.

The opinion of the court was delivered by: WEBER

This matter comes before the court on the Petition of the United States for Review of the Order of the Hon. William B. Washabaugh, Jr., Referee in Bankruptcy, entered October 10, 1969 granting a discharge to the Bankrupt and thereby denying priority treatment to certain claims of the United States for income taxes. Other matters raised by the Petition for Review are largely dependent upon the determination of the dischargeability issue.

 For over 20 years the Bankrupt *fn1" conducted a meat processing and distributing business and filed income tax returns showing all gross income and claiming as a business deduction 3% of gross sales as a "sales promotion expense" represented by payments to managers, chefs, purchasing agents and other customer representatives, all generally known as "kickbacks". These returns were examined annually, the deduction was not questioned by the Internal Revenue Service, and the practice was known by the I.R.S. as almost universal throughout the industry. In 1958 the I.R.S. instituted a policy of questioning these deductions and checked the returns of persons engaged in this business on a nationwide scale.

 The deductions were disallowed and then a formula was adopted for compromising the disallowed "kickback" deductions; 50% of the claimed deduction would be allowed where the payments were "substantiated" (i. e. where the recipient of the payment was identified), and 25% would be allowed where the payment was "unsubstantiated" (i. e. on sufficient proof of payment but no identification of the recipient). An obvious purpose of the I.R.S. policy was to enforce income tax reporting by recipients. As a result of the 1958 policy, Bankrupt's returns were audited and the claimed deductions were disallowed for the years 1955, 1956 and 1957. A notice of proposed deficiency (the 90 day letter) was sent, the taxpayer petitioned the Tax Court within this time, thus preventing the assessment of the deficiency within the three years prior to the bankruptcy, a condition imposed by Sec. 17a (1) (c) of the Bankruptcy Act for denial of discharge. The case was at issue and never tried before the filing of the bankruptcy petition.

 It may be noted that for the years in question the business was conducted as a partnership, with Bankrupt owning a 95% interest, and the claimed deductions were reported on the partnership income tax return. Bankrupt reported all income from the partnership on his individual tax return.

 The 1966 amendments to the Bankruptcy Act in Sec. 17a (1) [ 11 U.S.C. ยง 35a (1)] made taxes dischargeable which became legally due and owing more than 3 years preceding the bankruptcy, except those taxes * * *

"(c) which were not reported on a return made by the bankrupt(s) and which were not assessed prior to bankruptcy by reason of a prohibition on assessment pending the exhaustion of administrative or judicial remedies. * * *"

 No assessment of the deficiency was made in this case within 3 years prior to bankruptcy because administrative and judicial remedies were pending. Despite the possibility of a jeopardy assessment, we will consider the second requirement of Sec. 17a (1) (c) as met.

 Our problem is whether the taxes in question were "taxes * * * which were not reported on a return made by the bankrupt", when the gross income of the bankrupt was reported and the basis and amount of the claimed business expense deductions was fully set forth, and the resultant taxable income after taking such deductions was correctly computed, but when the Commissioner disallowed certain claimed business expense deductions and sent the taxpayers a 90 days notice of a proposed deficiency the determination of which was still pending at the time of the filing of the bankruptcy petition.

 There is an extreme scarcity of judicial interpretation of the meaning of the provision "taxes * * * not reported on a return". Only one case has dealt with the problem in a factual context similar to this case, a decision which was issued subsequent to the Memorandum and Order of the Referee in the present case: Indian Lake Estates, Inc. v. Stewart, Trustee, 428 F.2d 319 [5th Cir., 1970].

 There the Court faced the same problem as here:

"We are not presented with a situation where the taxpayer filed a fraudulent or evasive return. It appears that the reason for the assessment arose because of a difference of opinion in the resultant tax liability properly attributable to a non-fraudulent return. It is obvious that the assessment was for the difference between the amount shown by the taxpayer on its return and the amount calculated as correct by the Director."
(p. 324)

 and also

"No issue is presented as to any failure to file a return or as to filing of a false or fraudulent return or as to any attempt to evade or defeat taxes. The taxes here involved were not collected or withheld from others."
(p. 322)

 The Court of Appeals for the Fifth Circuit had a difficult time with the question. It sought guidance from the legislative history as to the meaning of the specific phraseology.

"From all we have been able to discover, the specific proviso which controls the case at bar just never received direct public congressional attention of explication."
(p. 323)

 However, the court did find that the Senate Committee on the Judiciary declared the fundamental policy of the Bankruptcy Act to be twofold: (1) the effective rehabilitation of the bankrupt, and (2) the equitable distribution of the bankrupt's assets among the creditors, citing Sen. Report 1158, 89th Congress, 2nd Sess. [1966].

 The Court then considered that,

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