Opinion
CV-99-1332 (DGT)
May 31, 2001.
MEMORANDUM ORDER
Although familiarity with the facts this case, a recited in detail in the underlying bankruptcy court decision, is assumed, see In re FM Transmix, 229 B.R. 583, 584-89 (E.D.N.Y. 1999), a brief, chronological recitation of the procedural history of this bankruptcy appeal is appropriate. On July 26, 1995, FM Transmix Corp. ("Debtor" or "FM") filed a voluntary petition under Chapter 11 of the Bankruptcy Code. Approximately a year later, Debtor challenged $45,000 of a $45,252.20 claim filed against it by the United States Department of Treasury, Internal Revenue Service ("IRS"), representing a penalty assessed against Debtor pursuant to 26 U.S.C. § 6715. The relevant part of § 6715 provides that:
The penalty was originally assessed under 26 U.S.C. § 6714(5). However, the 1996 revisions to the Internal Revenue Code renumbered § 6714 as § 6715.
[I]f . . . any dyed fuel is held for use or used by any person for a use other than a nontaxable use and such person knew, or had reason to know, that such fuel was so dyed, . . . then such person shall pay a penalty in addition to the tax . . .26 U.S.C. § 6715(a) (emphasis added). On February 9, 1999, after conducting a two-day evidentiary hearing, the bankruptcy court issued a written decision finding that Debtor did not "know, or have reason to know, that it had received and was using dyed fuel for an improper purpose" and expunged the penalty portion of the IRS' claim against Debtor. See In re FM Transmix, 229 B.R. at 593. In May of 1999, the IRS appealed the decision of the bankruptcy court.
After reviewing the parties' briefs, a lengthy oral argument was conducted before this court and the decision of the bankruptcy court was affirmed, specifically for the reasons stated on the record. See In re FM Transmix, No. 99-CV-1332 (E.D.N.Y. Sept. 13, 1999). Shortly thereafter, on September 27, 1999, the IRS filed a motion for rehearing, asserting that the affirmance of the bankruptcy court's decision was in error because of "the erroneous determination that the United States bore the burden of proof with respect to whether the debtor was liable for the penalty tax assessed against it." (U.S. Mot. Reh'g ¶ 3). Research of the IRS' argument revealed that the Second Circuit had never decided this burden of proof issue in the context of a bankruptcy proceeding and the decisions of the Circuit Courts of Appeal that had decided the issue were in conflict. See In re FM Transmix, No. 99-CV-1332 at 4-5 (E.D.N.Y. April 25, 2000) [hereinafter the April Order]. Moreover, the Supreme Court was in the process of hearing an appeal from a Seventh Circuit case in which Chief Judge Posner held that the burden of proof mandated by the tax code did not shift simply because the taxpayer declared bankruptcy. See In re Stoecker, 179 F.3d 546, 550-53 (7th Cir. 1999), cert. granted sub nom., Raleigh v. Illinois Dept. of Revenue, 120 S.Ct. 784 (Jan. 7, 2000) (Mem.). Accordingly, the IRS' motion for rehearing was denied with leave to renew after the Supreme Court issued a decision in Raleigh.
On May 30, 2000, the Raleigh decision was handed down, see 530 U.S. 15, 120 S.Ct. 1951 (2000), and on June 13, 2000, the IRS moved to vacate the April Order. Then, on June 28, 2000, the IRS filed a motion for an Order to Show Cause why Debtor's counsel should not be held in contempt for releasing the penalty funds it had been holding in escrow. On June 29, 2000, a telephone conference was held, during which the IRS' renewed motion for rehearing was granted, the IRS' motion to vacate was denied as moot, and the IRS' motion for an Order to Show Cause was denied, with leave to renew if the penalty is found to be owing. See In re FM Transmix, No. 99-CV-1332 (E.D.N.Y. June 30, 2000). Both parties were given ample time to submit additional briefs, but neither party chose to do so.
Meanwhile, on the same day the telephone conference before this court was held (June 29, 2000), the Debtor's underlying Chapter 11 bankruptcy was dismissed by the bankruptcy court, upon motion of the New York State Department of Taxation Finance. Notices of dismissal were mailed on July 1, 2000.
The dismissal of the underlying bankruptcy case "does not automatically strip a federal court of jurisdiction over an adversary proceeding which was related to the bankruptcy case at the time of its commencement." In re Porges, 44 F.3d 159, 162 (2d Cir. 1995). Instead, "[t]he decision whether to retain jurisdiction should be left to the sound discretion of the court . . where the [ ] proceeding is pending."Id. The four factors to consider in determining whether or not to retain jurisdiction — judicial economy, convenience to the parties, fairness and comity, see id. — weigh in favor of resolving the instant case, particularly in light of the fact that a full hearing on the appropriateness of the assessed penalty was conducted and both parties expressed a desire to have this appeal resolved, even after the underlying case was dismissed, since the appropriateness of the penalty has relevance outside the bankruptcy context.
Discussion (1)
The Supreme Court in Raleigh addressed the following question: "who bears the burden of proof on a tax claim in bankruptcy court when the substantive law creating the tax obligation puts the burden on the taxpayer." 530 U.S. at 17, 120 S.Ct. at 1953. The answer was unanimous: "bankruptcy does not alter the burden imposed by the substantive law."Id. Thus, even in bankruptcy, the taxpayer in Raleigh retained theburden imposed on it by Illinois state law to prove the penalty assessed by the State Department of Revenue was improper. See id. at 18— 19, 120 S.Ct. at 1954. In the last sentence of the opinion, the Court succinctly stated its "simple rule, that in the absence of modification expressed in the Bankruptcy Code the burden of proof on a tax claim in bankruptcy remains where the substantive tax law puts it." Id. at 26, 120 S.Ct. at 1958. This rule must now be applied to the instant case.
Outside the bankruptcy context, "'[t]he Commissioner[of Internal Revenue] "s determination of an income tax deficiency enjoys a presumption of correctness, requiring a taxpayer petitioning for review to prove it wrong.'" American Valmar Int'l Ltd. Inc. v. Commissioner, 229 F.3d 98, 101 (2d Cir. 2000) (quoting Douge v. Commissioner, 899 F.2d 164, 167 (2d Cir. 1990)); see also Tax Ct. R. 142(a)(1) (placing the burden of proof on person challenging the tax assessment). To state the general rule in terms more applicable to this case, "[i]t is well-settled that the penalty assessments of the IRS are generally presumed to be correct and that the [taxpayer] bears the burden of proof in challenging such an assessment." In re Tax Refund Litigation, 766 F. Supp. 1248, 1254 (E.D.N.Y. 1991)
As Debtor rightfully pointed out, when this general rule is applied to the specific formulation of § 6715, a taxpayer is put in the difficult position of having to prove a negative by a preponderance of the evidence — that he did not know or have reason to know that the fuel he was using was dyed. However, such a situation is not uncommon in federal tax law. See, e.g., Addington v. Commissioner, 205 F.3d 54, 58 (2d Cir. 2000) ("Once the Commissioner has imposed a negligence penalty [under 26 U.S.C. § 6653(a)(1)], the taxpayer bears the burden of showing the absence of negligence."); Winter v. United States, 196 F.3d 339, 344-45 (2d Cir. 1999) ("The person against whom the IRS assesses a [26 U.S.C.] § 6672 tax penalty has the burden of disproving, by a preponderance of the evidence, the existence of one of the[statute's] two elements.") (internal quotation and citation omitted). Accordingly, the mere fact that Debtor's burden requires proof of the absence of knowledge does not shift the burden of proof to the IRS.
Moreover, simply because it may be difficult for a debtor to meet this burden of proof does not mean it is impossible. Here, Debtor can be found to have met its burden if there is sufficient proof on the record that FM's employees did not know or have reason to know that the fuel stored in the wrong underground tank and used to fuel the trucks sometime prior to February 26, 1996 was dyed fuel. The placement of the burden of proof on the Debtor does not alter the knowledge standard required by statute in order to justify imposition of a penalty.
(2)
In the underlying bankruptcy case, and again on appeal to this court, the Debtor made two central arguments in support of its claim that the tax penalty assessed against it was improper. First, the Debtor claimed that none of its employees were aware that the tax law distinguishes between the two different types of fuel (dyed, heating fuel and clear, diesel fuel) or that there is a penalty imposed for improper use of dyed fuel. See FM Transmix, 229 B.R. at 589. Second, Debtor claimed that Montebello, its fuel supply company, filled Debtor's underground clear fuel tanks with dyed fuel by mistake and that Debtor had no way of knowing about the mistake or that its trucks were thereafter fueling up with the wrong type of fuel. See id. The bankruptcy court found that the evidence produced during the hearing supported both of the Debtor's arguments. See id. at 592-93. In light of developments in the law since that decision, however, only one of these two assertions is a proper basis for affirming the bankruptcy court's determination.
In one of only five reported federal cases examining § 6715, the Second Circuit explained that the only relevant question when examining the appropriateness of a dyed fuel tax penalty is (1) whether or not the dyed fuel was held or used for an improper purpose and (2) whether the taxpayer ""knew, or had reason to know, that such fuel was so dyed.'"Consolidated Edison Co. of New York, Inc. v. Commissioner, 221 F.3d 364, 370 (2d Cir. 2000) (quoting I.R.C. § 6715(a)(2)). "It is immaterial whether [the taxpayer's] employees understood the significance of red coloration or that a violation or other consequence would stem from [the taxpayer's] possession or use of red-dyed fuel. . . . All that matters under this statute is [the taxpayer's] awareness that the fuel was dyed."Id. Thus, Con Edison makes clear that Debtor's employees' lack of familiarity with the tax code and its penalty provisions applicable to improper use of dyed fuel is irrelevant and not a proper ground upon which to base a decision.
However, the central question still remains: did Debtor have reason to know that the fuel in its underground tank was dyed? Based on the evidence and testimony presented at the hearing, the bankruptcy court answered this question in the negative. Similarly, after conducting oral argument, reviewing both the decision of the bankruptcy court and the transcripts of the evidentiary hearing, and while cognizant of the proper allocation of the burden of proof, this court agrees with the bankruptcy court's conclusion that assessment of a penalty was inappropriate here.
There was no evidence to indicate that Debtor actually knew there was dyed fuel in its underground tank, and this prong of § 6715 was not pursued by the IRS.
One of the central arguments asserted by the IRS on appeal was that the tickets issued to Debtor by Montebello each time either type of fuel was delivered alerted Debtor to the fact that dyed fuel was being used for an improper purpose, or, at the very least, put Debtor on notice to investigate further. However, the tickets only prove that the Debtor knew dyed fuel was being delivered, a fact that is not in dispute. Instead, the essential issue to be resolved is whether the Debtor should have known that dyed fuel was being delivered to the clear fuel tank and used to fill up Debtor's trucks. Nowhere do the delivery tickets resolve that crucial question. In fact, the bankruptcy court explicitly found that Debtor's claimed lack of knowledge was actually supported by the delivery tickets and the contradictory information and misleading warning stamps they contained. See FM Transmix, 229 B.R. at 592-93.
Review of the delivery tickets revealed that some, but not all, of the clear fuel delivery tickets contained the following stamped warning: "This Product Is Being Sold For On Highway Use Only . . . Legal For Motor Vehicle Use . . . ." See 229 B.R. at 586. Likewise, some, but not all, of the dyed fuel delivery tickets contained a typed, boilerplate warning that was sometimes obscured by other stamped notices: "This Product is Heating Oil (Dyed Fuel). Non-Taxable Use Only. Penalty For Taxable Use. Does Not Apply To Sales Tax, # 4 # 6." See id. Additionally, some of the dyed fuel tickets contained both notices and one contained only the clear fuel notice. See id.
Even more persuasive than the inconsistent delivery tickets, however, is the fact that Debtor relied on Montebello, a reputable fuel delivery company which had been delivering
clear fuel to Debtor for well over a year without incident, to fill its dyed fuel requirements. See id. at 585. Debtor admitted that none of its employees ensured that Montebello filled the proper tank with the proper fuel during each delivery, see id. at 585-86; however, the evidence also revealed that instead of the drivers who regularly delivered clear fuel to FM, Montebello had employed (without notice to Debtor) a brand-new driver to make some of the dyed fuel deliveries, see id. at 585, a reasonable explanation for the fuel tank mix-up.
Additionally, both the clear and dyed fuel tanks were underground and the hoses used to fill the tanks and the hoses used to fill Debtor's trucks were not transparent, see id., making visible detection of the presence of dyed fuel by any of FM's employees virtually impossible. While Debtor's failure to carefully label its tanks or take other action to prevent mistaken fillings from occurring should some new deliveryman appear was certainly careless, this failure does not equate with "had reason to know", the level of knowledge necessary to impose a penalty under § 6715. Instead, the preponderance of the evidence here supports the bankruptcy court's holding that Debtor did not know or have reason to know that the fuel it was holding and using for an improper purpose was dyed.
Conclusion
Thus, the penalty assessed against Debtor by the IRS was improper and for the reasons stated, the decision of the bankruptcy court is affirmed.
SO ORDERED: