ALI-ABA
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
Summary of Tax Provisions
Carl M. Jenks
Jones Day
New York and Cleveland
I. Introduction
In every bankruptcy case in which the debtor is liable for pre-petition taxes, there is an inherent tension among giving the debtor a “fresh start”, affording private creditors an appropriate recovery, and allowing the fisc to collect what it is owed. Congress itself expressly acknowledged this tension more than 25 years ago in connection with the enactment of the Bankruptcy Act of 1978:
In a broad sense, the goals of rehabilitating debtors and giving equal treatment to private voluntary creditors must be balanced with the interests of governmental tax authorities who, if unpaid taxes exist, are also creditors in the proceeding. . . .
A three-way tension thus exists among (1) general creditors, who should not have the funds available for payment of debts exhausted by an excessive accumulation of taxes for past years; (2) the debtor, whose “fresh start” should likewise not be burdened with such an accumulation; and (3) the tax collector, who should not lose taxes which he has not had reasonable time to collect or which the law has restrained him from collecting.[1]
Many of the tax-related provisions contained in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA” or “the Act”) and summarized herein resulted from the participation of the Department of Justice, the Internal Revenue Service (“IRS”), and the National Association of Attorneys General in the work of the National Bankruptcy Review Commission in the mid-Nineties.[2] Not surprisingly, these governmental representatives were largely focused on eliminating the frustrations that their agencies faced when the bankruptcy system made it difficult for them to collect taxes to which they asserted they were entitled.[3] As a result, the basic effect of the tax provisions in the Act is to adjust the “three-way tension” between debtors, general creditors, and taxing authorities in favor of the government.
II. Ad Valorem Taxes and Liens
Subordination of Ad Valorem Taxes. The general rule in Chapter 7 liquidations is that, when property is sold, the claims of secured creditors must be satisfied before any payment is made to priority or general unsecured creditors.[4] Under present law, however, there is an important exception to this general rule: secured tax claims are subordinated to the payment of administrative and certain other priority claims set forth in Section 507 of the Bankruptcy Code, thereby allowing the trustee to “step into the shoes” of the holder of the tax lien claim.[5] Under the Act, this subordination will not apply to liens securing claims for ad valorem real and personal property taxes, but these taxes would still be paid after certain wage and employee benefit plan claims. New rules governing payment priorities, expense recoveries, and the trustee’s duty to exhaust the estate’s unencumbered assets are mandated in cases where the downgrading rule continues to apply. BAPCPA §701(a).
Commentary. The most common type of tax lien subject to subordination under present law is the state or local lien for real property taxes.[6] The policy behind subordination is the belief that the taxing authorities should not recover until administrative and other priority claims have been paid.[7] The changes made by the Act to Section 724 reverse that result, and will in some cases have a dramatic and negative impact on the recoveries obtained by holders of administrative and other priority claims (other than those wage and employee benefit plan claims that will retain their superiority to tax liens under the new law). State and local taxing jurisdictions, which have long argued (uniformly in vain) that Section 724(b) was an unconstitutional violation of their Tenth Amendment rights,[8] have finally prevailed by statutory amendment.
Jurisdiction to Determine Ad Valorem Taxes. Under present law, the bankruptcy court has broad jurisdiction to determine the amount of any tax, provided that the tax had not actually been determined by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case.[9] Under the Act, that jurisdiction will not extend to ad valorem real or personal property taxes if the period of limitations for contesting the tax has expired under applicable non-bankruptcy law. BAPCPA §701(b).
Commentary. Section 505(a) of the Bankruptcy Code confers extremely broad authority on the bankruptcy court to determine any unpaid tax liability of the debtor that has not been contested before or adjudicated by a judicial or administrative tribunal before the debtor filed for bankruptcy.[10] In particular, there is nothing in Section 505(a) that expressly prohibits debtors from contesting in bankruptcy court tax liabilities (especially real property or ad valorem tax claims) that arose many years ago and with respect to which the debtor never filed timely objection.[11] The state and local taxing jurisdictions have occasionally argued that there is an unwritten, equitable time limitation on debtor actions to contest stale property tax claims under Section 505(a), but the bankruptcy courts have generally been unreceptive to these arguments.[12] The effect of BAPCPA §701(b) is to reverse this result, but only with respect to ad valorem taxes. Under the Act, if the liability became fixed and the debtor's time to contest it outside of bankruptcy court had expired by the time of the filing, the debtor may not contest the liability in bankruptcy.
Creation of Property Tax Liens. Under present law, the automatic stay does not prevent the creation of property tax liens for taxes becoming due after the filing of the petition.[13] The Act will extend this principle to a “special tax or special assessment.” BAPCPA §1225.
Avoidance of Statutory Liens Prohibited. Under present law, the trustee is given lien avoidance rights of a hypothetical bona fide purchaser, whether or not such a purchaser exists.[14] The Act will make this provision inapplicable to federal tax liens arising under Section 6321 of the Internal Revenue Code (“I.R.C.”). BAPCPA §711. This provision arguably does no more than codify existing law.[15]
III. Priority and Subordination of Taxes
Priority Status of Straddle-Year Tax Claims. Several U.S. Court of Appeals panels have held that the income tax liability of a corporate debtor for the year of bankruptcy filing (the “Straddle Year”) must be bifurcated into a pre-petition component and an administrative expense component, notwithstanding that the filing of a petition does not terminate the corporate debtor's taxable year.[16] The Act amends Section 507(a)(8) governing the priority of taxes to provide that income and gross receipts taxes for Straddle Years are post-petition administrative expense claims that must be paid in full in the ordinary course, rather than pre-petition priority claims that are not payable until emergence (and may at that point be subject to the deferred payment rules of Section 1129(a)(9)(C)). BAPCPA §705.
Commentary. Under prior law, it was not clear whether income and gross receipts taxes for Straddle Years should be treated partly as pre-petition priority claims or entirely as post-petition administrative claims.[17] The IRS position, and that of some states, was that the entire period was post-petition because the debtor's liability for the tax did not arise until the last day of the tax year. Debtors generally argued that taxes associated with the Straddle Year should be bifurcated into pre- and post-petition portions, with only the post-petition portion having administrative status, and most courts agreed.[18] After studying the issue, the National Bankruptcy Review Commission recommended that Congress amend Section 507 so that Straddle Year taxes would be treated entirely as administrative period expenses but corporate debtors would have an election to close the Straddle Year as of the date of the filing, thereby effectively bifurcating the Straddle Year. The IRS and the Department of Justice argued that the bifurcation cases should be overruled, primarily because of fears that significant tax revenue might be lost if taxing authorities had to comply with the earlier bar dates associated with pre-petition claims.[19] The amendment to Section 507(a)(8) contained in the BAPCPA is clearly intended to follow the government's position on this issue and to overrule the bifurcation cases, although the technical draftsmanship of the amendment may have left something to be desired.[20] The change should, on balance, be neutral or even helpful to most large corporate debtors, at least if one takes administrative convenience and expense into account. The principal advantage of bifurcation was to increase the taxes eligible for deferred payment, since most bankruptcy plans call for payment in full of priority as well as administrative tax claims. As noted below, under the bill the deferral period has been shortened and the cost of deferral potentially increased. Treating the entire straddle year as a post-petition tax period is also much simpler administratively. Debtors do not need to allocate their income and deductions between the pre- and post-petition tax portion of the filing year, or defend the decision to bifurcate when challenged on audit.
Priority Status of Stale Tax Claims. Underpresent law, a claim for income taxes of a debtor receives priority status if the return in respect of such tax is due, including extensions, after three years before the date of the filing of the petition.[21] Courts have generally, but not uniformly, held that the three-year period is tolled during the period when a stay against collection is in effect during a prior bankruptcy case of the debtor.[22] Under the Act, the three-year period is tolled during the stay period of the prior case plus 90 days. In addition, under present law, a claim for income taxes of a debtor receives priority status if it was assessed within 240 days before the filing of the petition.[23] That 240-day period is also tolled during the period an offer in compromise was pending plus 30 days, if made within 240 days after the assessment.[24] Under the Act, the tolling will apply to the period when an offer in compromise is actually in effect plus 30 days, and during the time a prior bankruptcy case is in effect plus 90 days.[25] Finally, under present law, the 240-day assessment safe harbor is not tolled during other periods during which a taxing authority is precluded from taking action. Under the Act, tolling will apply during any period when a taxing authority is prohibited from collecting a tax as a result of a request by a debtor for a hearing and an appeal of any collection action taken or proposed against the debtor. BAPCPA §705.
Commentary. It is unusualfor the existing time requirements set forth in Section 507(a)(8)(A)(ii) to cause a pre-petition tax claim against a corporate debtor to lose its priority status, because old tax claims that fail to meet the time requirements set forth in (A)(ii) generally continue to qualify for priority status under the entirely parallel route set forth in (A)(iii), which requires that the tax not be assessed prior to the petition but that it be assessable after that date.[26] As a result, these changes to Section 507(a)(8)(A)(ii) should be of importance to corporate debtors only in very limited circumstances.
Priority Status of Property Taxes. Under present law, priority status applies to property taxes “assessed” before the commencement of the case and last payable without penalty after one year before the date of the filing of the petition.[27] Confusion arises because the term “assess” has a different meaning under state and local ad valorem real property tax laws than under other tax laws.[28] The Act will substitute the word “incurred” for the word “assessed” in the case of such taxes. BAPCPA §706.
Tardily Filed Priority Tax Claims. Under present law, priority claims are entitled to distribution in Chapter 7 even if tardily filed, provided they are filed before the trustee commences distribution.[29] Under the Act, if the trustee mails to creditors a summary of his final report prior to commencing distribution, a late-filed priority claim must be filed within ten days after the mailing of that summary. BAPCPA §713.
IV. Determination and Payment of Taxes
Request for Determination of Taxes. Under Section 505(b) of the Bankruptcy Code, a trustee or debtor in possession may seek a prompt determination of the debtor's liability for administrative expense taxes.[30] In order to invoke this procedure, the debtor submits a tax return and a request for determination of tax to the governmental unit charged with responsibility for collecting the tax in question. If the governmental unit does not notify the debtor within 60 days that the return has been selected for examination, or complete such an examination within 180 days of the request, the debtor is generally discharged from liability for that tax.[31] It has not always been clear to debtors seeking to invoke Section 505(b) what procedures should be followed in notifying the taxing authority.[32] Under the Act, taxing authorities may register with the clerk of the bankruptcy court an address for service of requests and describe where further information concerning additional requirements may be found. If a taxing authority fails to do so, the trustee may serve the request at the address for filing a tax return or protest with the applicable taxing authority. BAPCPA §703.
Rate of Interest on Tax Claims. Present law is silent on the applicable rate of interest on tax claims when such interest is allowed. Under Section 1129(a)(9)(C), if a Chapter 11 debtor avails itself of the privilege of deferring payment of tax claims, the payments must have a present value equal to the allowed amount of the claim. New Section 511 provides that the interest rate paid on pre-petition and administrative period tax claims (as well as the interest rate applied to deferred payments made under Section 1129(a)(9)(C)) shall be the applicable rate under non-bankruptcy law. (In the case of a confirmed plan, the interest rate in effect as of confirmation may be used, rather than the variable rate called for by some state tax laws.) BAPCPA §704.
Commentary. This provision will generally increase the rate of interest that debtors pay on oversecured pre-petition tax claims or deferred tax payments made after emergence. Although the prior case law on point was divided, many courts had held that the rate determined under non-bankruptcy law (typically the state rate of interest on secured property taxes) was generally not controlling, and that the court should instead look to some combination of market rates, the generally lower federal statutory or judgment rates, or rates determined by the bankruptcy court exercising its discretion.[33] Note also that the enactment of new Section 511 would appear to circumscribe the impact of the U.S. Supreme Court's decision in Till v. SCS Credit Corp.,[34] where at least the Court plurality suggested in dictum that the so-called prime-plus method (pursuant to which the national prime rate is treated as the starting spot and is augmented as necessary to account for the nonpayment risk posed by the debtor's particular financial position) should be applied to deferred payments under Section 1129(a)(9)(C).
No Discharge of Fraudulent Taxes in Chapter 13. Under present law, individuals who file under Chapter 7 face a different set of rules with respect to the discharge of taxes than individuals who file under Chapter 13. First, in order for income taxes to be discharged in a Chapter 7 case, the individual must have filed returns with respect to the taxes whose discharge is being sought and must have done so in timely fashion to the extent that the taxes in question arose in the last two years prior to bankruptcy.[35] By contrast, in a Chapter 13 case taxes can be discharged without any return being filed at all.[36] Second, a taxpayer who files a fraudulent return or willfully attempts to evade or defeat a tax cannot discharge that tax in a Chapter 7 case,[37] but the same is not the case in Chapter 13.[38] Under the Act, the Chapter 13 rules will be largely conformed to those in Chapter 7, with the consequence that this “superdischarge” result will no longer be applicable to taxes owed by Chapter 13 debtors who fail to file, file late, or file fraudulently. BAPCPA §707.
No Discharge of Fraudulent Taxes in Chapter 11. Under present law, confirmation of a plan of reorganization discharges a corporate debtor from all debts, except when the plan is a liquidating plan.[39] Under the Act, a corporation will not be discharged from a tax or a customs duty with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat the tax or duty. BAPCPA §708.
Stay of Tax Court Proceedings. Under present law, the filing of a petition operates as a stay against the commencement or continuation of a proceeding before the United States Tax Court concerning the debtor.[40] Literally read, this stay would apply even to a post-petition year over which the bankruptcy court has no jurisdiction.[41] Under the Act, the stay will apply to a corporate debtor's tax liability for any period that is subject to the bankruptcy court’s jurisdiction and to an individual debtor's pre-petition tax liability. BAPCPA §709.