Income Taxes In Bankruptcy

							 Income Taxes in the
  Year of Bankruptcy
        Gregory Germain
    Assistant Professor of Law
Syracuse University College of Law
       Two Bankruptcy Issues
• Priority - Distribution of assets in bankruptcy
  estate.
  – Administrative priority
  – 8th Priority
  – General Unsecured Claims
• Dischargeability – debtor’s continuing
  liability to pay taxes from post-bankruptcy
  earnings.
  – Cross-Reference: All taxes entitled to 8th priority are
    excepted from discharge. 11 U.S.C. 523(a)(1)(A).
  Priority Before 2005 BAPCPA
• Administrative. 11 U.S.C. 503(b)(1)(B)
   – “Any tax incurred by the estate, except a tax
     of a kind specified in section 507(a)(8).”
• Eighth Priority – 11 U.S.C. 507(a)(8)
  – 3 Alternative Rules
     • Lookback Rule;
     • 240 Day Rule; or
     • Post-Petition Assessability Rule
            LOOKBACK RULE
• Was return for year first due w/i 3 years of
  bankruptcy.
   – Only covered taxes for years ending prepetition.
      • Only applies to year-of-bankruptcy taxes if split-year election
        or file bankruptcy on last day of tax year.
   – Assessed or not.
   – Grants priority and prevents discharge of recent
     years’ taxes – must be older then 3 or 4 years
     (depending on when filed in relation to when 4 year-
     old taxes first due).
             240 Day Rule
• Taxes assessed within 240 days of
  bankruptcy.
  – Only relevant to taxes older than that covered
    by the lookback rule.
  – Period extended under certain circumstances
    if the debtor made an offer in compromise that
    was pending during 240 day period.
  – Not relevant to year-of-bankruptcy taxes –
    could not have been assessed prepetition.
Post-Petition Assessability Rule
• Not assessed before bankruptcy
• Assessible after bankruptcy under applicable non-
  bankruptcy law
   – General rule: 3 years from filing return.
   – Longer period for substantial overstatements
• Does not apply to “taxes of a kind specified in section
  523(a)(1)(B) or 523(a)(1)(C).
   – (B): No return filed, or filed late and w/i 2 years of bankruptcy
   – (C) Fraudulent return, willful attempt to evade or defeat taxes.
• Cases say rule only applies to pre-petition taxes.
   – Correct because refers to “claims” – which, under section 502,
     are prepetition claims.
       The Split-Year Election
• Bankruptcy Tax Act of 1980, IRC 1398, 1399
  – Only Individual debtors in Chapter 7 & 11 Cases are
    eligible.
     • If elect: file separate returns for prepetition partial year and
       post-petition partial year.
     • If don’t elect, “the taxable year of the debtor shall be
       determined without regard to the case under Title 11.”
  – Entity debtors and individuals in Ch 12 and 13 not
    eligible.
  – If don’t or can’t elect, what happens?
 Year of Bankruptcy Tax Claims
• Part Prepetition, Part Post-Petition.
• Policy Clash.
   – Bankruptcy Policy:
      • Prepetition portion: Claim against estate
      • Post-petition portion: Administrative expense
   – Tax Policy: If year ends post-petition, entire tax
     liability arises post-petition.
• Possible Results
   – Bankruptcy Policy: Allocate annual taxes by time.
   – Tax Policy: Treat entire year’s taxes as arising post-
     petition when return due.
        Non-Electing Individuals
              Chapter 7
• Courts Adopt Tax Theory:
  – Entire year’s tax claim arises at the end of the year.
    The portion attributable to pre-petition activities is a
    personal obligation of the debtor.
     • Relies entirely on committee report: “If the debtor does not
       make the [split-year] election, no part of the debtor’s tax
       liability from the year in which the bankruptcy case
       commences is collectible from the estate, but is collectible
       from the individual debtor.”
  – Strong incentive to split year: payment from estate
    reduces personal obligation.
          Non-Electing Individuals
               Chapter 11
• Johnson, 190 B.R. 724 (Bankr. Mass 1995)
   – Followed individual cases – no claim against estate. Yet, Court
     refused to confirm plan unless debtor provided for full payment of
     taxes. “Integral to feasibility and good faith.”
• Wood, 240 B.R. 609 (C.D. Cal. 1999)
   – If Chapter 7 rule applied, taxes would be dischargeable in
     Chapter 11.
       • Non-Priority under Chapter 7 rulings because post-petition
       • Debtor’s post-petition debts dischargeable if incurred pre-
         confirmation.
   – Court says taxes not dischargeable because administrative
     expenses.
       • If administrative expenses, then estate - not debtor - would be liable
         in Chapter 7 cases.
       • Also, administrative expenses not excepted from discharge – have
         to be paid in full on effective date. Confirmation difficult.
                   Individuals
                 Chapters 12 & 13
• Michaelson, 200 B.R. 862 (Bankr. Minn 1996)
   – Bound by O’Neill Shoe: Pre-P taxes covered by post-petition
     assessability rule.
   – Did not know how to determine amount of Pre-P claim since no
     separate return. Did not consider time allocation. Refused
     debtor’s motion to estimate claim. Threw up hands.
• Wilkoff, 2001 Bankr. Lexis 124 (Bankr. ED Pa 2001)
  (unpublished).
   – Claim arises post-petition, either at end of the year or when the
     return is due.
   – IRS has election under 1305(a) to pursue a “claim”
   – If no election under 1305(a), taxes are a personal obligation of
     the debtor and not effected by the Chapter 13 discharge.
                  Corporations
• Courts Adopt Bankruptcy Theory.
• Pre-petition portion of year-of-bankruptcy taxes covered by
  post-petition assessability rule.
   – OPM Leasing, 68 B.R. 979 (Bankr. SDNY 1987): Taxes
     incurred as accrue – focus on activity giving rise to tax
     liability.
   – PATCO, 64 F3d 1292 (9th Cir. 1995): (1) Pre-P taxes
     deemed “incurred” post-petition. (2) Pre-P taxes
     nevertheless covered by eighth priority rule. (3)
     Argument that all post-petition taxes would be covered
     by eighth priority rule is “absurd.”
   – O’Neill Shoe, 64 F.3d 1146 (8th Cir. 1995): Withholds
     judgment on (1). Agrees with (2). Concerned about (3)
     – All eighth priority rules only apply to Pre-P Taxes.
                        Summary
• Individual Chapter 7:
   – Arises post-petition –personal obligation of debtor
• Individual Chapter 11:
   – Arises pre-petition but must be paid in plan,
   – Arises post-petition as administrative expenses, which are
     somehow excepted from discharge
• Individual Ch 12 or 13
   – Arises Pre-P, but how to determine amount?
   – Arises Post-P. Personal obligation of debtor not discharged
     under plan
• Corporate:
   – Arises Post-P, but is covered by 507(a)(8)
   – Don’t know when claim arises, but covered by 507(a)(8) in either
     case.
       When are Taxes Incurred?
• Very Important After 2005 Act
   –   Professor Todres & Patco: end of year.
   –   OPM Leasing: Allocate like split year return.
   –   Attorney Graham Stieglitz: allocate on basis of time.
   –   Professor Jack Williams: Congress needs to fix this mess!
        • See debate, 9 Am. Bankr. Inst. L. Rev. 463 et seq.
   – I agree with Stieglitz:
        • Allocation by time is consistent bankruptcy goals everywhere but in
          the third circuit. Frenville, 744 F.2d 332 (3rd Cir. 1984) (equitable
          indemnity claim arises when ripe for suit).
        • Better result would be to require everyone to make split-year
          returns.
        • 502(i): Says that taxes deemed to arise postpetition but entitled to
          eighth priority are to be allowed or disallowed as if prepetition.
          Before 2005 act, this should have covered the pre-petition portion of
          year of bankruptcy taxes.
507(a)(8) Eighth, allowed unsecured claims of governmental units, only to the
extent that such claims are for—
(A) a tax on or measured by income or gross receipts for a taxable year ending on
or before the date of the filing of the petition—
    (i) for a taxable year ending on or before the date of the filing of the petition
    for which a return, if required, is last due, including extensions, after three
    years before the date of the filing of the petition;
    (ii) assessed within 240 days before the date of the filing of the petition, plus
    any time plus 30 days during which an offer in compromise with respect to
    such tax that was made within 240 days after such assessment was pending,
    before the date of the filing of the petition; or exclusive of—
         (I) any time during which an offer in compromise with respect to that tax
         was pending or in effect during that 240-day period, plus 30 days; and
         (II) any time during which a stay of proceedings against collections was in
         effect in a prior case under this title during that 240-day period, plus 90
         days.
    (iii) other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C)
    of this title, not assessed before, but assessable, under applicable law or by
    agreement, after, the commencement of the case;
                  2005 Act Changes
•   Eighth Priority only applies to tax years ending prepetition.
     – Only applies to split-year elections or filing bankruptcy on last day of tax
        year.
•   Individual Cases
     – Ch7: If Pre-2005 law applies, no change in law. Personal obligation of
        debtor
     – Ch 11: Maybe courts will follow flawed reasoning of Wood (admin
        expenses).
     – Ch 13: Incorporated 523(a) – can’t discharge non-dischargeable taxes.
        1328(a)(2). But since taxes no longer 8th priority, would not be covered in
        523(a). May be dischargeable if provided for in plan?
•   Corporate Cases
     – If Pre-2005 law applies, very confusing
           • Under PATCO, claim arises post-petition. Cannot be eighth priority. So
             would be administrative expense? (“Incurred by the estate”?). If so, full
             years taxes must be paid in cash on effective date.
           • Under OPM, pre-p portion of year of bankruptcy taxes should be a
             dischargeable general unsecured claim.
           • Under O’Neill Shoe, likely dischargeable general unsecured claim
             (although did not specifically rule whether claim arises pre- or post-p).
    What should Congress do?
• Require split-year returns by everyone.
• Priority: Pre-petition taxes incurred within 3 years of
  bankruptcy. Allocate earlier returns by time.
• Discharge Exceptions:
   – 3 years taxes
   – Fraud
   – Non-filed return, or late filed within 3 years.
      • Need to address the question of what is a return.
         Overrule In re Payne, 2005 U.S. App. Lexis 27243
         (7th Cir. 2005, Posner J.)