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 IndividualsChapter 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 IndividualsChapter 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.
IndividualsChapters 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.
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.)