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 –8 th Priority –General Unsecured Claims Dischargeability – debtors continuing liability to pay taxes from post-bankruptcy earnings. –Cross-Reference: All taxes entitled to 8 th 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 dont 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 dont or cant 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 years taxes as arising post- petition when return due.

Non-Electing Individuals Chapter 7 Courts Adopt Tax Theory: –Entire years 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 debtors 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 Debtors 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 ONeill 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 debtors 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 (9 th 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. –ONeill Shoe, 64 F.3d 1146 (8 th 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) –Dont 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) – cant discharge non-dischargeable taxes. 1328(a)(2). But since taxes no longer 8 th 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 ONeill 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 (7 th Cir. 2005, Posner J.)