Bankruptcy Court challenges Eighth Circuit on taxation of estate's assets abandoned to debtor.

Under Bankruptcy Code Section 554{a}, an estate's trustee "may abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate." In re A. J. Lane & Co., Inc., 133 B.R. 264 (Bankr. Dist. Mass. 1991), found the Bankruptcy Court deciding whether a Chapter 11 trustee's abandonment of debt-encumbered property to the debtor was a taxable event to the estate. Another Bankruptcy Court had previously addressed this issue in both In re McGowan, 95 B.R. 104 (Bankr. N.D. Iowa 1988), and In re Olson, 100 B.R. 458 (Bankr. N.D. Iowa 1989), aff'd, 121 B.R. 346 (N.D. Iowa 1990), aft'd, 930 F2d 6 (Sth Cir. 1991), and concluded that abandonment was not a taxable event to the estate. Both McGowan and Olson were Chapter 7 liquidation proceedings.

Sec. 1398(f)(1)provides that there is no disposition on the transfer of an individual debtor's assets to a bankruptcy estate, unless it is a sale or exchange. Sec. 1398(f)(2) provides that the transfer of assets back to the debtor "[i]n the case of a termination of the estate" is also not a disposition, absent a sale or exchange. The debtor's tax attributes (e.g., loss carryovers), if any, transfer to butes, in turn, return back to the debtor at the bankruptcy estate's termination under Sec. 1398(g) and (i).

In McGowan, the Bankruptcy Court interpreted "termination of the estate" broadly enough to include abandonment. It also concluded that, under bankruptcy law, there was no benefit to the estate to create a sale or exchange from the abandonment. This allowed the court to apply the "no disposition" rule of Sec. 1398(f)(2), and the trustee shifted the tax consequences of foreclosure to the debtor by abandoning the property. The Bankruptcy Court noted that this removed the tax burden from the unencumbered assets available to distribute to unsecured creditors; at the same time, there was no proof that the shift inhibited the debtor's "fresh start" under bankruptcy.

The same judge refined his approach in 01son. Even if the definition of "termination" in McGowan was too broad, the judge saw no reason to treat abandonment during administration differently from abandonment at the end of the case. Both the district court and the Eighth Circuit affirmed.

In A.J. Lane & Co., the trustee of an estate in a Chapter 11 proceeding was faced with three parcels of real estate subject to imminent foreclosures that would lead to a tax liability of $3.27 million after utilizing the available net operating losses {NOLs). As a result, the trustee served notice of his intention to abandon the properties to the debtor.

The debtor, facing a potential tax liability of $13 million from the foreclosures if the abandonment went through, objected to the trustee's plan. (The debtor's exposure was higher because all of the NOLs had been transferred to the estate as a result of the bankruptcy filing.) Ultimately, the estate was able to refinance two properties, and the trustee withdrew his request to abandon those. The third property was foreclosed.

The Bankruptcy Court determined that the properties had value and benefit to the estate, so that the burden of the potential tax liability at foreclosure was the only basis for abandonment. This Bankruptcy Court first found that, for tax purposes, foreclosure is a sale or exchange, relying on longestablished precedents. Based on Yarbo, 737 F2d 479 (5th Cir. 19841, the court also found that abandoning debt-encumbered property is the functional equivalent of a foreclosure. I Yarbo was not followed in the earlier cases because it did not involve a bankruptcy.) Because abandonment occurred while the estate still held the property, the tax consequences flowed to the estate, an approach not raised by McGowan or 01son.

The facts of A.L Lane & Co. indicated that foreclosure on the third property was both imminent and unavoidable, even if the property was abandoned to the debtor. The withdrawal of the request to abandon the refinanced properties also linked the abandonment to the foreclosure. These "compelling" factors led the Bankruptcy Court to Court Holding Co., 324 US 331 (1945). The Bankruptcy Court found that the last minute request to abandon the third property was similar to the last minute liquidation in Court Holding Co. It decided that the estate could not shift the foreclosure's tax consequences to the debtor by abandonment any more than Court Holding Co. could shift the tax consequences of the sale of its assets by liquidation.

The court then addressed Sec. 1398. Both McGowan and 01son had held that abandonment was not a sale or exchange to which Sec. 1398(f)(2) could apply. Although this court had ruled that there was a sale or exchange, it did not apply that determination to the Sec. 1398 issue. Instead, because the proposed abandonment was not at the "termination" of the estate, the court believed that Sec. 1398(f)(2) did not apply; to hold otherwise would, in the court's view, break the "symmetry" in the treatment of the debtor's assets and tax attributes. This would also permit the trustee to shift the tax liabilities to the debtor while keeping those beneficial tax attributes that could reluce that liability. The court was particularly impressed by the size of the difference in the tax consequences to the estate ($3.27 million) and the debtor ($13 million) if all three properties had been foreclosed.

To reach this conclusion, the court had to reconcile McGowan and 01son. It did not address the different goals under Chapter 7 (liquidation) and Chapter 11 (reorganization), but simply concluded that the earlier decisions had "ignored the interplay of subsections (f)(2)and (i)."

Because the court had concluded that the tax consequences would burden the estate even if the property was abandoned, it decided that the property was not burdensome. It went on to rule that the abandonment had no substance because the foreclosures were imminent, and that transferring the tax liability to the debtor violated the "fresh start" policy of the Bankruptcy Code. (Both McGowan and Olson had rejected the "fresh start" argument, but on much smaller dollar amounts.) Ultimately, it denied the trustee's request to abandon the property.

The key to the different results in these cases seems to be whether the court filtered the tax laws through bankruptcy rules and policies to reach tax decisions (McGowan and 01son), or resolved the tax issues separately and applied them to bankruptcy (A.L Lane & Co.). Since the Bankruptcy Court in the District of Massachusetts disagrees with the Bankruptcy Court in the Northern District of Iowa and the Eighth Circuit, practitioners advising debtors and trustees should consider all of these decisions carefully until the circuits resolve the conflict.

From Richard G. Price, LL.M., CPA, Amper, Politziner & Mattia, Edison, N.L