Post-Holywell: a liquidating trustee's personal liability.

The treatment of tax liabilities in a bankruptcy involves the balancing of conflicting objectives. Tax collection is essential for the orderly operation of the Government. Bankruptcy exists to provide an opportunity for the financial rehabilitation of the debtor. This cannot be accomplished unless the debtor is provided some relief from tax liabilities. These competing interests often strain the relationship between tax administration and orderly bankruptcy administration.

In many bankruptcy cases, the tax aspects are inadequately addressed or even ignored by both the bankruptcy and tax counsel. In Holywell Corp., Sup. Ct., 2/25/92, rev'g 911 F2d 1539 [11th Cir. 1990], the liquidating trustee in a Chapter 11 case did not file Federal tax returns. The liquidating plan consolidated the debtor's estate, established a liquidating trust and appointed a liquidating trustee. The plan encompassed all of the debtor's assets, including the proceeds of preconfirmation sales. There was no provision directing the liquidating trustee to either file tax returns or pay income taxes. Furthermore, the reorganization plan made no express provision for the payment of Federal income taxes. The corporate debtor filed a delinquent tax return reporting the gains on the preconfirmation sale. Neither the corporate debtor nor the liquidating trustee filed a tax return for the subsequent fiscal year. Such a return, if filed, would have reported gains on postconfirmation sales.

In the reorganization plan, the Service was listed as a creditor, and received copies of the plan and the disclosure statement. The IRS had an opportunity to object to the proposed plan, which did not provide for the payment of capital gains taxes, but did not.

Subsequent to the confirmation, the debtor sued to determine the responsibility of the trustee to file and/or pay Federal income taxes on the postconfirmation gain. The bankruptcy court, reasoning that the trustee had only limited powers, found that the trustee had the responsibility neither to file a return nor to pay the tax. Additionally, the liquidating trustee was not an assignee within the meaning of Sec. 6012{b){3) and thus was not compelled to file a return.

On appeal, the Service argued that the postconfirmation taxes were administration expenses. The Eleventh Circuit rejected this argument, holding that administration expenses did not include postconfirmation taxes because administration of the estate ceased on confirmation of a plan. The Eleventh Circuit additionally found that the provisions of Sec. 6019. applied only to Chapter 11 trustees, and that a liquidating trustee is not a trustee under Chapter 11 but is rather a contract trustee performing limited and essentially administerial functions.

The Supreme Court reversed and held that the liquidating trustee was an assignee of corporate properties and that Sec. 6012[b][13] specifically provides that an assignee who has possession of or holds title to all or substantially all of a corporation's property will file the income tax return required by the corporation and in the same manner and form as required by corporations.

Previously, a liquidating trustee under Chapter 11 had been considered to be exempt from filing returns for postconfirmation sales. Because of the Supreme Court's decision in Holywell, the balance between the Bankruptcy Code and the Internal Revenue Code has been disturbed; Chapter 11 liquidating trustees are essentially immobilized by the potential for personal liability for any taxes resulting from liquidation.

On first reading, Holywell suggests that the trustee, pursuant to Sees. 6012[b][3] and 6151, must file the returns and personally pay the taxes owed by the corporate debtor. [The subject of liability is not directly addressed in the Holywe11 decision.]Postconfirmation taxes are not administration expenses but instead are liabilities of the debtor. Holywell holds that the liquidating trustee must, pursuant to Sec. 6012[b][3], file a return reporting gains on postconfirmation sales. On this basis, the Holywell decision does not place the trustee in an adverse position any more than any corporate debtor that sold its property in a liquidation, each party would be required to file a return. 'There would be no quandary regarding Holywell, were its effect limited to the reorganized debtor. Prior to Holywell, the reorganized debtor was required to file a return, following the Holywell decision, the liquidating trustee is required to file a return on behalf of the corporate debtor or as trustee for an individual in Chapter 11.

The Holywell issue is not a bankruptcy problem. Postconfirmation matters do not remain within the province of the bankruptcy court because the debtor is no longer in bankruptcy. The primary Holywell issue is a tax: issue. Holywell established that the liquidating trustee must file a return. The unresolved question is that of personal liability for the tax. Sec. 6012[b][3] requires that the assignee "make the return of income for such corporation in the same manner and form as corporations are required to make such returns." [Emphasis added.)Every corporation subject to taxation under subtitle A must file a return [Sec. 6012[a][2)). Thus, the trustee must prepare a return for the reorganized corporation to file. The person obligated under Sec. 6651 to pay the tax is the corporation. Sec. 6012(b)(3)requires that an assignee step into the shoes of the corporation. The Court concluded in Holywell that "the trustee must pay the tax due on the income attributable to the corporate debtors' property because section 6012(b)13) requires him to make a return .... "Corporate officers filing an income tax return are not individually liable for the tax. It follows from Sec. 6012(b)(3)that the trustee assumes a role akin to that of a corporate officer who files a return on behalf of the corporation. The proper result is that the corporation is the "person" responsible to pay the tax. If there were individual liability by the trustee, the result would depend on whether or not a liquidating trustee was named. Absent a liquidating trustee, the reorganized debtor would be responsible for filing its return and paying its tax, but if a liquidating trustee was appointed, the corporate debtor would escape liability. The postconfirmation tax should remain a corporate liability in both instances.

In Holywell, the trustee argued that the trust was a grantor trust and that the individual debtor remained personally liable. The Court rejected this argument. This aspect of the decision is detrimental to the protection of Government revenues. The bankruptcy trustee has the same obligations as the liquidating trustee. Every trust with a gross income in excess of $600 must file a return. The trust is the person responsible for filing the return and thus the trust, not the trustee, must pay the tax.

In some instances the Holywell decision is unworkable. If the obligation to file a return and pay the tax falls on any "assignee" who by order of the court or by operation of law has possession of or holds title to all or substantially all of a corporation's property or business, the burden of filing a return would extend to public officials. A sheriff who takes control of the debtor's property and conducts a sheriffs sale is an assignee by order of a court of competent jurisdiction or who holds property by operation of law or otherwise. Based on Holywell, the sheriff is obligated to file a return and pay the tax.

Questions arise when attempting to determine whether the assignee holds "all or substantially all of the corporate property." In the event of multiple trustees, must a return be filed by all, or would no return be required ? Likewise, if there were sheriffs' sales involving multiple properties in various counties, must all sheriffs file a return or would no return be required? Alternatively, should the return be filed by the sheriff holding the greatest value of the properties?

Problems result from the overlap between the Internal Revenue Code and the Bankruptcy Code. As decided in Holywell, the liquidating trustee must file a return. If the secured creditors are under secured, there is nothing on which the Government's claim can attach. Thus the filing, though mandated, would be for naught. On the other hand, if the trustee desires to fulfill its filing obligation in an oversecured matter, there is no ready solution. The tax resulting from gains on asset disposal is a postbankruptcy matter. The trustee has no guidance on how to meet its obligation.

Counsel could project the tax effects of the liquidating sales and include them in the liquidation plan. Accuracy of the projection would be of major concern to the trustee. If the bankrupt% records as to basis, accumulated depreciation or net operating loss carryovers are erroneous, the proposed plan could be disrupted [if not in fact foileds, depending on the outcome of a subsequent IRS audit.

The Bankruptcy Code provisions do not provide a ready solution. Bankruptcy Code Section 505(b} allows the trustee to request a determination of a tax liability for a tax incurred during the administration of the estate. It could be argued that if the estate's returns were subjected to this procedure, there would be returns that could be relied on. Bankruptcy Code Section 505(a)[1) gives the court the authority to determine the amount of any tax. As it does not limit the tax to one that has already been assessed, the trustee could petition the court to make the prospective tax determination based on the returns previously filed. When the IRS has had an opportunity to be heard, it should be precluded from changing the return on audit.

An alternative would be to obtain an opinion on the exposure related to the return as filed. This is equivalent to a private tax audit, which as a practical matter might be unattainable (because of the liability considerations).

Can the court determine the anticipated liquidating taxes as part of a confirmed plan? Bankruptcy Code Section 1141(a)provides that confirmation of a plan binds the debtor, creditors and other parties in interest to the plan even if a party has not accepted the plan. There would be a problem with postconfirmation taxes, since this provision binds only claimants. With regard to postconfirmation matters, a claim has not been determined. Thus the Service is not bound. Therefore, if the projected postconfirmation liability determination is erroneous or grossly erroneous, the potential exists for criticism or for a claim for personal liability by the unsecured creditors.

Any trustee contemplating service in a Chapter 11 liquidating plan should consider negotiating for indemnification in the event of a successful claim for personal liability. At the very least the trustee should insist that any projections as to the effect of taxes be accompanied by an appropriate disclaimer stating that the actual result may differ for the projections and that there is no guarantee implied as to the final outcome. Another option is for the liquidating plan to provide that required distributions are to be made after the payment of taxes related to or resulting from postconfirmation gains.

Congress must clarify the question of personal liability for resulting income taxes. Because of the uncertainty in the area, liquidating under Chapter 11 will currently yield to Chapter 7 liquidation under which the liability for any resulting' tax is predictable and, more importantly, dischargeable.

From Michael M. Billion, Esq., Woods, Fuller, Shultz & Smith, P.C. (not affiliated with DFK), Sioux Fails, S.D.