Tax and pension claims in bankruptcy.

EXECUTIVE SUMMARY

* Individuals may elect to bifurcate Federal income tax liability for the filing tax year.

* Corporations and partnership cannot elect bifurcation; however, pre-and postpetition taxes are assigned significantly different priority status and treatment in bankruptcy proceedings.

* Payments not normally considered taxes may nonotheless be deemed taxes for bankruptcy purposes.

Planning in bankruptcy may produce valuable savings for vulnerable clients. Part II of this two-part article examines specific types of tax and pension claims, bifurcation of tax liability and other helpful bankruptcy planning considerations.

Nontax creditors and debtors in bankruptcy will generally seek the lowest priority for tax claims, while governmental tax claimants will claim the highest possible priority. The priority of tax claims and their characterization as tax claims in the first place can be significant factors in the outcome of a bankruptcy proceeding. In the August 2003 issue, Part I of this two-part article provided a general summary of bankruptcy law and claims rules and how they relate to tax. Part II, below, examines how (1) the priority of specific tax and pension claims is determined, (2) a debtor may influence a claim's priority by planning the bankruptcy petition and (3) priority, bifurcation and other considerations may affect liability and settlement.

Commingled Priorities

In the year of a bankruptcy filing, taxes on a single return might include a portion of a liability incurred after the taxpayer filed for bankruptcy (a first-priority administrative item) and a portion of a liability incurred before the filing (generally, an eighth-priority item). Exhibit 1 on p. 558 summarizes the priority treatment of specific types of taxes.

Exhibit 1: Summary of tax treatments in bankruptcy

Type of tax        Pre-/postpetition          Priority/treatment

Ad valorem taxes   Prepetition if imposition  8th priority if
                   date is prepetition,       prepetition;
                   regardless of assessment   administrative if
                   or payment date            postpetition

Property taxes     Prepetition if imposition  8th priority if
                   date is prepetition,       prepetition;
                   regardless of assessment   administrative if
                   or payment date;           postpetition
                   liability for leased
                   property may be prorated
                   if called for by
                   contract (1)

Excise taxes       Prepetition if underlying  8th priority if
                   transaction date is        transaction is
                   prepetition, regardless    prepetition;
                   of payment date            administrative if
                                              postpetition

Oil production     Prepetition if production  8th priority if
taxes              is prepetition             prepetition;
                                              administrative if
                                              postpetition

Sales taxes        Prepetition to the extent  8th priority if
                   that underlying sales      prepetition;
                   are prepetition            administrative if
                                              postpetition

Employment taxes   Prepetition if wage        8th priority if
                   payment is made            prepetition;
                   prepetition                administrative if
                                              postpetition

Unemployment       Taxes on prepetition if    8th priority if
taxes              work is performed          prepetition;
                   prepetition                administrative if
                                              postpetition

Pension            Statutorily created        8th priority if
contributions      retirement plan premiums   prepetition;
                   are "taxes"                administrative if
                                              postpetition

Individual income  Liability for years ended  If bifurcated, 8th
tax                prepetition (including     priority for
                   "short" year if elected)   prepetition portion
                   is prepetition,            and administrative
                   regardless of whether      for postpetition
                   taxpayer filed return      portion; if not
                                              bifurcated, all
                                              postpetition
                                              (responsibility of
                                              individual)

Corporate income   Liability attributable to  Functionally
tax                prepetition portion of     bifurcate income tax
                   year based on interim      liability for year
                   closing of books is        into pre- and
                   prepetition                postpetition
                                              portions; prepetition
                                              is 8th and
                                              postpetition is
                                              administrative

Type of tax        Example

Ad valorem taxes   Midland Central Appraisal
                   District, 35 F3d 164
                   (5th Cir. 1994)

Property taxes     In re Columbia Gas
                   System, Inc., 146 BR 114
                   (D DE 1992); see also In
                   re Marion County
                   Treasurer, 214 BR 188
                   (SD IN 1997)

Excise taxes       In re Melino Cigar &
                   Candy Co., 22 BR
                   703 (1982)

Oil production     In re Brent Explorations,
taxes              Inc., 91 BR 104
                   (D CO 1988)

Sales taxes

Employment taxes   In re Pacific-Atlantic
                   Trading Co., 64 F3d 1292
                   (9th Cir. 1995); see also
                   Aron Bellus, 125 F3d 821
                   (9th Cir. 1997)

Unemployment       In re Northeastern Ohio
taxes              Gen. Hosp. Ass'n, 126 BR
                   513 (ND OH 1991)

Pension            In re Sunnyside Coal Co.,
contributions      146 F3d 1273
                   (10th Cir. 1998)

Individual income  In re Marshall Dixon,
tax                Jr., 218 BR 150
                   (10th Cir. BAP 1998)

Corporate income   In re O.P.M. Leasing
tax                Services, Inc. 68 BR 979
                   (SD NY 1987); In re Prime
                   Motor Inns, Inc., 144 BR
                   544 (SD FL 1992)

(1) In re Montgomery Ward Holding Corp., 242 BR 142 (D DE 1999);
see also In the Matter of Handy Andy Home Improvement Ctrs.,
Inc., 144 F3d 1125 (7th Cir. 1998).

Individuals

Bifurcation is the process under Sec. 1398(d)(2)(A) of dividing the tax year including the bankruptcy filing date into two shorter tax years. In a Chapter 7 or 11 bankruptcy, individuals are required to bifucate state and local income taxes, (8) but have the option to bifurcate Federal income taxes. Bifurcation means that prepetition taxes for the short yea ending with the petition filing will be liabilities of the bankruptcy estate, while the individual will be liable for postpetition taxes not incurred by the estate, a separate tax return has to be filed for each period. Thus, for individuals, bifurcation is official in both form (two different tax returns) and substance (two different taxpayers with two potentially different tax treatments).

Corporations

Bankruptcy laws specifically forbid corporations from formally bifurcating their tax year into two partial-year returns. (9) However, the assignment of different priorities (bankruptcy treatments) to the pre- and postpetition categories generates a different kind of bifurcation in substance. Under corporate bifucation, taxes due prepetition for the current year receive a lower, less urgent priority than do current-year taxes incurred postpetition. The corporate taxpayer is responsible for both pieces, but the pieces have different payment terms (priorities).

In the Chapter 7 case of Pacific-Atlantic Trading Co., (10) for example, the Ninth Circuit ruled, "corporate debtor's federal income tax liability for [the] fiscal year ending two months post-petition was not entirely an administrative expense." It held that the income tax liability corresponding to the first 10 months of the fiscal year (prepetition) was an eighth-priority claim and the tax attributable to the last two months of the fiscal year was a first-priority claim, even though the company filed only one return for that year. Similarly, in the Chapter 11 case of Hillsborough Holdings Corp., (11) the court ruled,"[t]o the extent that income is not earned by the estate during the case, but is instead earned by the prepetition debtor, any tax liability on that income is not entitled to an administrative expense priority"

Partnerships

Generally, partnerships cannot bifurcate their Federal tax year into two returns. Being a flowthrough entity, a partnership pays taxes at the partner (not the partnership) level; the partnership has no Federal tax liability. (12) When a partnership enters into bankruptcy, it files Federal income tax returns on the same basis as before, with each partner absorbing his or her share of the bankrupt partnership's income or loss.

When a partnership is solvent and an insolvent partner files for bankruptcy, the individual bankrupt partner may bifurcate Iris or her own tax year. Nonetheless, the income tax liability flowing through to an insolvent partner affects the partnership tax liability on the last day of its fiscal year.

For example, in Katz, (13) a Chapter 7 case, the taxpayer did not elect Sec. 1398(d)(2) bifurcation, and filed one unbifurcated tax return for the year. Despite this, he attempted to bifurcate his partnership interests before both the IRS and the Tax Court. Some of the partnership in which the taxpayer held an interest undertook an interim closing of the books to determine the taxpayer's distributive pre- and postpetition shares of partnership items. When some other partnership did not undertake such closings, the taxpayer undertook an interim closing of the books on their behalf. He then allocated a $18,569,842 prepetition loss to himself in his individual capacity, and $33,381,880 of postpetition income to the bankruptcy estate, and disclosed this treatment on Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, attached to his original Federal return. The Tax Court rejected the allocation, finding that "where a partner's bankruptcy estate retains beneficial ownership of a partnership interest as of the close of the partnership taxable year, the partner's distributive share for the entire partnership taxable year is reportable by the bankruptcy estate."

Claims for Specific Types of Taxes

Income Taxes

Taxpayers incur income tax liabilities unevenly throughout the year. Absent formal bifurcation, they have to allocate these taxes between pre- and postpetition portions of the filing year, with an interim closing of the books. The prepetition tax liability is an eighth-priority claim, while the postpetition portion of the income tax liability is a first-priority administrative claim.

In allocating the income tax liability, taxpayers have to carefully separate discrete items (e.g., capital gains and losses) from continuous items (e.g., sales, cost of goods sold (COGS) and ordinary expenses). Discrete items are not prorated and are attributed to the period in which incurred. Capital gain taxes are assigned to the period in which the underlying asset sale took place. For example, in Prime Motor bins Inc., (14) the debtor sold assets before filing a bankruptcy petition. The court found that the tax on the asset sale gain was a prepetition obligation, even though the filing aim payment date of the applicable return was postpetition.

Once a taxpayer attributes discrete items to the appropriate period, it can then allocate continuous items. It can most accurately allocate these items with an interim closing of the books, using principles similar to those in Accounting Principles Board, Opinion No. 28(15) and Financial Accounting Standards Board, Interpretation No. 18.(16) Like Sec. 1398 and recent bankruptcy court rulings, these principles recognize that a taxpayer can report on portions of a year without abandoning the concept that the portion of the year is an integral portion of the whole year. The taxpayer's sales would be calculated up through the cut-off point; the taxpayer would match COGS against these sales. Because it matches COGS with the intent of determining an interim income tax liability, it would figure such cost pursuant to the Code rules. That is, file taxpayer would usually need an adjusting entry to inventory to adapt COGS for GAAP purposes to COGS for Federal income tax purposes. If the company is under the periodic system of inventory and did not take an interim inventory count, it would estimate this figure using the gross-profit method, (17) It would also need adjusting entries for accruals, prepayment adjustments and estimates (e.g., tax depreciation). (18) The company would then apply tax rates to each short period, equitably apportioning the lower marginal rate brackets between the pre- and postpetition periods. (19)

Employment Taxes and the 100% Penalty

Employment taxes follow the character of the underlying wages. For example, if the wages are prepetition, the corresponding employment taxes are prepetition (eighth priority). Nonexempt employment taxes and unemployment taxes differ slightly: employment taxes receive eighth priority to the extent they relate to wages paid prepetition; (20) unemployment taxes receive eighth priority to the extent they relate to work performed prepetition. (21)

Secs. 6671 and 6672 impose a penalty on the failure to properly collect and pay employment taxes. The penalty would equal the total tax not correctly accounted for and paid.

Real Estate and Ad Valorem Taxes

These taxes are based on property ownership, rather than on a transaction. Although laws vary among the jurisdictions, these taxes are generally based on having ownership of underlying property at a discrete point in time and, thus, they are not prorated. (22) Specifically, courts "essentially seek out the date on which the tax is inescapably imposed on the debtor or the estate and declare that to be the date the tax is incurred." (23) The tax incurred on that date is entirely pre- or postpetition. For example, tax incurred after the taxpayer files the petition is not partly allocated to a prepetition period, even if a portion of the period in which the tax is assessed is prepetition.

Moreover, the date the tax is deemed incurred determines its priority, even if the amount is not determinable as of that date. For example, counties and other jurisdictions in Indiana assess property taxes on property owned on January 1 of each year. The actual tax rate and extrapolated tax due is assessed much later in the year. When a bankruptcy petition falls between the ownership date (January 1) and the assessment date, the resulting tax is deemed eighth priority, not first priority, reducing the likelihood that the county will be paid in full. (24)

Sales Taxes

A taxpayer has to treat oil production taxes, excise taxes and sales taxes based on when the underlying transactions occurred, regardless of whether the return reporting those transactions and the payment of those taxes is due pre or postpetition. Because these transactions happen rather continuously over time, the taxpayer has to carefully account for them, to make an accurate interim-period determination of the pre- and postpetition portions. It would assign taxes on prepetition transactions eighth-priority status, and taxes on postpetition transactions first-priority status.

Pension Claims and Other Pseudo-Taxes

In some cases, payments not normally considered taxes may be deemed taxes for bankruptcy purposes, and accorded priority status. Conversely, "fees" extracted by a government may not be accorded priority status as taxes. The Ninth Circuit established a four-prong test to determine whether funds paid to the government represent a tax or a fee: (25)

* Does the fee impose an involuntary pecuniary burden?

* Is the burden imposed by legislative act under the taxing power?

* Is the revenue raised by the payment intended for a public purpose?

* Is the payment under the police or taxing powers of the government?

Normally, pension claims are general unsecured claims. However, regardless of name, pension contributions and other expenses are "taxes" when each of the above four factors is met. (26) Statutorily required pension benefits meet these criteria. Consequently, the required contribution that arise prepetition are eighth priority; those arising postpetition are first priority. By classifying statutory prepetition pension contributions as a tax instead of as a general unsecured claim, pension plans are likely to receive a greater level of funding, benefiting plan participants. Unfunded benefit liabilities arising from Employee Retirement Income Security Act of 1974 Section 1362 that are predicated on work performed prepetition are deemed a prepetition contingent claim. (27) Premiums assessed against coal mining operators (as required by the Coal Industry Retiree Health Benefit Act) are taxes for bankruptcy purposes. (28) Thus, pension contributions receive priority status as if they were other, related, nonexempt employment or unemployment taxes.

Pensions not fitting the definition of "tax" can take first-priority, fourth-priority or general unsecured status. When underlying services have been rendered postpetition, these costs still qualify as administrative expenses. When the services have been provided within the last 180 days prepetition, the fast $4,650 of each employee's benefit plan, less that employee's wages, salaries mad commissions receiving third-priority status (29) receives fourth-priority status. Prepetition contributions above $4,650 per employee are general unsecured claims. The benefits earned must be timely paid; a retiree benefit plan cannot be modified, except by a court order or when the trustee and the beneficiaries agree to specific modifications. (30)

Planning Considerations

Creditors' Considerations

Creditors rarely have the luxury of predicting when a debtor will file for bankruptcy. Tax claimants would do well to file a hen to secure their claim in the event of a bankruptcy. Once a debtor files a bankruptcy petition, secured creditors must timely establish their security in debtor property, if any. Nontax creditors will seek the lowest priority for taxes, while governmental tax claimants will claim the highest possible priority. In a Chapter 11 reorganization, the debtor and creditor negotiate their respective payoffs, based largely on their priority status.

Debtors' Considerations

Debtors want creditors to have nonexempt, lowest-priority (general unsecured) status, to shed liabilities as conveniently mad completely as possible. Consequently, debtors argue that a claim is not a tax and, if a tax, not exempt and/or of low (or no) priority. Having tax issues settled in bankruptcy court is advantageous to creditors, because the bankruptcy- court (more so than the Tax Court or the IRS) tends to err in favor of a "fresh start" for the debtor. When a debtor voluntarily files a bankruptcy petition, the bankruptcy court will decide all related claims. By skillfully planning the timing of the bankruptcy petition, the debtor can influence the priority of tax claims.

Planning the timing of bankruptcy to maximize file benefits of bifurcation is an important value-added accounting tool. For example, if a taxpayer has identical tax circumstances (as shown in Exhibit 2 below), with the exception of the fiscal month in which it files bankruptcy (first versus eleventh month), the results of bankruptcy bifurcation differ significantly.

Exhibit 2: Effects of bifurcation on emergence from bankruptcy

                                        Case 1       Case 2

Total tax liability for the year        $72,000     $72,000
x Prepetition period liability       11/12 year   1/12 year
= Prepetition liability                 $66,000      $6,000
Postpetition liability                    6,000      66,000
Total other unsecured debts              80,000      80,000
Total other administrative expenses      10,000      10,000
Total estate assets                     $30,000     $30,000

In Case 1 of Exhibit 2, total administrative expenses of $16,000 ($10,000 + $6,000) are less than estate assets of $30,000, indicating that if the debt were restructured into an approved plan, the debtor could emerge from bankruptcy under a Chapter 11 reorganization. (31) The $66,000 prepetition tax would be an eighth-priority claim; if any of the $80,000 of unsecured debts represented taxes due and filed prepetition, in the last three years, they would be paid outside of bankruptcy. (32)

In Case 2, however, total administrative expenses of $76,000 ($10,000 + $66,000) far exceed plan assets of $30,000. Under this scenario, as there would not be sufficient assets to cover administrative expenses, the debtor would likely liquidate under Chapter 7. Of course, there may not be much flexibility in the tinting when it files a petition. On the other hand, it could achieve similar results by timing asset sales and petition filing.

Legislative Trends

Recent bankruptcy bills introduced in Congress have tended to be more protective of creditors' claims than of the debtors' fresh start. For example, S. 2996, file Bankruptcy Abuse Reform Act of 2002, proposes to limit the state and local governments' protection of homestead and other exemptions to an aggregate $125,000. Similarly, H.R. 2609, the Equal Treatment of Pension mad Bankruptcy Act of 2003, proposes to limit transfers relating to retirement benefits and prosecute debtors who violate this rule. As of this writing, both bills are in committee.

Conclusion

Careful planning for clients in bankruptcy can produce valuable cost and timing savings. In particular, both debtors and taxing authorities have an interest in the classification of tax claims, whether to protect an interest in those claims or to shed liabilities and maximize a "fresh start."

For more information about this article, contact Mr. DeGeargio at [e-mail], or Dr. Chambers at [e-mail].

(8) 11 USC Sections 728(a) and 1146(a)

(9) 11 USC Section 346(c)(1) prohibits corporations from bifurcating state and local income tax periods; Sec. 1399 states that no new taxable entity is created when a corporation files for bankruptcy.

(10) In re Pacific-Atlantic Trading Co., 64 F3d 1292 (9th Cir. 1995); see also Elizabeth Bellus, 125 F3d 821 (9th Cir. 1997).

(11) In re Hillsborough Holdings Corp., 156 BR 318 (MD FL 1995), aff'd, 116 F3d 1391 (11th Cir. 1997).

(12) Sec. 1398(b)(2) states that for the purposes of bankruptcy, a partnership is not treated as an individual but an individual debtor's interest in a partnership is treated the same as any other interest of the debtor.

(13) Aron B. Katz, 116 TC 5 (2001).

(14) In re Prime Motor Inns Inch., 144 BR. 554 (SD Fla. 1992).

(15) Accounting Principles Board, Opinion No. 28, Interim Financial Reporting (1973).

(16) Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 18, Financial Reporting for Segments of a Business Enterprises--Interim Financial Statements (November 1977).

(17) Under the gross profit method, previous-period returns are examined to arrive at an estimated gross-profit percentage of sales. Current-year sales are then multiplied by this percentage to derive this period's estimated gross profit. COGS is the difference between sales and gross profit.

(18) Because the purpose of bifurcation is to determine tax liabilities, modified accelerated cost recovery, rules (not GAAP methods) will he used to derive the current-years depreciation figures, pro-rated daily between the two short periods.

(19) See Kieso and Weygandt, Intermediate Accounting (John Wiley & Sons, 7th ed. 1992).

(20) See note 10, supra.

(21) In, re Northeastern Ohio Gen. Hosp Ass'n, 126 BR 513 (ND OH 1991).

(22) See In re Garfinckels Inc., 203 BR. 814 (D DC 1996).

(23) Id.

(24) See In re Marion County Treasurer, 214 BR 188 (SD IN 1997).

(25) See In re Lorber Indus. of California Inc., 675 F2d 1065 (9th Cir. 1982).

(26) See In re Sunnyside Coal Co., 146 F3d 127 (10th Cir. 1998).

(27) In re Bayly, Corp., 163 F3d 1205 (10th Cir. 1998).

(28) See note 26, supra.

(29) This includes wages, salaries and commissions for vacation, severance and sick pay.

(30) 11 USC Section 1114(e)(1).

(31) This treatment is new to the last decade. Previously, all taxes for the year of a bankruptcy filing would have been considered first priority. Taxes for the previous three years would have been (and still are) exempted clams. Older taxes would have been (and still are) dismissible through bankruptcy court.

(32) For example, Federal income taxes can be collected without the bar of the statute of limitations. A side agreement with the IRS for these particular taxes, in addition to the bankruptcy plan/discharge, would be required to stay all creditor action. As a practical matter, if the taxpayer were a corporation and could not reach an agreement on both the bankruptcy plan and with the IRS on exempted claims (if any), the corporation might have to liquidate.

Thomas J. DeGeorgio, MBA, CPA

Director, Income Tax Audits

Shell U.S. Tax Organization

Shell Oil Company

Houston, TX

Valrie Chambers, Ph.D., CPA

Assistant Professor of Accounting

Texas A&M University Corpus Christi

Corpus Christi, TX