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Net operating loss carryforward: revenue collection vs. bankruptcy.

Net Operating Loss Carryforward:

Revenue Collection vs. Bankruptcy

With the increasing usage of the bankruptcy laws(1) over the last several years, the interest of the federal government in collecting taxes has frequently collided(2) with the bankruptcy policies of protecting similarly-situated creditors while providing a fresh start for the debtor.(3)

One of the most recent collisions of revenue collection policy vs. bankruptcy policy is documented in the Russell case decided in the Eighth Circuit.(4) The primary area of confrontation was whether the Bankruptcy trustee had the legal authority to set aside an irrevocable income tax election by the debtor-in-possession to carryforward net operating losses (rather than to carry back the net operating losses with the resulting refunds being available to compensate creditors).

This article will analyze the Russell case from its inception to the resolution by the Eighth Circuit. In addition, a proposed resolution to these types of conflicts will be proposed along with certain statutory modifications.

The Facts

The Russell case involves an individual under Chapter 11 of the Bankruptcy Code with substantial tax net operating losses (NOLs).(5) In August of 1983, Russell filed his properly-extended 1982 federal tax return. The return contained a substantial NOL. On the 1982 return, the taxpayer made an irrevocable election to forego the carryback option and instead use the NOL in future years.(6)

The taxpayer filed a voluntary bankruptcy petition in July, 1984. He managed the bankruptcy estate as a debtor-in-possession until March, 1985, when co-trustees were appointed. In October, 1984 (while functioning as a debtor-in-possession), the taxpayer filed his properly-extended 1983 federal tax return. Again, he elected to forego the carryback of another substantial NOL in favor of carrying forward the loss to future tax years.

In February, 1986, the trustees filed amended federal tax returns on behalf of the bankruptcy estate for the years 1976 through 1981. The trustees disregarded the taxpayer's elections to forego the NOL carrybacks and claimed refunds totaling $1,234,134 for the prior years based on the carryback application of the 1982 and 1983 NOL's.

Pre-Eighth Circuit Litigation

The IRS denied the refund claim by failing to approve it within the prescribed statutory period. The trustees filed a timely tax refund suit in the bankruptcy court in March, 1987.

The IRS requested a summary judgement in December, 1987, arguing that Russell's NOL elections were irrevocable under IRC Section 172(b)(3)(C). The trustees countered that they were not seeking to revoke the elections, but to avoid them as improper transfers from the bankruptcy estate under 11 U.S.C. Sections 548(7) and 549.(8)

The trustees noted that the elections made no economic sense and that Russell made the elections only so that the tax benefits would survive the bankruptcy proceedings. The trustees also opposed a summary judgement arguing that many disputed issues of fact remained to be resolved.

The IRS responded that the Bankruptcy Code Sections 548 and 549 were inapplicable because any claim for refund should be determined under the Internal Revenue Code. The IRS stressed that Russell had already made an irrevocable election under the governing Internal Revenue Code section. As a back-up procedural defense, the Service contended that since the Bankruptcy Code sections were not cited in the refund claim, the court had no jurisdiction over the claims.

In June of 1988, the bankruptcy court granted the IRS motion for summary judgement determining that the court had jurisdiction over the tax refund claim under 28 U.S.C. Section 157(b)(2)(E). The bankruptcy court dismissed the trustee's suit stating that the elections made by Russell were proper and irrevocable under the Internal Revenue Code. The bankruptcy court refused to address the trustees' arguments regarding the elections being improper transfers stating that those issues were not properly raised by the trustee. The district court affirmed the bankruptcy court's opinion.

The trustees then appealed to the Eighth Circuit raising two main arguments. First, the trustees argued that the bankruptcy improper transfer issues were appropriately raised for consideration, and that existing issues of material fact precluded summary judgment. Both the trustees and the IRS expressly consented to the Eighth Circuit deciding the case on the merits as enunciated in the written briefs and the oral arguments.

The Eighth Circuit Decision

After deciding that the appellate court did have jurisdiction and that the merits of the case were properly before the court, the Eighth Circuit found the threshold issue in the Russell case to be whether the trustee's powers under the Bankruptcy Code can be used to invalidate a debtor's irrevocable tax election under the Internal Revenue Code. This was an issue of first impression for the Eighth Circuit.

The IRS argued that Congress did not expressly authorize trustees to avoid irrevocable elections, and for the court to do so would "create administrative chaos." The trustees argued that to allow such an irrevocable election by the debtor to bind bankruptcy trustees would enable debtors to improperly draw assets from the estate.

The Eighth Circuit noted that the purpose of the irrevocability of the NOL election was to ensure that the taxpayer assumes the risk that the carryback would later prove more beneficial.(9) Since the court found that the bankruptcy trustees were merely seeking to preserve the estate (rather than attempting to avoid the consequences of a prior election which proved less beneficial), the court held that the purpose of IRC Sec. 172(b)(3)(C) was not at issue.

In the Eighth Circuit's opinion, the controlling purpose was that purpose underlying a trustee's broad avoidance power, that is the protection of the bankruptcy estate from improper transfers.(10) The court ruled that the purpose underlying a bankruptcy trustee's avoidance powers and the danger of permitting a debtor to improperly manipulate the Internal Revenue Code require that a trustee have the ability to avoid (rather than revoke) the NOL carryforward election. Once the election is avoided, the trustee is free to elect as the trustee sees fit. Accordingly, the trustees were ruled to have the ability to avoid a debtor's irrevocable election to carry forward NOL's.

With the power to avoid the irrevocable election decided, the Eighth Circuit turned to the bankruptcy issue of whether the tax elections were unauthorized pre-petition or post-petition transfers voidable under Bankruptcy Code Sec. 548 and 549.

The trustees argued that the NOL election with the 1982 return constituted a fraudulent transfer and that the election with the 1983 return constituted an unauthorized post-petition transfer. The IRS did not address the trustees' claims directly, but responded with procedural arguments.

The Eighth Circuit ruled that the above-referenced Bankruptcy Code sections involving unauthorized transfers did apply and that the requirement of each must be met to avoid the tax elections. The requirements found to be at issue involved the debtor's intent in making the elections. Specifically, under Bankruptcy Code Sec. 548(a)(1), whether the debtor intended to hinder, delay, or defraud any existing or future creditors must be determined. With regard to Bankruptcy Code Sec. 549, the issue is whether the taxpayer made the election in the ordinary course of business.(11)

The case was remanded to the district court with instructions that it be returned to the bankruptcy court for a determination as to the debtor's intent for the 1982 tax year election and for determination as to whether the 1983 tax year election was in the ordinary course of business.

Recommendations and Conclusion

Conflicts between bankruptcy officials and the IRS have resulted in significant resources being wasted in bankrupt estates as well as in the federal government sector (i.e. in the federal court system and in the IRS). Since the federal government has control over both the Bankruptcy Code and the Internal Revenue Code, it is important that Congress and the executive branch act to eliminate (or at least reduce) the conflicts in the bankruptcy/tax area with the attendant waste of resources.

When there is a direct conflict between the policies supporting the Bankruptcy Code and the maximum revenue collection under the Internal Revenue Code, courts (including the U.S. Supreme Court(12)) have consistently held that the legislative intent was that the policies underlying the bankruptcy statutes prevail over revenue collection. This is an appropriate reading of Congressional intent.

Based on the foregoing analysis, the following actions are suggested:

1. The Bankruptcy Code should be

amended to specifically include

tax elections in the definition of

voidable preferences. 2. The Internal Revenue Service

litigation policies should be changed

to prohibit bankruptcy

litigation which conflicts with the

underlying policies of the

Bankruptcy Code.

With the volume of bankruptcy cases now being filed and administered, Congress and the executive branch must act to avoid bankruptcy/tax conflicts and the attendant waste of resources in this area.

Footnotes

(1)U.S. Bankruptcy Code at 11 U.S.C. Section 101 et seq. (2)See IRS v. Energy Resources Co., Inc., 110 S. Ct. 2139 (1990); Harry P. Beiger, Jr., et. al. v. IRS, 110 S. Ct. 2258 (1990); IRS v. Nordic Village, Inc., 915 F.2d 1049 (CA-2, 1990); Kathleen A. Laughlin, Trustee v. IRS, 912 F.2d 197 (CA-8, 1990), cert. denied 111 S. Ct. 1073 (1991). (3)11 U.S.C. Sec. 726(b)(1982 ed.); H.R. Rep. No. 95-595, pp. 177-178 (1977). (4)In re Russell, 927 F.2d 413 (CA-8, 1991) (5)The term "net operating loss" denotes the excess of business deductions over gross business income with certain modifications. IRS Section 172(c). (6)A taxpayer normally may carry the NOL back to the third preceding tax year of the loss and use it as a deduction in that year. Unused NOLs are applied to and deducted in the following two years. Any unused NOL that remains after this carryback to the three years prior to the year of the loss may be carried forward and deducted from the taxpayer's income in subsequent years until it is exhausted beginning with the year after the loss was incurred. Any unused NOL after 15 such years expires. IRC Section 172(b)(1)(A). An election is provided that allows a taxpayer to relinquish the carryback period and only apply the NOL to future years. This election is made upon the filing of the tax return for the loss year and once made is irrevocable. IRC Section 172(b)(3). (7)Bankruptcy Code Section 548(a)(1) permits a trustee to avoid a debtor's transfer of property made within one year of filing for bankruptcy if the debtor intended to hinder, delay or defraud any creditor. (8)Bankruptcy Code Section 549(a) permits the trustee to avoid a transfer of estate property that occurs after the commencement of the bankruptcy case and is not authorized by a court or statute. (9)Young v. Commissioner, 783 F.2d 1201, 1206 (CA-5, 1986). (10)"Congress has given bankruptcy trustees' extraordinary abilities to avoid and recover various liens and transfers for the purpose of protecting the bankruptcy estate. In re Haugen Constr. Serv., Inc., 104 Bankr. 233, 239 (Bankr. D.N.D. 1989). These avoidance powers |are exclusively geared toward protecting the rights of creditors via protection of the bankruptcy estate,' Palmer & Palmer, P.C. v. United States Trustee (In re Hargis), 887 F.2d 77, 79 (CA-5, 1989), clarified, 895 F.2d 1025 (CA-5, 1990), and are so broad that they even enable trustees to avoid transfers considered |irrevocable' under state law. See Flanigan v. Lewis. (In re Lewis), 45 Bankr. 27, 29-30 (Bankr. W.D. Mo. 1984)." (11)"The fourth element of Sec. 549 is that the transfer not be authorized by any court or statute. Russell's election was not authorized by a court, so we turn to the Bankruptcy Code to determine if any of its provisions authorized Russell's transfer. After filing for Chapter 11 bankruptcy, Russell was appointed debtor-in-possession. A debtor-in-possession has almost all of the rights, powers and duties of a Chapter 11 trustee. 11 U.S.C. Sec. 1107(a). This includes the power to operate the debtor's business. Id. Sec. 1108. Thus, the issue for determination is whether Russell elected to carry forward the NOLs in the ordinary course of business." (12)IRS v. Energy Resources Co., Inc., 110 S. Ct. 2139 (1990).

Craig J. Langstraat, JD, CPA, is an associate professor of accountancy at Memphis State University. He received his JD degree from Arizona State University and his LLM (taxation) from the University of San Diego. A member of the Arizona and California bars, he has authored or co-authored more than 35 articles in various accounting and legal periodicals. Mark S. Aquadro, CPA, received his BBA and MS (accounting) degrees from Memphis State University. He is also a certified public accountant in the state of Tennessee.
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Author:Langstraat, Craig J.; Aquadro, Mark S.
Publication:The National Public Accountant
Date:Dec 1, 1991
Words:2132
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