Tax and pension claims in bankruptcy.
* Congress enacted bankruptcy laws to give debtors relief from the burdens of excessive debt and to provide equal treatment of similarly situated creditors.
* The distinction between secured and unsecured taxes is important, because it affects the priority of claims and the debtor's responsibilities after bankruptcy.
* The timing of tax, the type of tax and whether a claim is a tax are factors in determining priority.
Priority and status of tax and pension claims in bankruptcy are important to many, including the estate, debtors, creditors, employees and taxing authorities. Part I of this two-part article provides a summary of bankruptcy law and claims rules and discusses how they relate to tax liability.
Generally, tax practitioners look to Congress to set tax laws and to the courts to interpret them. Throughout the last decade, the bankruptcy courts have been changing the standard interpretation of tax laws, making it a source worthy of frequent reference.
Part I, below, discusses bankruptcy laws in general, the treatment of tax and pension claims in bankruptcy and why the treatment of such claims is so important. It addresses both individuals and corporations. Part II, in the September 2003 issue, will examine specific types of tax and pension claims, bifurcation and other planning considerations. The articles are relevant to tax or bankruptcy practitioners, whether they represent debtors, private creditors or government tax authorities.
Purpose of Bankruptcy Law
Congress originally enacted the bankruptcy laws to give debtors relief from the burdens of excessive debt and to provide equal treatment of similarly situated creditors. Bankruptcy can be filed by debtors to obtain relief from the pressures of creditors (i.e., voluntary bankruptcy) or be forced by creditors (i.e., involuntary bankruptcy).When a bankruptcy petition is filed, an estate is formed to aggregate the debtor's assets as of the bankruptcy petition date, so that they can be distributed fairly. Creditors of similar standing receive ratable proceeds; the debtor can be discharged of all nonexempted claims, providing the debtor with a "fresh start." While the case is pending before the bankruptcy court, stays of collection and of unsecured interest are in effect. When the debtor is highly leveraged and the interest expense is burdensome, the stay of interest alone is a valuable benefit. On completion of the bankruptcy case, all claims against the estate are discharged, except those exempted by statute or court order, which remain the debtor's responsibility (if the debtor continues to exist).
Types of Bankruptcy Cases
Bankruptcy petitions are filed with the bankruptcy court (an adjunct of the district court) and governed by the Bankruptcy Code. (1) Bankruptcy filings for individuals or corporations can constitute either a petition for complete liquidation (Chapter 7) or a reorganization of assets and debts (Chapter 11). Chapter 13, which provides temporary relief from creditor action for nonbusiness entities who plan to pay liabilities from future earnings, is available only for individuals.
In a Chapter 7 filing, a trustee is appointed to liquidate the debtor's assets in a way that best satisfies creditors' claims. Because the client is not expected to emerge from bankruptcy, there is an emphasis on maintaining the corporate veil, which frees stockholders and managers from liability for corporate debts. However, corporate veils can be pierced (and managers and stockholders held responsible for debts) on isolated issues, like the trust fund portion of payroll taxes.
In contrast, Chapter 11 companies plan to emerge from bankruptcy. Chapter 11 bankruptcies are filed for the purpose of reorganizing a financial structure. Under Bankruptcy Code Section 362, a Chapter 11 filing protects debtors from collection activities until the court approves a payment plan. Often, current management continues to control the business during reorganization, and the company continues to operate and file returns. Chapter 11 normally operates in three stages:
* Stabilization of current operations;
* Submission of a reorganization plan; and
* Acceptance of the plan by a voting majority of creditors (2) (normally, within 60 days of plan filing).
When a reorganization plan acceptable to the court cannot be negotiated, a Chapter 11 filing can be used for liquidation, similar to a Chapter 7 bankruptcy.
Bankruptcy Estates vs. Federal Income Tax Laws
A bankruptcy petition creates an estate separate from an individual for both bankruptcy and tax purposes. The individual and his or her bankruptcy estate are separate taxpayers and must each file their own returns. The estate is taxable on income to which it is entitled, except for amounts received or accrued prior to the estate's commencement date. The debtor's gross income includes all items not taken into account by the estate. The estate succeeds to the debtor's net operating loss (NOL) carryovers and other tax attributes; however, on termination, such NOLs and attributes revert to the debtor.
In general, besides its own income taxes, the estate is only responsible for an individual's Federal income taxes owed in tax years ending before the debtor filed the bankruptcy petition, as such tax would constitute a liability of the debtor and a claim against the estate. Sec. 1398(d)(2)(A) offers individuals filing a Chapter 7 or 11 bankruptcy petition the option of "bifurcating" the tax year in which they file the petition. If elected, this option will result in a short tax year ending the day before the individual files the bankruptcy petition. Hence, the bankruptcy estate will be responsible for the individual's income taxes for the short year and prior years.
If an individual does not elect bifurcation, his or her year would not end until after the petition date, so the estate would have no responsibility; the individual would remain responsible for such year's income taxes.
For corporations, no separate taxable entity arises from the bankruptcy; the bankruptcy estate is not a separate taxpayer. The corporate debtor continues to report all income and retain all of its tax attributes and does not have the option of bifurcating its tax year. However, recent bankruptcy court rulings have created results similar to bifurcation, by allocating taxes for the year to pre- and postpetition periods and assigning different priorities to the pre-and postpetition tax claims. (3)
Claims in General
To have a bankruptcy plan approved, there must first be an accounting of all assets and liabilities. If the company records are in adequate order, the bankruptcy trustee or debtor-in-possession can make this filing without omitting any creditors; these creditors are then notified that the company has filed bankruptcy. However, creditors must file claims that are disputed, incorrectly scheduled or omitted. This protection is especially important when the company does not recognize a claim (as can be the case with contingent claims and current-year tax cases).
Once claims are filed, they are preliminarily sorted into secured claims and unsecured claims. Unsecured claims are then sorted by "priority." Initial claims sorting works the same way in Chapter 7 and Chapter 11 bankruptcy cases.
Generally, creditors that have secured claims (e.g., a bank or a local municipal district that has filed a lien against real property for back taxes) are paid to the extent of their collateral before any other creditor is paid. (4) If the amount of the security exceeds the amount of the liability, creditors generally receive full (and often, immediate) payment, plus statutory or contractual interest. To the extent that the secured interest is less than the amount owed, the unsecured portion of the debt is an unsecured claim, entitled to whatever priority the debt that caused the lien would otherwise qualify.
When all unsecured claims cannot be paid in full, the priority of an unsecured claim may make the difference between full payment and no payment. Bankruptcy Code Section 507 assigns priority stares to certain unsecured claims, as follows (from first to last priority):
1. Administrative expenses of the bankruptcy estate, such as attorneys' fees and postpetition taxes.
2. Involuntary gap claims, including tax claims arising in the ordinary course of business after the debtor has been placed involuntarily in bankruptcy, but before a trustee is appointed or the order for relief is entered.
3. Employee claims for wages, salaries and commissions, including vacation, severance and sick pay, earned within 90 days before the petition's filing date (or date of cessation of the business, if earlier), and the employees' share of employment taxes on those wages (up to $4,650 per employee).
4. Contributions to an employee benefit plan for services rendered within 180 days before the petition filing date (or date of cessation of the business, if earlier), up to $4,650 less the compensation paid in #3 above.
5. Claims arising from the production of grain, against a debtor who owns or operates a grain storage facility, for grain or the proceeds therefrom, up to $4,650, per each such individual.
6. Claims for deposits made by individuals in connection with the purchase, lease or rental of undelivered property, or the purchase of unprovided services for the personal, family or household use of the individuals, up to $2,100 per individual.
7. Claims for the unassigned debts to a spouse, former spouse or child of the debtor pursuant to alimony, maintenance or support of those individuals in connection with a separation agreement, divorce decree or other court order.
8. Certain taxes:
* Income or sales taxes reflected on returns due (as extended) after three years before the petition filing date, or assessed within 240 days before such date, (5) and other prepetition taxes not assessed before, and assessable after, the commencement of the case.
* Property tax assessed before the commencement of the case and last payable without penalty after one year before the petition filing date.
* A prepetition tax required to be collected for which the debtor is liable.
* An employment tax on priority-three-type compensation earned prepetition, for which a return is last due after three years before the petition filing date.
* An excise tax on a prepetition transaction for which a return, if required, is last due after three years before the petition filing date, or if a return is not required, a transaction occurring during the three years immediately preceding the petition filing date.
* Certain customs duties on prepetition imports.
* A penalty related to a priority claim and in compensation for actual pecuniary loss.
9. Commitments by the debtor to a Federal depository institution regulatory agency to maintain an insured depository institution's capital.
Postpetition taxes classified as first-priority administrative expenses must be paid as they become due, while postpetition eighth-priority taxes may be paid over periods as long as six years. General unsecured claims (including tax claims not entitled to priority status) may be paid over any period.
In a Chapter 7 liquidation, after the secured creditors are paid, unsecured creditors are paid strictly according to their Bankruptcy Code Section 507 priority class. First-priority items are paid first, followed by payment (to the extent of the remaining estate assets) to creditors of each subsequent priority class. General unsecured creditors generally split any remains of the estate, pro rata, until fully paid. However, when it is deemed that the nature of a claim for taxes or penalties would inappropriately hurt general unsecured creditors, such taxes and penalties could even be subordinated to these creditors. (6)
Because Chapter 11 petitions are filed for reorganization purposes, there is generally more flexibility in negotiating payment plans. In particular, the unsecured creditors might agree to less than full payment to facilitate plan approval, with the hope of getting paid more by the going concern than they would receive if the Chapter 11 filing were converted to a Chapter 7 liquidation.
Secured Tax Claims
Tax claims may be secured (e.g., if a lien is in place) or unsecured. This distinction is important; when specific assessed taxes remain unpaid, a taxing authority can protect its claim by filing a tax lien in the county in which the taxpayer owns property. The property then acts as a security for that tax claim, ensuring that in the event of a sale of the property, the claim would be paid before the owner would receive the sales proceeds.
A 1995 bankruptcy determination of taxes in a Chapter 11 case (7) was the largest bankruptcy case ever filed in the eastern district of Missouri. The state had not successfully filed a tax lien for past due taxes, penalties and interest on company property prior to the bankruptcy filing. As a result, its tax claims were relegated to unsecured status and not paid. Had the state successfully filed a tax lien and secured its claim, it might have made a substantial recovery.
Unsecured Priority Taxes
The highest priority of unsecured taxes is for taxes necessary to administer the estate. These taxes are considered first-priority items of the same stature as bankruptcy attorney's fees. However, most unsecured, nonexempted prepetition taxes are afforded eighth priority. The timing of the tax, the type of tax and whether a government claim is a tax generally determine the claim's priority status.
Generally, the remaining tax claims, if any, consist of:
* Old income and sales taxes;
* Recent taxes other than income and sales taxes;
* Employment and FICA taxes collected for employees;
* The employer's share of employment taxes; and
* Penalties compensating for actual monetary losses (such as prepetition interest on taxes).
These claims receive no priority and are general unsecured claims. Moreover, under Bankruptcy Code Section 523(a)(1), the unpaid portion is not discharged in bankruptcy and remains the responsibility of the (surviving) corporation or individual filing for bankruptcy, in addition to any taxes paid through the bankruptcy estate. Thus, these tax claims are "exempted claims" Because bankruptcy assets are used to pay secured claims first, followed by priority claims, then followed by unsecured claims, a creditor of such a tax claim is unlikely to fully collect on it in the bankruptcy itself. However, an individual or corporation undergoing a Chapter 11 reorganization is still legally required to pay the balance over time.
Careful bankruptcy planning can produce valuable cost and timing savings for vulnerable clients. In particular, both debtors and taxing authorities have an interest in the classification of (potential) tax claims, whether to protect their interest in those claims or to shed liabilities and maximize a fresh start. Part II, in the September 2003 issue, will examine specific types of tax claims, bifurcation and other planning considerations.
Editor's note: Mr. DeGeorgio is a member of the AICPA Tax Division's IRS Practice and Procedures Committee.
(1) 11 USC Sections 101-1330 govern bankruptcy; Section 505 of that code governs tax claims.
(2) Consent from the voting majority of creditors is required when payment is for less than the full amount due.
(3) See, e.g., In re Pacific-Atlantic Trading Co., 64 F3d 1292 (9th Cir. 1995). This issue will be discussed in Part II, in the September 2003 issue.
(4) Secured claims are occasionally subordinated to the claims of the unsecured creditors when it is in the interest of justice to do so.
(5) Longer, if an offer-in-compromise has been filed.
(6) For example, in In re Airlift International Inc., 97 BR 664 (SD FL 1989), excise taxes assessed on failure to meet minimum-funding standards on employee pension plans were subordinated to the claims of general unsecured creditors. The court reasoned that the purpose of the excise tax was to punish employers for underfunding plans, but failing to subordinate this claim would actually punish unsecured creditors to the extent the tax reduced unsecured creditors' recoveries.
(7) Missouri Dep't of Rev. v. L.J. O'Neill Shoe Co., 64 F3d 1146 (8th Cir. 1995).
Thomas J. DeGeorgio, MBA, CPA
Director, Income Tax Audits
Shell U.S. Tax Organization
Shell Oil Company
Valrie Chambers, Ph.D., CPA
Assistant Professor of Accounting
Texas A&M University-Corpus Christi
Corpus Christi, TX
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|Title Annotation:||part 1|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 2003|
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