DEFERRED PAYMENTS OF PRIORITY TAXES UNDER SECTION 1129(a)(9)(C) OF THE BANKRUPTCY CODE

(COMMISSION TRACK NUMBER 214)

Present Law

Section 1129(a)(9)(C) of the Bankruptcy Code provides that, unless the holder of a priority tax claim otherwise agrees, such a tax authority must receive deferred cash payments, over a period not exceeding six years from the date of assessment, of a value, as of the effective date of the plan, equal to the allowed amount of the claim.

No specific interest rate is prescribed by the statute with respect deferred payments. Similarly, the statute does not require that payments be made in a specific amount (i.e. level payments) or on a specific schedule (e.g., quarterly or annually).

Proposals Before the Commission

Commission Track Number 214. Commissioner Shepard has proposed that the statute be amended to provide for a specific interest rate. Because the federal and state tax laws often impose different interest rates on delinquent taxpayers, Commissioner Shepard suggested adoption of either the federal tax deficiency rate for all priority taxes or would simply adopt the non-bankruptcy Federal Judgment Collection rate. See Santa Fe Discussion Issues, p. 14, Item II D6. See also Justice Proposal, p. 93, IRS Proposal p. 12.

Commissioner Shepard also suggests amending the statute to require level monthly payments over the six year period. See Santa Fe Discussion Issues, p. 15, Item IID11. See also Justice Proposal, p. 93, IRS Proposal p. 12.

The Commission is not considering any changes other than as herein proposed in determining the date from which the six year deferral period should be measured.

Task Force Position

(a) Interest Rate

The Task Force recommends that the statute be amended to provide that the interest rate used to value deferred payments of priority taxes shall be equal to the applicable rate for underpayments as determined under section 6621(a)(2) of the Internal Revenue Code on the date of confirmation of the plan.

There has been a significant amount of litigation between debtors and tax authorities in determining the appropriate interest rate which should be charged on deferred payments under section 1129, and the courts have not been consistent in determining such rates. Although both federal and state tax laws set specific interest rates (or formulae for calculating such rates) applicable to taxpayers not in bankruptcy with unpaid tax liability, bankruptcy courts generally have interpreted section 1129 to require the court to engage in a present value calculation, based on the credit markets and an analysis of the credit risk of the debtor (fn. 75), prior to setting an interest rate on the deferred payments. Often the interest rates set by the bankruptcy courts are less than the statutory tax interest rates, and the uncertainty now inherent in the existing statute affords the debtor unintended leverage in its negotiations with a tax authority holding priority claims. Also, current law arguably unfairly prefers Chapter 11 debtors by giving them an opportunity to obtain lower interest rates on their unpaid tax liability than would be available to non-debtor taxpayers. The disparity appears even more unfair because a Chapter 11 debtor, unlike a non-debtor taxpayer, is permitted a six year period over which to pay its tax liability. A tax authority typically will seek immediate payment of the entire liability from a non-debtor taxpayer; if a non-debtor taxpayer is unable to satisfy the entire liability, the authority usually imposes heavy penalties or severe restrictions on the delinquent taxpayer.

It can be contended that the tax authority is entitled only to the "true" present value of its claim and that, by sanctioning what may be an above market interest rate, the Bankruptcy Code will prefer the claims of tax authorities to other creditors. Also, it will be argued that if the Bankruptcy Code requires the debtor to pay high interest rates on its priority tax claims, the reorganized debtor's chances for a successful reorganization may be adversely affected. Neither of these reasons is sufficient to justify the current provisions. Where Congress or the states have provided for specific tax interest rates (or formulae to set such rates), there is no overriding policy which justifies the Bankruptcy Court setting an entirely different interest rate, particularly when the tax authorities have been forced to wait (without interest) during the pendency of the Chapter 11 proceeding before collecting the delinquent tax liability.

On the other hand, the Task Force agrees that a debtor's future obligations for priority tax payments should be clearly known at the time of confirmation, and that the applicable interest rate should be easily determinable and generally related to current market rates.

For these reasons, the Task Force believes that the interest rate on allowed deferred priority tax claims should be fixed at the time of confirmation, and should not be subject to change over the deferral period. Also, the Task Force suggests that a single rate be applied to all priority tax payments, federal, state and local. In our view, the rate determined under section 6621(a)(2) of the Internal Revenue Code should be adopted for bankruptcy purposes. The section 6621(a)(2) rate not only reflects federal tax policy, but is reset every calendar quarter to reflect changes in market interest rates (fn. 76).

The Task Force recommends that the additional interest rate imposed on corporations for underpayments in excess of $100,000 (5 percent above the short-term federal rate) not apply to the priority tax claims of Chapter 11 corporate debtors (fn. 77). The additional 2 percent reflects the fact that a C corporation may deduct such interest (as compared with individuals who are not entitled to a similar deduction), which is not relevant to the Bankruptcy Code.

(b) Deferred Payments

In numerous cases, debtors have proposed repayment schedules providing for no or nominal payments of priority tax claims in the initial years following the effective date, with much larger payments (or perhaps a balloon payment) in the later years. Tax authorities often contest such repayment schedules, typically arguing for level principal payments over the six year deferral term. In interpreting the six year deferral provision, the courts have permitted debtors flexibility in crafting repayment schedules, where the courts found that a debtor required some breathing room initially following confirmation (fn. 78).

It has been proposed to the Commission that the Bankruptcy Code be amended to require level payments of priority taxes during the six year deferral period. First, we believe that such level payments should be calculated as if the priority tax debt were a self-amortizing mortgage, so that the scheduled payments of principal and interest will be in equal amounts during the entire six year period. (Such level payments should be made at least annually, or more frequently as ordered by the bankruptcy court.) If the Bankruptcy Code is amended to require equal principal payments over a six year period, the burden imposed on the debtor to meet its priority tax claim obligations immediately following the effective date of reorganization will be significantly larger than in the later years because the interest payable on the unpaid balance will be larger in the earlier years. This additional burden is inconsistent with the goal of an effective reorganization.

Second, and more important, we believe that the level payment rule should not be mandatory; the debtor should be allowed to adopt a different payment schedule if it demonstrates that such a schedule will facilitate the successful reorganization of the debtor (fn. 79). At the same time, we recognize that the Bankruptcy Code affords priority to the tax collector, who should not lose his priority as a result of the deferral of priority tax payments. For these reasons, we suggest that, if the priority tax claims are not paid on a level payment basis (calculated similar to a self-amortizing mortgage), the debtor's payment schedule for such claims must provide recoveries on at least as rapid a basis as the most favored nonpriority unsecured claims. In other words, if the holders of unsecured claims are receiving 25 percent recoveries in quarterly installments over the first two years, then the priority tax claims must receive at least a 25 percent recovery in quarterly installments over the first two years; the 75 percent balance then will be paid over the next four years in accordance with the plan. In this way, a tax authority which is not receiving level payments will not be in the position of obtaining its recovery at a slower pace than unsecured creditors (fn. 80). Of course, the debtor may decide to pay the priority tax claims on a level payment basis over the six year period following the effective date, which will enable the debtor to pay its unsecured creditors on a faster basis.

(c) Commencement of Deferral Period

The Task Force recommends that the deferral period for priority tax claims commence on the effective date of reorganization and not relate back to an earlier assessment date.

The six year deferral period is now measured from the date of assessment, not the effective date (fn. 81). In some cases, the tax authority may have assessed the priority tax before the Chapter 11 petition was filed. If the Chapter 11 proceeding takes two years, such a tax authority will be entitled to collect its priority tax claim in only four years following the effective date, while other tax claimants will be subject to a six year deferral period. Also, recent changes in the Bankruptcy Code permit tax authorities to make assessments during the Chapter 11 proceeding. We do not believe that in amending section 362(a)(9) Congress intended this result.

Priority taxes, whether or not assessed prior to the filing of, during, or at the close of the Chapter 11 proceeding should be subject to the same deferral period. We believe that the six year deferral period should be measured from the effective date of the plan of reorganization. This will place all priority tax claims in the same position.

Other Institutional Positions

The Association of the Bar of the City of New York opposes uniform payment schedules and interest rates. A focus group of the American College of Bankruptcy takes the same position.

****************************FOOTNOTES*************************************

fn. 75: The courts generally have rejected using either I.R.C. Section 6621 or the federal judgment rate (28 U.S.C.A. Section 1961) as per se benchmarks, although some courts have viewed such rates as relevant in their determination. See, e.g., Souther States Motor Inss, Inc., 709 F.2d 647 (11th Cir. 1983), cert. denied, 465 U.S. 1022 (1984); In re Camino Real Landscape Contractors, Inc. 818 F.2d 1503 (9th Cir. 1987); U.S. v. Neal Pharmacal Co., 789 F.2d 1283 (8th Cir. 1986).

fn. 76: The rate on underpayments is equal to 3% above the average market yield on 3 year Treasury obligatiosn during the first month of the preceding calendar quarter. I.R.C. Sections 6621(b) and 1274(d).

fn. 77: I.R.C. Section 6621(c).

fn. 78: Compare In re Volle Electric, Inc. 139 B.R. 451 (C.D. Ill. 1992) (Court approved small payments initially and large fuel balloon payment) with In re Mason & Discon Lines, Inc. 71 B.R. 300 (Bankr. M.D.N.C. 1987) (Court rejected plan provies for single balloon payment at end of six years). See also In re Gregory Boat Co., 144 B.R. 361 (Bankr. E.D. 1992); In re Sanders Coal & Trucking, Inc. 129 B.R. 516 (Bankr. E.D. Tenn. 1991).

fn.79: See, e.g., In re Snowden's Landscaping, 110 B.R. 56 (Bankr. S. D. Ala. 1990.

fn. 80: Similarly, to protect the holder of the priority tax claim, a debtor should be required to pay accrued interest on an annual or more frequent basis, as the bankruptcy court determines.

fn. 81: In re Collins, 184 B.R. 151 (Bankr. N.D. Fla. 1995); In re Cline, 100 B.R. 660 (Bankr. W.D.N.Y. 1989).

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Last updated June 1, 1997