Report of the American Bar Association Tax Section Task Force on the Tax Recommendations of the National Bankruptcy Review Commission

POST-PETITION TAXES AS ORDINARY COURSE EXPENSES

(COMMISSION TRACK NUMBER 421-4)

Present Law

Administrative expenses generally receive priority over all claims other than the claims of secured creditors. Under Chapter 7, administrative claims get paid first after secured claims on a pro rata basis, except for certain creditors and lenders who obtain superior status in return for allowing the use of collateral property or credit by the trustee or debtor in possession. Administrative claims of a Chapter 7 case take precedence over the administrative claims of a predecessor chapter from which the claim was converted. Under Chapter 11, administrative claims do not vote as a class on the reorganization plan, but must be paid in full upon the effective date of the plan. Administrative claims in Chapter 13 receive full payment.

Generally, administrative expenses are those incurred after the order for relief which are necessary to administer the estate and, if the debtor is reorganizing or not immediately liquidating, to conduct the business of the debtor. The policy behind this treatment is that the estate as a whole is benefited if pre-bankruptcy creditors subordinate their claims in order to enable the debtor to obtain the goods and services necessary to an orderly and economic administration of the estate after the petition is filed. However, the administrative claimant must prove both the reasonable value of the expense and that the expense was actual and necessary, without the favorable presumption that would attach to a proof of claim. Generally, the bankrupt estate pays no interest on administrative claims, but could be liable for interest and penalties in respect of administrative expense taxes. Moreover, if administrative expenses have been paid on an interim basis and it is ultimately determined that either the payments were not all justified or that there are insufficient funds to pay all other legitimate administrative claims, those who have received interim payments may be required to disgorge funds so that all administrative claimants share pro rata. The bankruptcy court has considerable discretion in determining what costs qualify as administrative expenses within the intendment of section 503 of the Bankruptcy Code.

Notwithstanding the priority afforded administrative claims, an important practical question of creditors with such claims is when they will be paid. Further, the timing of payment is within the reasonable discretion of the bankruptcy court, and may well affect the present value or even the face amount of payment from a practical standpoint.

Under current law, most taxes incurred postpetition have priority as administrative expenses. Under section 503(b)(1)(B) administrative expenses include (i) any tax incurred by the estate except certain prepetition assessed, assessable, or withheld taxes [Section 507(a)(8)] or (ii) asserted claims for previously paid excessive tentative tax refund allowances attributable to net operating loss carrybacks. Interest and penalties payable on postpetition taxes are usually asserted by the IRS as administrative expenses.

Under section 503(b) of the Bankruptcy Code, extraordinary administrative expenses appear generally to be payable only pursuant to a creditor's request for payment, notice, and a hearing. As a result, the timing of the payment may be delayed because of the time needed to obtain court approval. This treatment may be different from the more timely payment of ordinary administrative expenses consisting of normal operating expenses for an ongoing business of the bankrupt estate (whether based on a standing order or on the debtor's general authority to operate its business as a debtor-in-possession. Such operating costs are not generally subject to disgorgement).

At the same time, 28 U.S.C. Section 960 provides that "any officers or agents conducting any business under authority of a United States court shall be subject to all Federal, State and local taxes applicable to such business to the same extent as if it were conducted by an individual or corporation." The Congressional purpose of this provision is to ensure that bankruptcy trustees and receivers do not conduct tax-free businesses in competition with tax-burdened operators of businesses not in bankruptcy or receivership. In re New York, N.H. & H.R., 360 F. Supp. 1155 (D.Conn. 1973).

Under Bankruptcy Code Section 362(b)(18), filing a petition for relief acts as an automatic stay for most creditor activities except certain measures, including a local taxing authority's creation or perfection of a statutory lien for an ad valorem property tax if such property tax comes due after the filing of the petition. On the other hand, the provisions of Bankruptcy Code Section 363(f)(5) allow a trustee to sell property free and clear of any creditor's interest in such property under certain circumstances, including where the creditor can be compelled to accept money instead of the property (i.e., such as for a property tax lien creditor). Moreover, Bankruptcy Code Section 724(b) imposes a distribution order on the proceeds from the sale of debtor estate property that effectively subordinates an allowed ad valorem property tax lien to private consensual liens and certain other administrative expense and higher priority claims (i.e., Section 507(a)(1)-(7)) in Chapter 7 liquidation proceedings. See our response to Commission Track Number 100, supra.

Under Bankruptcy Code Section 507(a)(1), administrative expenses under Bankruptcy Code Section 503 enjoy first priority of payment by the estate. Local taxing authorities believe that the attachment of a county's tax lien to real property should not remove ad valorem property taxes from treatment as administrative tax expenses, entitled to first priority, as was held in In re Sylvia Development Corp., 178 B.R. 96 (Bankr. D. Md. 1995) and several pre-1994 cases. They do not believe there is a windfall benefit from the double protection, because they can only recover the entire tax once.

Under Bankruptcy Code Section 506(c), the trustee may liquidate property subject to an allowed secured claim and use part of the proceeds to pay "reasonable and necessary costs and expenses of preserving, or disposing of, the property to the extent of any benefit to the holder of such claim." Local taxing authorities appear to believe that by specifically including property taxes in the definition of "reasonable and necessary or preservation" costs, this would enable them to recover some property taxes from real property that would otherwise go unpaid.

Proposals Before the Commission

Commission Track Numbers 421-4. The Commission is considering several proposals that would treat taxes as administrative expenses incurred in the ordinary course of the debtor's business so as to be payable on a more current basis without request and a hearing and/or otherwise to have special protections from the claims of other creditors. More particularly, these objectives would be obtained by the following:

1. Bankruptcy Code Section 503 and 28 U.S.C. Section 960 would be amended to provide that bankruptcy estates must pay all taxes accrued postpetition, whether or not related to a business operated by the estate, in the normal course of the business of the estate and without request or motion. See Justice Proposal, p. 98; Santa Fe Discussion Issues, p. 1, item IA1; Government Working Group Proposal No. 10.

2. Bankruptcy Code Section 507(a)(1) and 503(b)(1)(B) would be amended to provide that ad valorem real estate taxes accrued postpetition are an administrative expense whether secured or unsecured and payable as a course of business expense. See Santa Fe Discussion Issues, p. 2, item IB2 and p.3, item IB4.

3. Bankruptcy Code Section 506(c) would be amended to provide that ad valorem real property taxes accrued postpetition are a reasonable and necessary cost or expense of preservation of secured property. See Santa Fe Discussion Issues, p. 2, item IB3.

Task Force Position

The Task Force agrees that a chapter 11 debtor or one operating a business should currently pay all taxes, including ad valorem real property taxes, as an administrative expense, without a request by the taxing authority. It is not clear that any statutory amendment is needed to accomplish this result. However, the same flat rule should not apply to non-operating trustees. The principle of pro-rata payment of administrative claims should be preserved.

Postpetition ad valorem real property taxes should be treated as administrative expenses even if secured. Consistent with our position with respect to repeal of Bankruptcy Code Section 724(b)(2), such taxes should be borne by the secured creditor if the estate is administratively insolvent. See our response to Commission Track Number 100.

Reasons for Position

The Government believes that taxing authorities are placed at a disadvantage by bankrupt taxpayers who do not file tax returns and pay taxes when due in a timely manner or at all. Taxing authorities purportedly lose significant sums each year from debtors with unpaid or late-paid postpetition taxes, although such post-filing taxes incurred by the estate have first priority administrative status. The Government believes that it is bad policy to allow debtors to enjoy the benefits of bankruptcy without paying some of the attendant costs, such as timely payment of postpetition taxes. Outside of bankruptcy, taxpayers must pay their taxes when due, and bankruptcy should not change this obligation.

When a debtor seeks to reorganize under chapter 11 or otherwise operates a business under the jurisdiction of the bankruptcy court, such debtor should pay postpetition taxes as ordinary course expenses. We think this is the fair reading of Bankruptcy Code Sections 363(c)(1) and 503(b)(1)(B)(i) and 28 U.S.C. Section 960. We have not found anyone who thinks otherwise, and question whether any statutory change is needed to reach this result. If there is any question about the status of ad valorem real property taxes, whether because they may not be related to the operation of a business, cf. In re R.H. Macy & Co., Inc., 176 B.R. 315 (S.D.N.Y. 1994) or because they are in rem, cf. In re Carolina Triangle LTD Partnership, 166 B.R. 411 (9th Cir. BAP 1994), clarification may be needed.

When a business is not being conducted, the principle must give way to the principle of equal distribution to administrative creditors. There should be a presumption of current payment, but the court should be empowered to withhold current payment, on request of a party in interest, after notice and hearing, if the estate may be administratively insolvent.

Adoption of these positions might mean that in some situations ad valorem real property taxes might not be paid currently, and might not be paid in full if present section 724(b)(2) is retained. As we said in our response to Commission Track Number 100, "If an estate is administratively insolvent, the secured creditor should not receive a windfall at the expense of the local taxing authority. The private secured creditor should bear the burden of ad valorem real property taxes."

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