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Internal Revenue Code Section 1399 provides that no new taxable entity is created when a corporation files bankruptcy. Moreover, it is clear that the act of filing for bankruptcy has no effect on the corporation's taxable year, which continues uninterrupted. Similarly, if the corporation is a member of a consolidated group for tax purposes, even if it is the common parent of such group, the filing of bankruptcy has no effect on the taxable year of the group or the requirement to continue filing tax returns on a consolidated basis. In short, from a corporate tax viewpoint, the act of filing for bankruptcy is a "non-event." Notwithstanding the bankruptcy, the corporation must combine all of its operating income and losses, as well as other items of gain or loss realized during the entire taxable year and come up with a net taxable income for the full period and compute the corresponding tax liability. For federal income tax purposes, it makes no difference whether that income was realized entirely before, entirely after, or partly before and partly after the bankruptcy filing.
The critical question from a bankruptcy viewpoint is whether any such income tax liability is a prepetition tax entitled to priority treatment under Section 507(a)(8) of the Bankruptcy Code (fn. 170), an administrative expense under Bankruptcy Code Section 503(b)(1)(B) entitled to priority under Bankruptcy Code Section 507(a)(1), or a combination of the two. There are at least three important consequences that differ depending on whether the tax is characterized as prepetition versus administrative. These are (1) the deadline by which a proof of claim must be filed by the taxing authority in the bankruptcy proceeding, (2) how much of the claim will be paid and when will such payment be made and (3) whether the taxing authority is entitled to collect interest and penalties with respect to the unpaid taxes. If the tax liability is an administrative expense: (1) the deadline for filing a proof of claim is typically much later in the bankruptcy proceeding; and (2) the taxing authority will be paid in full not later than upon confirmation of a Chapter 11 Plan and (3) the taxpayer debtor may be liable for penalties and interest.
The relevant portions of Section 503 are as follows:
Section 503 Allowance of administrative expenses
* * * * * *
(b) After notice and a hearing, there shall be allowed administrative expenses, other than claims allowed under section 502(f) of this title, including-
* * * * * *
(1)(B) any tax-
(i) incurred by the estate, except a tax of a kind specified in Section 507(a)(8) of this title; or
* * * * * *
The relevant portions of Section 507 are as follows:
Section 507. Priorities
(a) The following expenses and claims have priority in the following order:
(1) First, administrative expenses allowed under section 503(b) of this title,
* * * * * *
(8) Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for-
(A) a tax on or measured by income or gross receipts-
(i) for a taxable year ending on or before the date of the filing of the petition for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
* * * * * *
(iii) other than a tax of a kind specified in section 523(a)(1)(B) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case;
* * * * * *
Following the statutory framework courts that have addressed the issue have articulated a two prong test for determining when a tax claim will be a first priority administrative claim, as follows:
1. The tax must have been incurred by the estate; and
2. The tax must not be specified in Section 507(a)(8).
In order for a tax to be characterized as an administrative expense, it must be "incurred" by the estate. Section 503(b) of the Bankruptcy Code does not distinguish between corporate and individual debtors in the classification of taxes as administrative expenses or priority claims. However, it is important to note that there is a fundamental difference in the treatment of income taxes between individual and corporate debtors. As mentioned earlier, no separate taxable estate is created when a corporation files bankruptcy, nor is there any change to the taxable year of the corporation, even though it has filed a bankruptcy petition. In contrast, when an individual debtor files a Chapter 11 or Chapter 7 bankruptcy proceeding a separate taxable entity is created (fn. 171). Moreover, the Internal Revenue Code specifically allows individuals to terminate their tax years as of the day before the bankruptcy filing (fn. 172). Where the individual files bankruptcy and makes the election to close his tax year it is clear that the tax liability associated with the prepetition short period will be a priority claim under Bankruptcy Code 507(a)(8). Since a separate taxable entity, the bankruptcy estate, is created when the individual files bankruptcy, it is clear that any tax liability attributable to income earned by the bankruptcy estate will be an administrative expense (fn. 173). Any taxable income earned by the individual after filing for bankruptcy will be taxed to him individually and will not constitute a claim of any type, either priority or administrative, against his bankruptcy estate (fn. 174). This is logical inasmuch as none of the individual's postpetition income will be an asset of the bankruptcy estate. Where an individual files bankruptcy but does not make the short-year election, the tax liability for the entire year is payable by the individual and not by the bankruptcy estate. There is no legitimate basis to charge the bankruptcy estate for any portion of the tax liability for the year because the tax was not yet incurred at the date of the filing of bankruptcy. Only claims existing as of the date of the filing can be asserted in the bankruptcy proceeding. Of course, the individual can change this result by making the short period election.
One of the early leading cases addressing the question as to when a tax is incurred in a corporate setting was In re International Match Corporation (fn. 175). In that case the debtor filed bankruptcy in April of 1932. The Delaware Franchise tax for 1932 was due April 1, 1933. The franchise tax was computed by reference to the capital structure of the corporation for the entire year, prorated for changes incurred during the year. The relevant section of the Bankruptcy Act required the trustee to pay all taxes "legally due and owing" (fn. 176). Thus, the key issue was whether any portion of the franchise tax was due and owing at the time the bankruptcy petition was filed. The Court found that until the last day of the accounting period, it was impossible to accurately compute the tax liability. Clearly, the same analysis is applicable to corporate income taxes. Until the accounting period is complete, the very existence of a tax liability is speculative. This case equated the concept of "due and owing" with the question of whether the tax was accrued, but continues to be cited for how to determine when a tax is "incurred" for purposes of Section 503(b).
In O.P.M. Leasing Services, Inc., (fn. 177) the Court analyzed whether a corporate income tax claim filed by the State of Indiana should be treated as a prepetition priority claim or as an administrative expense. In this case, the trustee paid the taxes attributable to the postpetition period of the taxable year with the tax return; Indiana's claim was only for the taxes attributable to the prepetition portion of the year. The bankruptcy petition was filed on March 11, 1981, and the bar date for prepetition claims was March 30, 1982. The State of Indiana did not file its proof of claim for the prepetition corporate income taxes for the fiscal year ending November 30, 1981 until April 8, 1985. By the same token the trustee did not file a tax return for this fiscal year until November 21, 1984. The Court found this situation to fit squarely under Section 507(a)(8)(A)(iii) as a tax "not assessed before, but assessable, under applicable law or by agreement, after the commencement of the case." Accordingly the Court found the Indiana claim to be a claim for prepetition taxes and therefore, time barred (fn. 178).
In 1995 the Eighth Circuit in In re L.J.O'Neill Shoe Co. (fn. 179) and the Ninth Circuit in In re Pacific-Atlantic Trading Co. (fn. 180) addressed the issue in question and concluded that a corporate debtor's income tax liability for the taxable year of the bankruptcy filing should be bifurcated between the prepetition and postpetition periods of the year for purposes of determining what priority should be assigned to the corresponding tax liabilities.
The Ninth Circuit in In re Pacific-Atlantic Trading Company (PATCO), first considered whether the income tax for the year of the bankruptcy filing was "incurred by the estate". The Court considered the legislative history, including statements by congressmen, and concluded that the drafters of Section 503(b)(1)(B)(i) intended that a tax on income should be treated as "incurred" on the last day of the taxable period. Since the bankruptcy proceeding was filed prior to the last day of the tax year, the Court concluded that the taxes were incurred by the estate. The Court then focused its attention on the second test, which requires that the tax cannot be an administrative expense if it is described in Section 507(a)(8). In O'Neill the Court went directly this test. Each Court focused on the language of 507(a)(8)(A)(iii), which describes taxes "not assessed before, but assessable under applicable law or by agreement, after, the commencement of the case". Both Courts concluded that this language included taxes attributable to the prepetition period because such taxes are not assessed before, and do not become assessable until after, the bankruptcy filing when the tax year finally closes. In each case the government argued that such interpretation was erroneous because, if followed literally, there could never be a tax liability that would be characterized as administrative. This is because even taxes relating solely to a postpetition year would not have been assessed before but would be assessable after the commencement of the case. The Court in PATCO acknowledged that this conclusion would be absurd and accordingly rejected the interpretation that would give rise to such an absurd result (fn. 181). Each court concluded, based on legislative history and analysis, that Section 507(a)(8) was only intended to deal with prepetition taxes. Accordingly, it was necessary to interpret this section in that context.
In summary, present law is that a corporate income tax liability related to the year of the bankruptcy filing should be bifurcated. The tax liability attributable to the prepetition portion of the year should be treated as a priority claim under Section 507(a)(8) and the tax liability associated with the postpetition portion of the year should accorded administrative status under Section 503(b).
Commission track number 432. Both the IRS and the Justice Department have urged the Commission to propose legislation to the effect that a corporate income tax liability for a tax year that straddles the petition date is "incurred" for purposes of Section 503(b) of the Code on the date when that liability can be calculated, namely, the last day of the tax year. The primary concern expressed by the IRS and the JusticeDepartment is that absent this change the government will lose out on significant tax revenues because claims for prepetition tax claims will typically be subject to an early bar date (generally 180 days after the filing of the bankruptcy petition). Both the Justice Department and the IRS maintain that the possible solution of filing of protective claims in every corporate bankruptcy case would be unduly burdensome on the debtor, the courts, and the taxing authorities. Justice Proposal, p. 99; IRS Proposal, p. 60.
The Task Force takes no position on these proposals.
The Justice Proposal and the IRS Proposal would amend the Bankruptcy Code to provide that straddle year taxes are "incurred" on the last day of the taxable year. We assume this to mean that the entire year's liability is an administrative expense, entitled to a first priority. If so, the statute should say so. Both O'Neill and PATCO held that the taxes were incurred by the estate. The Task Force is concerned that merely stating that it is incurred on the last day of the taxable year leaves room for continued confusion.
This issue divided the Task Force, and others we consulted, on the merits. Some members believe that because no actual liability arises until the last day of the taxable year when all income and deductions, regardless of when during the year they are incurred, are netted against each other. The liability is properly treated as an administrative expense. These members agree with the IRS and the Justice Department.
Other members (the "Opponents") are of the view that the present law treatment is appropriate. Specifically, the Opponents believe that it is appropriate to bifurcate the tax liability for the year of filing. The portion of the liability attributable to the prepetition period would have priority status under Section 507(a)(8) and the portion attributable to the post-petition period would be accorded administrative priority status under Section 503(b). However, the Opponents are sympathetic to the concern of the governmental authorities that they could be subject to a bar date that precedes the normal due date of the relevant tax return (fn. 182). The Opponents would suggest that a provision be made to allow claims for the prepetition portion of the tax liability to be filed up to the later of the normal bar date or the normal due date for the a tax return plus an additional period of time (fn. 183). The Opponents believe that in the majority of the Chapter 11 cases that are filed by corporations, there is no corporate tax liability for the year of the bankruptcy filing and in those cases, the issue is academic. However, in those cases where there is a significant tax liability, to the extent it is characterized as prepetition the Chapter 11 Plan can provide for the payment of the prepetition tax liability over an extended period of time of up to six years (fn. 184). This may well be a critical element of formulating a successful plan of reorganization. This privilege should not be taken away merely to ease an administrative burden otherwise imposed on taxing authorities.
As a result of these divisions, the Task Force takes no position on these proposals at this time.
Although the Opponents believe that the Government's interests would be adequately served by giving the taxing authority a reasonable extension of the bar date, the Task Force notes that there is another possible solution. A corporate debtor could be given an election, similar to that now provided to individuals under Internal Revenue Code Section 1398(d)(2), to terminate its tax year as of the day prior to petition filing. The liability attributable to the prepetition short period would be an eighth priority tax subject to the deferred payment provisions of Bankruptcy Code Section 1129(a)(9)(C); the postpetition tax liability would be an administrative expense. The Task Force recommends that if this approach is adoptedthe due date for both returns be the normal due date for a full year return and that the taxing authority be given an appropriate extended bar date for the prepetition return.
The Task Force will continue to consider this question in hopes of reaching a consensus. We hope the Commission will give careful consideration to crafting a solution which reconciles theoretical correctness with the legitimate concerns of the taxing authorities.
The Association of the Bar of the City of New York supports bifurcation of the filing year tax liability.
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fn. 170: Bankruptcy Code Section 507(a)(8).
fn. 171: IRC Section 1398.
fn. 172: IRC Section 1398(d)(2).
fn. 173: BC Section 503(b)(1)(B).
fn. 174: See In re Mirman, 98 B.R. 742 (Bankr. E.D. Va. 1989).
fn. 175: 79 F.2d 203 (7th Cir., 1935); cert. denied, 296 U.S. 652 (1935).
fn. 176: Section 64a of Bankruptcy Act, as amended by Act May 27, 1926, 11 USC 104(a).
fn. 177: 68 Bankr. 979 (Bankr. S.D.N.Y. 1987).
fn. 178: For a similar result See In re: Hillsoborough Holdings Corporation, et al., 156 Bankr. 318 (Bankr. M.D. Fla., 1993).
fn. 179: 64 F.3d 1146 (8th Cir. 1995).
fn. 180: 64 F.3d 1292 (9th Cir. 1995).
fn. 181: Id at 1303.
fn. 182: As noted by the PATCO court, a late filed proof of claim for priority taxes is still entitled to be paid in a Chapter 7 liquidation case. This is not the normal result in a Chapter 11 reorganization.
fn. 183: The Task Force is of the view that this additional time should enable the taxing authority to review the actual return - or the extension request - and detrmine whether a proof of claim should be filed. If this does not provide for sufficient time, provision could be made for additional extensions where the taxpayer has not yet filed a return. However, it is likely that in many cases the debtor taxpayer will be delinquent in filing returns - even returns for pre-petition years. Under current law the taxing authority is still subject to the early bar date for pre-petition claims notwithstanding that no retgurn has been filed. Indeed, in most Chapter 11 situations the debtor does not anticipate any income tax liability because it is typically incurring losses. Therefore, the Task Force would be opposed to any proposal that extended the bar date to a date after the return has actually been filed.
fn. 184: Section 1129(a)(9) of the Bankruptcy Code requires that a plan provide for payment of all priority taxes. However, taxes described in Section 507(a)(8) may be satisifed with deferred cash payments over up to a six year period from the date such taxes were assessed. The deferred payments must include interest at a market rate.
Questions, comments or suggestions? kbercik@taxcounsellor.com
Last updated July 6, 1997