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

SUBORDINATION OF TAX PENALTIES

(COMMISSION TRACK NUMBER 703704)

Present Law

Noncompensatory prepetition tax penalty claims are subject to subordination in Chapter 7 cases under the authority of Section 726(a)(4) of the Bankruptcy Code. There is no corresponding authority in Chapter 7, however, for the subordination of penalties relating to postpetition taxes. Nor does Chapter 11 provide any automatic subordination; tax penalties are entitled to priority over all other unsecured claims by virtue of Section 507(a)(1) and 503(b)(1)(C), in the case of postpetition taxes, and Section 507(a)(8)(G), in the case of prepetition taxes. Moreover, recent Supreme Court decisions have struck down the use of equitable subordination under Section 510(c) as a basis for categorical subordination of tax penalties, although general principles of equitable subordination may allow a bankruptcy court to subordinate a tax penalty when justified by particular facts. U.S. v. Reorganized CF&I Fabricators of Utah, Inc., 116 S. Ct. 2106 (1996); U.S. v. Noland, 116 S. Ct. 1524 (1996).

Proposals Before the Commission

Commission Track Numbers 703 and 704. This proposal.

Task Force Position

Amend Section 507(a)(8) of the Bankruptcy Code to exclude subsection (G) (affording priority status to "a penalty related to a [tax claim] and in compensation for actual pecuniary loss"), and amend Section 510 to add a new subsection (d) providing for the subordination of all such tax penalties to claims of ordinary unsecured creditors.

Reasons for Position

Before the 1996 Supreme Court decisions in Noland and CF&I, a majority of lower courts had concluded that bankruptcy courts could and should subordinate tax penalties in chapter 11 cases on general equitable grounds. Although Section 510(c) does not define the phrase "principles of equitable subordination," the legislative history includes the following statement by the House sponsor of the Bankruptcy Code: It is intended that the term "principles of equitable subordination" follow existing case law and leave to the courts development of this principle. To date, under existing law, a claim is generally subordinated only if [the] holder of such claim is guilty of inequitable conduct, or the claim is of a status susceptible to subordination, such as a penalty . . . 124 Cong. Rec. 32,398 (1978) (Rep. Edwards).

Notwithstanding Representative Edwards's statements, however, the actual state of the case law at the time Section 510(c) was enacted was that the doctrine of equitable subordination always required creditor misconduct and never was based merely on a "status susceptible to subordination, such as a penalty." Nevertheless, perhaps partly on the strength of the legislative history, many circuit courts thereafter reasoned that government misconduct was not a prerequisite to the equitable subordination of tax penalties. In re C-T of Virginia, 977 F.2d 137 (4th Cir. 1992), cert. denied, 113 S. Ct. 1644 (1993) (excise tax on reversion of pension assets denied priority status); Cassidy v. Dumler (In re Cassidy), 983 F.2d 161 (10th Cir. 1992) (excise tax on premature withdrawal of pension funds denied priority status); In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990) (employment tax held unenforceable penalty in bankruptcy); Schultz Broadway Inn v. U.S., 912 F.2d 230 (8th Cir. 1990) (court should consider equities in applying subordination test; stamp tax subordinated as penalty); In re Burden, 917 F.2d 115 (3d Cir. 1990) (tax penalties may be subordinated after weighing of equities); In re Seneca Oil Co., 906 F.2d 1445 (10th Cir. 1990) (denying subordination because claim found not to be penalty); In re Unified Control Systems, Inc., 586 F.2d 1036 (5th Cir. 1978) (pension excise tax under Internal Revenue Code Section 4971 held unenforceable penalty under Bankruptcy Act); but see In re Mansfield Tire & Rubber Co., 942 F.2d 1055 (6th Cir. 1991), cert. denied, 112 S. Ct. 1165 (1992) (pension excise tax deemed "tax," not penalty, under "plain meaning" rule).

Even if the Supreme Court had not overruled this line of cases in Noland and CF&I, the former approach created a difficult problem: it raised the specter of extending equitable subordination to other types of claims in which no creditor misconduct was proven, which is anathema to the investment community and could chill the availability of credit. This concern would be addressed by a statutory amendment that was limited specifically to tax penalty claims.

Granting a priority to penalties works an unfairness on general unsecured creditors by, in effect, punishing them for the debtor's wrongdoing. The unreasonableness of this result is partially recognized by the express subordination of tax penalties to general unsecured claims in chapter 7 cases. While there is every reason to enforce a tax penalty in preference to the retention of equity, there is no obvious policy justification for enforcing a tax penalty in preference to innocent creditors who have suffered pecuniary loss.

Absent a statutory amendment, unsecured creditors will have only one realistic means of protecting their recoveries from devastation by potentially huge tax penalty claims: they may rely on their right to receive at least as much as they would have received in a liquidation (the so-called "best interests of creditors" test codified at Section 1129(a)(7)). Because prepetition tax penalty claims are clearly subordinated by statute, the allowance of any such claim in a significant amount would prevent unsecured creditors from receiving distributions as large as they could have expected in a chapter 7 liquidation, even taking into account the expected discrepancy between the going-concern and liquidation values of the debtors' estate. This approach offers little comfort to creditors, however, because it requires difficult and often expensive litigation over the projected value of distributions in a theoretical liquidation. Thus, Section 510 should be amended to generally subordinate tax penalties to the claims of unsecured creditors.

A possible middle ground is the subordination only of those penalties that relate to prepetition taxes. Granting a priority to penalties for postpetition taxes would create an incentive for creditors to monitor and work with the debtor to prevent the estate's failure to pay all taxes when due postpetition. Granting a priority to penalties for prepetition taxes would serve no such purpose and, in fact, would not address the purported policy underlying tax penalties in any defensible way.

Questions, comments or suggestions? kbercik@taxcounsellor.com