August/September 2003

Alan Barton
Taxation Section Editor
KPMG LLPHouston, TX
abarton@kpmg.com

Federal Circuit

Can professional fees incurred during a bankruptcy proceeding be considered a liability arising under a Federal law and, therefore, a specified liability loss under IRC section 172(f), which can then be carried back 10 years under IRC section 172(b)(1)(C)?

In 1992, Standard Brands Paint Company and its subsidiaries (“Debtor”) petitioned for relief under Chapter 11 of the Bankruptcy Code. Under bankruptcy court supervision, Debtor employed various legal and other professionals, who incurred fees and expenses in connection with their services. The bankruptcy court ultimately awarded final compensation to the various professionals for services rendered. Debtor emerged from bankruptcy during 1993.

Debtor deducted a portion of these professional fees on its federal income tax returns for 1992 and 1993. The remainder of these professional fees (approximately $5.4 million) was capitalized.

In December 1995, Debtor filed for bankruptcy a second time, this time as a liquidation.

In 1998, Debtor filed a Form 1120X for the 1986 tax year claiming a refund of taxes paid in 1986 (the “claim”). The claim represented the carryback of a net operating loss deduction from 1996 under IRC section 172(b)(1)(C) attributable to a purported specified liability loss arising in 1996. The purported 1996 specified liability loss represented the write-off of the previously capitalized professional fees incurred in the Debtor’s 1992-1993 bankruptcy, totaling approximately $5.4 million.

After reviewing the claim, the IRS issued a technical advice memorandum denying the loss deduction and disallowing the claim. IRS Letter Ruling 199941006 (6/17/1999). On April 5, 2000, Debtor filed a complaint seeking refund of taxes plus interest.

The Court of Federal Claims granted summary judgment in favor of the government, finding that “the connection between [Debtor’s] capitalized expenses and the Bankruptcy Code [was] too attenuated to meet the requirements of IRC section 172(f)(1)(B).” Debtor appealed this decision.

The issue addressed by the appeals court was whether Debtor’s capitalized bankruptcy costs were specified liability losses within the meaning of IRC section 172(f)(1)(B). The court noted that, for the deductions in question to be a specified liability loss under IRC section 172(f)(1)(B), such deductions must be with respect to a liability which arises under a Federal or State law and only if the act (or failure to act), giving rise to such liability, occurs at least three years prior to the tax year in question.

Debtor asserted that, because the Bankruptcy Code makes the bankruptcy judge the determiner of whether, when, and how much an outside professional will be paid, the cost of hiring outside professionals arose under the Bankruptcy Code.

The government argued that Debtor failed to identify any provision within the Bankruptcy code mandating the employment of professionals at all. The government went further to point out that the liability for the capitalized bankruptcy costs did not arise when Debtor filed for bankruptcy, but rather when these professionals performed services pursuant to their contracts with the creditors’ committee and the bankruptcy court approved payment of their fees.

The appeals court noted the absence of any published IRS guidance in this area, as well as the lack of any relevant legislative history. The court further noted that the issue of whether the cost of hiring outside professionals during a bankruptcy proceeding is a liability arising under federal law had not yet been determined at the appellate court level.

Accordingly, the appellate court looked to similar cases below the appellate level for guidance, including Sealy Corp. v. Commissioner, 171 F.3d 655 (9th Cir. 1999) (liabilities arising from professional fees paid to publish reports required under ERISA did not arise under a federal law), Host Marriott Corp. v. United States, 113 F. Supp. 2d 790 (D. Md. 2000) (liabilities arising from a federal income tax deficiency and costs for workers’ compensation payments did arise under federal and state law), and Intermet Corp. v. Commissioner, 117 T.C. 133 (2001) (liabilities arising from federal and state income tax deficiencies did arise under federal and state law).

The appeals court adopted the Court of Federal Claims’ reasoning that “‘arising out of a federal law’ means more than...the liability was incurred with respect to an obligation under a federal law; and the nature and amount of the liability must be traceable to a specific law and cannot be the result of choices made by the taxpayer and others.”

The appeals court found that the statutory provisions in question did not establish the taxpayer’s liability to pay the amounts at issue. It was the choice of the creditors’ committee and Debtor as to the means of compliance, including which firm to retain to do what work and how much to pay them, and it was that choice which ultimately determined the nature and amount of these costs. Accordingly, the appeals court affirmed the Court of Federal Claims’ judgment. Major Paint Co. v. United States, No. 02-5153 (Fed. Cir. June 27, 2003).

Tenth Circuit

Can the IRS challenge a loss allocation between a debtor and his bankruptcy estate where the loss is attributable to a partnership interest and the IRS did not conduct a partnership-level proceeding?

Debtor was a partner in a number of partnerships that suffered substantial losses in 1990. In July of 1990, Debtor filed a petition for Chapter 7 bankruptcy relief. Debtor opted to file a single return for 1990, rather than electing under IRC section 1398(d)(2)(A) to bifurcate his 1990 tax year into pre- and post-petition short years.

Several of the partnerships in which the Debtor was a partner issued two K-1s to the Debtor. The first K-1 was issued to the Debtor in his individual capacity and reported the Debtor’s allocable share of partnership losses and items that had been accrued by the partnership prior to the Debtor’s filing for bankruptcy. The second K-1 was issued to the Debtor on account of his bankruptcy estate and reported the allocable share of partnership losses and items accrued after the Debtor’s filing for bankruptcy. The remaining K-1s received by the Debtor from partnerships did not distinguish between the Debtor and his bankruptcy estate and, instead, treated all of the items as allocable to the Debtor. For these partnerships, the Debtor filed a Notice of Inconsistent Treatment and allocated the tax items from these partnerships between himself as an individual and his bankruptcy estate.

On his individual return for 1990, the losses in question exceeded the amount he could apply to reduce his 1990 tax liability. Therefore, Debtor carried the remaining losses over to his individual 1991, 1992, 1993, and 1994 tax years. The IRS disputed the validity of these carryovers and issued notices of deficiency for all four years. The IRS contended that Debtor’s interest in any partnership losses incurred in 1990 passed to the bankruptcy estate when he filed for bankruptcy and, therefore, these losses were not available for use on his 1990 individual return.

Debtor contested the notices of deficiency in Tax Court. The parties settled all matters of dispute, except for the treatment of the partnership losses. With respect to the partnership losses, Debtor contended that the Tax Court lacked jurisdiction to enforce the notices to the extent that they concerned adjustments to partnership items. Debtor argued that his portion of the partnerships’ 1990 losses were ‘partnership items’ and the carryovers of these losses would be ‘affected items.’

In response to Debtor’s argument, the IRS relied on Treas. Reg. section 301.6231(c)-7(a) (the “bankruptcy regulation”), specifically addressing the impact of bankruptcy on the characterization of items as partnership items, to support the position that Debtor’s 1990 partnership losses were converted into nonpartnership items.

The Tax Court rejected the jurisdictional argument and held that Debtor's allocation of partnership losses between himself and his bankruptcy estate was improper. In rejecting the jurisdictional argument, the Tax Court found that the manner in which the distributive share of a partner in bankruptcy is allocated between the partner and the partner’s bankruptcy estate is not a partnership item within the meaning of IRC section 6231(a)(3). As a result, the Tax Court also found that there was a tax deficiency for the three subsequent years. Debtor appealed the Tax Court decision.

The appeals court found that the bankruptcy regulation was effective with respect to “the latest taxable year of the partner with respect to which the United States could file a claim for income tax due in the bankruptcy proceeding.” The appeals court found that, because Debtor elected not to bifurcate his 1990 tax year into pre- and post-petition short years, his 1990 taxes would be treated as post-petition debt not included in the bankruptcy. The appeals court determined that the latest taxable year of Debtor for which the government could file a claim in the bankruptcy proceeding would have been 1989, and any partnership losses incurred in 1990 would not be converted under the bankruptcy regulation.

In its briefs on appeal, the IRS conceded that the latest year for which the government could file a claim for Debtor’s liability was 1989. However, the IRS argued that, for purposes of the bankruptcy regulation, the bankruptcy estate must be identified with the partner who declared bankruptcy. The IRS argued that the bankruptcy estate can continue to incur tax liability for the duration of the bankruptcy proceedings. As a result of this continuing liability, the IRS could file a claim in the bankruptcy proceedings for those income tax liabilities arising during the 1990 tax year. Because the bankruptcy estate tax year ended on or after December 31, 1990, the IRS concluded that the disputed partnership items converted into nonpartnership items under the bankruptcy regulation.

The appeals court found that it could not support a reading of the bankruptcy regulation that expands the term “partner” to include the partner’s bankruptcy estate. The court found that the debtor and the bankruptcy estate are separate and distinct entities within the bankruptcy proceeding. In re Smith, 235 F.3d 472 (9th Cir. 2000).

With respect to the jurisdictional issue, the appeals court majority found that the statute in question (IRC section 6231) requires partnership-level proceedings when a partnership item is being challenged. Maxwell v. Commissioner, 87 T.C. 783 (1986). The court majority, distinguishing between the process and the result, held that the partnership item itself is a result of the allocation of the partnership’s income, losses, etc. and, therefore, the requirement for a partnership-level proceeding in order to contest such an item would be triggered regardless of how the item itself was calculated.

One judge dissented on the basis that an allocation between a debtor and his bankruptcy estate was not a partnership item, since such an allocation did not affect any other partnership item or any other partner.

The decision of the Tax Court was reversed and the cases were remanded for further proceedings consistent with the circuit court’s majority decision. Katz v. Comm'r, Nos. 01-9009, 01-9010 and 01-9011 (10th Cir. July 7, 2003).

Treasury Regulations

Regulations Address Ownership Change of Loss Corporation on Distribution by IRC Section 401(a) Trust to Plan Participants

The Treasury Department and IRS recently issued advance copies of temporary regulations (T.D. 9063) and, by cross-reference, proposed regulations (REG-108676-03) under IRC section 382 with respect to interests in loss corporations held by qualified trusts. These regulations provide that the distribution of stock from a qualified trust under IRC section 401(a) itself does not result in an owner shift for purposes of IRC section 382. These rules are effective immediately and may be applied retroactively.

Under IRC section 382, the amount of taxable income that can be offset by certain loss carryovers and recognized built-in losses after an "ownership change" of a loss corporation is limited. Very generally, an "ownership change" occurs if the ownership of stock of 5-percent shareholders increases by more than 50 percentage points by value over a three-year period ending on a testing date.

The Treasury regulations under IRC section 382 contain detailed rules for determining stock ownership. As a general rule, stock owned by a trust is treated as owned by the beneficiaries of the trust (and not by the trust). Treas. Reg. section 1.382-2T(h)(2)(i). Consistently, a beneficiary of a trust does not increase his ownership of stock when the trust distributes his share of stock owned by the trust, because that stock is already treated as owned by the beneficiary.

There is an exception to the general rule that applies to a qualified trust under IRC section 401(a) (very generally, an employee benefit trust). Treas. Reg. section 1.382-2T(h)(2)(iii). Stock owned by a qualified trust is treated as owned by the trust and not by the beneficiaries of the qualified trust. Consistently, absent the new regulations, a beneficiary of the qualified trust increases his ownership of stock when the qualified trust distributes his share of stock owned by the qualified trust, because that stock was not treated as owned by the beneficiary.

The Treasury and the IRS issued these regulations to change the exception to the general rule. The temporary regulations provide, in effect, that a beneficiary steps into the shoes of the qualified trust when he receives a distribution from a qualified trust. The beneficiary is treated as if he acquired the stock on the same day and in the same manner as the qualified trust. Thus, if the qualified trust acquired the stock on a day before the beginning of the testing period, then the beneficiary is treated as if he acquired the stock on the same day before the beginning of the testing period. Similarly, if the qualified trust acquired the stock during the testing period, the beneficiary is treated as if he acquired the stock on the same day during the testing period. Consistent with the step-into-the-shoes treatment, the day of the distribution to the beneficiary is not treated as a testing date.

In general, a loss corporation may use a specific identification or first-in, first-out method to determine which stock of the loss corporation has been distributed by a qualified trust. The loss corporation, however, must apply the same method to all dispositions by the qualified trust.

The temporary regulations apply to all distributions from qualified trusts after June 27, 2003. A loss corporation may choose to apply the new rules retroactively to all distributions from qualified trusts on or before June 27, 2003, and within a testing period that includes June 27, 2003. Alternatively, a loss corporation may choose to apply the new rules retroactively to all distributions from qualified trusts after December 31, 1986.

In the preamble to the regulations, Treasury and the IRS note that retroactive application will affect a taxpayer's items of income, gain, deduction, or loss only in open years. T.D. 9063 and REG-108676-03.

Internal Revenue Service

Will the sale of stock of a widely held, publicly owned company by a qualified trust or a mutual fund result in a change in ownership under IRC section 382?

Parent is a loss corporation and common parent of an affiliated group filing consolidated returns. Parent is currently under the jurisdiction of a court in a Title 11 case. The Parent consolidated return group has generated substantial net operating losses.

Trust is a qualified trust under IRC section 401(a) and first acquired Parent stock more than three years ago. The maximum amount of Parent stock held by Trust was b percent (at least 5 percent) by value of the total outstanding Parent stock. On Date 1, the trustee of Trust determined that holding Parent stock was inconsistent with its duties under ERISA and directed that all Parent stock held by Trust be sold. On Date 2, Trust sold some, but not all, of the Parent stock that it held. Sales of Parent stock by Trust on Date 2 caused a reduction in Trust’s ownership in Parent stock to d percent (less than 5 percent, but greater than 0 percent). Trust has not owned 5 percent or more of Parent stock since Date 2.

Fund is a mutual fund and held e percent (at least 5 percent) of Parent stock by value during the past three years. During this time, no owner of an interest in Fund owned, directly or indirectly, 5 percent or more of Parent stock. Fund sold some of its shares of Parent stock on Date 3 causing a reduction in Fund’s ownership interest in Parent stock to f percent (less than 5 percent, but greater than 0 percent). Fund has not owned 5 percent or more of Parent stock since Date 3.

The Service ruled that Trust and Fund are 5 percent shareholders under Treas. Reg. section 1.382-2T(g)(1)(i) and that Date 2 and Date 3 are testing dates under Treas. Reg. section 1.382- 2(a)(4)(i). The Service held that for purposes of Treas. Reg. section 1.382-2T, Parent may presume, for each testing date that has a testing period including Date 2, that Trust owned d percent of Parent stock, provided Trust continues to own less than 5 percent of Parent stock. Likewise, Parent may presume, for each testing date that has a testing period including Date 3, that Fund owned f percent of Parent stock, provided the Fund continues to own less than 5 percent of the stock. Treas. Reg. section 1.382-2T(g)(5)(i)(B). In other words, Parent will not be required to take into account subsequent dispositions of Parent stock by Trust and Fund in its IRC section 382 owner shift calculations.

Finally, the Service ruled that, solely for purposes of any subsequent acquisition of Parent stock described in Treas. Reg. section 1.382-2T(j)(2)(vi), d percent of Parent stock related to Trust shall be treated as owned by a separate public group, and f percent of Parent stock related to Fund shall be treated as owned by a separate public group under Treas. Reg. section 1.382-2T(g)(5)(i)