October/November 2004

Tax Cases Alan Barton Taxation Section Editor KPMG LLP Houston, TX abarton@kpmg.com .

Tax Court

When does a bankruptcy estate terminate for purposes of IRC Section 1398? Can a debtor utilize net operating losses, which were carried over to and not utilized by his bankruptcy estate, to his post-commencement tax years ending before the tax year that includes the termination of his bankruptcy estate?

On February 23, 1995, Debtor and four related entities filed voluntary Chapter 11 bankruptcy petitions. An additional petition for a fifth related entity was subsequently filed in 1996, and all six cases were administered as a related group. As of the date of each petition, each entity’s assets became the assets of its respective bankruptcy estate. Pursuant to Internal Revenue Code (“IRC”) Section 1398(d)(2)(D), Debtor elected to terminate his tax year as of February 22, 1995. Debtor filed a return with respect to the short tax year ended February 22, 1995, and filed a separate return with respect to the short tax year beginning February 23, 1995 and ending December 31, 1995.

Debtor served as debtor-in-possession of the various bankruptcy estates. A second amended plan of reorganization, dated August 18, 1997, was to be effective for Debtor and his related bankruptcy estates effective August 31, 1997. The plan provided that the majority of the assets of the bankruptcy estates would be transferred into a liquidating trust administered for benefit of the creditors on August 31. The trustee would be responsible for all tax matters related to the estates, subject to oversight, and the creditors agreed in the plan that all remaining tax attributes would go to Debtor upon confirmation of the plan.

On September 1, 1997, Debtor was discharged from any debt that arose before confirmation, pursuant to Section 1141(d) of the Bankruptcy Code, and he was relieved of his debtor-in-possession status. On his 1997 Federal income tax return, Debtor claimed $84 million in net operating losses (“NOLs”) that arose before the commencement of his bankruptcy, which were not otherwise used by his bankruptcy estate, and which he said he received from the estate on August 31, 1997. During April 1999, Debtor amended his 1995 short year and 1996 calendar year individual returns utilizing certain of the NOLs originally reported on his 1997 return.
The Internal Revenue Service (“IRS” or “Service”) determined a federal income tax deficiency with respect to Debtor’s 1995, 1996 and 1997 individual income tax returns. Debtor challenged the deficiencies in Tax Court and the Service responded with a motion for partial summary judgment. The salient issues related to the point in time at which Debtor succeeded to the unused tax attributes of the bankruptcy estate, and whether such unused NOLs received by Debtor from the bankruptcy estate could be utilized in his 1995, 1996 and 1997 tax years.

Termination of the Bankruptcy Estate
Pursuant to IRC Section 1398(i), a debtor succeeds to unused tax attributes upon the “termination of an estate.” Debtor contended that, in the context of his bankruptcy filing, the estate terminated at the time the plan of reorganization was confirmed and Debtor was discharged, i.e., on August 31, 1997. The Service asserted that the bankruptcy estate did not terminate until the bankruptcy proceedings were formally closed, which at the time, had not yet occurred.

The Court found that the phrase “termination of an estate” was not defined by the Internal Revenue Code or underlying regulations, and could plausibly encompass either interpretation advanced by Debtor or the Service. Section 350(a) of the Bankruptcy Code specifically provides for the closing of a bankruptcy proceeding “after an estate is fully administered and the court has discharged the trustee.” The Court, citing S.S. Retail Stores v. Ekstrom, 216 F.3d 882, 884 (9th Cir. 2000), In re Duplan Corp., 212 F.3d 144, 148 (2d Cir. 2000), and Duebler v. Sherneth Corp., 160 F.2d 472, 474 (2d Cir. 1947), found that bankruptcy courts had regularly defined “closing of an estate” as the time a final decree was entered, closing the case.

The Court also found several instances where the phrase “termination of an estate” had been interpreted and defined as occurring upon confirmation of the plan of reorganization. See, In re Westhold Manufacturing, Inc., 20 Bankr. 368 (1982), affd. sub nom. United States v. Redmond, 36 Bankr. 932 (D. Kan. 1984), General Electric Credit Corp. v. Nardulli & Sons, Inc., 836 F.2d 184, 190 (3d Cir. 1988), and In re Greenly Energy Holdings, Inc., 110 Bankr. 173 (Bankr. E. D. Pa. 1990).

The Court, noting that Westhold, General Electric Credit Corp., and Greenly Energy were all Chapter 11 bankruptcy cases, recognized that Chapter 11 proceedings are intended to rehabilitate the debtor and that the phrase “termination of the estate” could have a different meaning with respect to a Chapter 7 liquidation. The Court, citing Holywell Corp. v. Smith, 503 U.S. 47 (1992), found that a liquidating trust is an entity separate from the bankruptcy estate and once a plan vesting an estate’s assets in a liquidating trust is confirmed, the estate is generally not required to report or pay tax on gains derived from disposition of those assets. Because of this, the Court noted, the post-confirmation estate lacks the potential to incur tax or utilize tax losses.

With respect to the issue of when Debtor’s bankruptcy estate terminated, the Court held that, based on the particular circumstances in this case, termination occurred at the time of confirmation of the plan of reorganization. The Court expressed no intent to create a “bright-line” test for determining when any other Chapter 11 bankruptcy would terminate.

In reconciling its holding with Section 346(i)(2) of the Bankruptcy Code, the Court, citing Firsdon v. United States, 95 F.3d 444, 446 (6th Cir. 1996), In re McGowan, 95 Bankr. 104 (Bankr. N. D. Iowa 1988), and In re A.J. Lane & Co., 121 Bankr. 346 (N.D. Iowa 1990), affd. 930 F.2d 6 (8th Cir. 1991), held that the concept of closing an estate as used in Section 346 of the Bankruptcy Code, was not identical to the phrase “termination of an estate” as used in IRC Section 1398, primarily as a result of language contained in Section 346(a) subjecting subsections (b) through (e) and (g) through (j) to the Internal Revenue Code of 1986. The Court also felt that Congress’ use of the term “termination” in the enactment of IRC Section 1398 following the use of the term “closed” in the enactment of Section 346 of the Bankruptcy Code two years earlier was not merely a coincidence, and that a distinction could be drawn from the difference.

Debtor’s Utilization of NOLs
With respect to the second issue regarding the utilization of NOLs by Debtor, the Service asserted that Debtor is entitled to carry forward qualified NOLs only to years occurring after the bankruptcy termination. Debtor, in turn, argued that, not only could he apply losses of the bankruptcy estate he succeeded to at confirmation to any year after the termination of the bankruptcy, but that he could apply such losses to his own separate tax years which followed the commencement of the bankruptcy.

Because the debtor continues as a separate taxable entity during the pendency of the bankruptcy, the Court determined the ultimate question to be whether the estate is treated as the sole taxpayer for purposes of applying NOLs in years which occur during the bankruptcy proceeding. IRC Section 1398(j)(2)(B) limits a debtor’s ability to use NOLs inherited as a result of the termination of the estate by providing that “the debtor may not carry back to a taxable year before the debtor’s taxable year in which the case commences any carry-back from a taxable year ending after the case commences.” Because it includes the word “any,” the Court held that the language at IRC Section 1398(j)(2)(B) would be inclusive of an estate’s NOLs succeeded to by a debtor, and only carrybacks to pre-commencement years are prohibited.

The Court found that IRC Section 1398 creates, in effect, two separate but parallel taxpayers during the pendency of the bankruptcy and recombines their attributes into one upon the estate’s termination. The Court also found that the language of the statute does not expressly prohibit carryovers to post-commencement years, including those years the bankruptcy was pending. Following this reasoning, the Court determined that IRC Section 1398 does nothing to prohibit the application of unutilized pre-commencement and estate NOLs to the Debtor’s nonbankruptcy income realized while the bankruptcy was pending.

IRC Section 1398(g)(1) refers to the application of IRC Section 172 with respect to NOLs inherited from the terminated estate. Accordingly, the Court looked to Section 172 to determine the allowable carryover and carryback periods for such losses, as well as the order in which they are used and/or expire. The Court found no specific prohibition to the use of inherited NOLs in the postcommencement years of Debtor.

Finally, the Court distinguished the treatment of unused loss carryovers by beneficiaries of a trust or non-bankruptcy estate under IRC Section 642(h). The Court noted that, while a beneficiary may only carry forward a trust’s unused losses beginning with the year of termination for purposes of IRC Section 642(h), the situations are not necessarily analogous because a trust and its beneficiary always remain two separate taxpayers, rather than parallel portions of the same taxpayer as the Court reasoned is the case with a debtor and his estate. Accordingly, the Court held that Debtor was entitled to carry forward losses inherited from the bankruptcy estate, as well as any remaining pre-commencement losses, and may be applied, in accordance with IRC Section 172, to his tax year which included the commencement of the bankruptcy and later years. Oren L. Benton v. Commissioner, 122 T.C. 353 (May 12, 2004).

10th Circuit Court of Appeals

Is a debt arising from transferee liability for unpaid income tax owed by the transferring corporation discharged by the transferee’s bankruptcy?

Debtor was the sole shareholder of New Century Corporation. During 1987, New Century began to be dismantled and its assets were transferred to Debtor. In January 1995, Debtor filed a voluntary petition for Chapter 7 bankruptcy, and in May 1995, an order of discharge was entered.

The Internal Revenue Service (“IRS” or “Service”) audited Debtor’s 1992 personal income tax return in November 1996. During the course of this examination, the IRS learned that no corporate tax return for New Century had been filed with respect to 1987. Debtor responded by filing an amended return for New Century on April 2, 1998.

Upon review of New Century’s 1987 amended tax return, the IRS concluded that corporate taxes were owed. The IRS also concluded the 1987 asset transfer subjected Debtor to transferee liability, pursuant to Internal Revenue Code (“IRC”) Section 6901(a), in the amount of $481,180, plus penalties and interest. Debtor moved to reopen his bankruptcy case to determine whether the transferee liability was discharged. The IRS responded by moving for summary judgment.

The bankruptcy court denied the Service’s motion for summary judgment, and found that Debtor’s transferee liability for New Century’s 1987 taxes constituted an unsecured debt. The bankruptcy court held that the transferee liability was discharged in bankruptcy. The IRS appealed to district court, which found that IRC Section 6901(a) required the debt be treated as a tax for purposes of determining exception from bankruptcy discharge. Accordingly, the district court reversed the bankruptcy court, concluding Debtor’s transferee liability was not discharged in the 1995 bankruptcy proceeding. Debtor appealed the district court’s order.

The 10th Circuit Court of Appeals found that, despite the purpose of a voluntary bankruptcy discharge being a fresh start for the debtor, Congress intended certain debts should be excepted from this policy, including “a tax that is on or measured by income or gross receipts, which is assessable after commencement of the bankruptcy case” pursuant to Sections 523(a)(1)(A) and 507(a)(8)(A)(iii) of the Bankruptcy Code.

In addition, the Court noted that IRC Section 6901(a) provides that a person who receives property from a taxpayer who owes income taxes may be liable for the transferor’s tax debt, and the Service may collect this liability from the transferee in the same manner, and subject to the same provisions and limitations, as it would for the taxes with respect to which the liabilities were incurred.

The Court, citing United States v. State of Colorado, 990 F.2d 1565, 1575 (10th Cir. 1993), held that “when Congress has enacted two statutes which appear to conflict, we must attempt to construe their provisions harmoniously.” Because Debtor’s transferee liability was derived from a tax on income which was owed by New Century, the Court found that it was exempt from discharge in bankruptcy and, accordingly, was not discharged in Debtor’s prior bankruptcy proceeding.

The Court recognized that the Bankruptcy Court relied on Pert v. United States, 201 B.R. 316 (Bankr. M.D. Fla. 1996), in determining that Debtor’s transferee liability was discharged during the bankruptcy proceeding, but found that the rationale of Hamar v. Commissioner, 42 T.C. 867 (1964), was more persuasive.

The Pert court held that, where a debtor’s transferee liability arose from her receipt of assets from her deceased husband’s estate which had unpaid taxes assessed against it, the liability was not a tax but rather a general unsecured claim, because the government also assessed taxes against the joint return the debtor filed with her deceased husband. The Pert court noted that allowing the transferee liability to be characterized as a tax in this case would allow the government “two bites at the nondischargeability apple.”

The Hamar court rejected the argument that transferee liability was discharged by bankruptcy, stating that “the government is seeking to collect what is primarily a tax and continues to be a tax although, because of the inability to collect from the taxpayer proper, it seeks to require his transferee to pay.” The Court found Hamar to be the compelling approach where the government was not attempting to impose a dual tax liability, as was the case in Pert.

Ultimately, the Court found that the Bankruptcy Code’s specific exemption of income tax debts from discharge reflected Congressional intent, and that IRC Section 6901 provided the mechanism with which to carry out this intent. Accordingly, the Court held that ignoring IRC Section 6901 and discharging Debtor’s transferee liability would override specific policy judgments made by Congress, and affirmed the decision of the District Court. McKowen v. IRS, 370 F.3d 1023 (10th Cir. June 1, 2004).

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