CHAPTER ELEVEN

Tax Priorities and Discharge

§ 11.1 Introduction

§ 11.2 Priorities

(a) General Provisions

(b) Administration Expenses

(i) Interest and Penalties on Administrative Tax Claims

(ii) Bifurcation of Corporate Taxes

(c) “Involuntary Gap” Claims

(d) Prepetition Wages

(e) Prepetition Tax Priority

(i) Income and Gross Receipts Taxes

(A) Three-Year Period

(B) Assessed within 240 Days

(C) Tax Is Assessable

(ii) Property Taxes

(iii) Withholding Taxes

(iv) Employer’s Taxes

(v) Excise Taxes

(vi) Customs Duties

(f) 100 Percent (Withholding Tax) Penalty

(i) Responsible Person

(A) Willfulness

(ii) IRS Procedure

(iii) Designation of Payments

(iv) Enforcement of Liability against Officers

(g) Tax Penalty

(h) Interest

(i) Postpetition Interest on Secured Tax Claims

(i) Accruing Interest Expense

(j) Interest Receivable

(k) Interest Paid by Guarantor

(l) Erroneous Refunds or Credits

(m) Chapter 11 Reorganization

(n) Dismissal of Bankruptcy Petition

(o) Chapter 12 and Chapter 13 Adjustments

(p) Impact of Plan on Tax Liability

(q) Taxes on Liquidation Sales

§ 11.3 Tax Discharge

(a) Introduction

(b) Individual Debtors

(i) Failure to File Tax Returns

(ii) Delinquent Returns

(iii) Fraudulent Returns or Attempts to Evade or Defeat the Tax

(iv) Penalties

(v) Failure to File Proof of Claim

(vi) Impact of Discharge

(vii) Chapter 13

(viii) Chapter 11 Cases Filed by Individuals

(A) Property Acquired Postpetition Including Earnings

(B) Future Earnings in Plan

(C) Plan Confirmation

(D) Domestic Support Obligations

(E) Discharge of Debts

(F) Plan Modification

(ix) Postpetition, Preconfirmation Interest

(c) Corporate Debtors

§ 11.1 INTRODUCTION

Tax priorities are important in chapter 7 cases because they determine the order in which unencumbered assets are distributed. For individuals, taxes with priority that are not paid cannot be discharged. Priority of taxes is also significant in chapter 11 cases, because debts with priority must be provided for in full, unless the holder of the claim agrees to different treatment, before the bankruptcy court will confirm a plan. A tax discharge may depend on the extent to which a given tax is a priority tax, whether the taxpayer is a corporation or an individual.

§ 11.2 PRIORITIES

(a) General Provisions

Normally, secured debts are first satisfied and then unsecured debts are paid in the order of priority specified in section 507 of the Bankruptcy Code. The unsecured debts, in their prescribed order, are:

The dollar amounts in the priorities described above are changed every three years based on the Consumer Price Index for All Urban Consumers. The dollar values shown are effective through March 31, 2013.

(b) Administration Expenses

Second priority among unsecured debts is given to administrative expenses. Included in these expenses is any tax incurred during the administration of the estate while bankruptcy proceedings are in progress (section 503(b) of the Bankruptcy Code). Examples of taxes that would qualify for second priority are income tax liabilities, employees’ withholding taxes and the employer’s share of employment taxes, tax penalties, interest on unpaid taxes, property taxes, excise taxes, recapture of investment tax credit arising from property sales, and claims arising from excessive allowance of “quickie” refunds to the estate (such as tentative net operating loss carrybacks allowed under Internal Revenue Code (I.R.C) section 6411).1 The taxable year to which the carryback adjustment relates may be one that ends either before or after the commencement of the case.2

A tax claim shares and shares proportionally with other administrative expenses. The bankruptcy court refused to subordinate a tax claim incurred during the proceeding to that of other costs of administering the debtors’ case and ordered that all of the administrative claims be paid pro rata.3

The bankruptcy court noted that there was no basis for subordinating the IRS’s claims, pointing out that the estate had admitted its liability for the federal income taxes and had not alleged any misconduct on the part of the IRS. The court noted that the doctrine of equitable subordination developed as a policy against fraud and the breach of duties imposed on a fiduciary of the bankrupt, not a creditor,4 and that this doctrine has been codified in section 510(c) of the Bankruptcy Code. Equitable subordination is an unusual remedy and should be applied only in limited circumstances.5

The court also noted that there is no authority for the equitable subordination of interest on a tax claim. According to the court, interest is an integral part of the tax claim representing actual pecuniary loss to the government, and thus cannot be subordinated.6 Dealing with penalties, the court noted that cases that have permitted the equitable subordination of penalties have done so because claims such as penalties were of a “status susceptible to subordination.”7 The court noted that abandoning the property most likely would have permitted the United States to obtain the same cash received by the trustee while at the same time pursuing the unpaid liability, because the tax liability would not have been dischargeable under sections 507(a)(8) and 523 of the Bankruptcy Code.

Taxes on postpetition payment of prepetition wages would not be a second priority (see §§ 11.2(e)(iii) and 11.2(e)(iv)). Income taxes due for taxable years ending after the petition is filed are administrative expenses. Section 503(b)(1)(C) of the Bankruptcy Code provides that any fine or penalty or reduction in credit relating to a tax classified as an administrative expense is also given second priority. The Fourth Circuit held that the taxes withheld from employees’ wages earned after the chapter 11 petition was filed, the employer’s share of the Federal Insurance Contributions Act (FICA) taxes, penalties for failure to pay the taxes on time, and interest from the date taxes accrued are all second-priority items.8 The taxes, penalty, and interest retain second-priority status even when a chapter 11 petition is subsequently converted to a chapter 7 petition. Excise taxes under I.R.C. sections 4971(a) and (b) that are based on funding deficiencies for prepetition plan years were held by the bankruptcy court9 not to be an administrative expense but an eighth priority. Because the events on which the taxes are based were prepetition, the taxes cannot be administrative expenses.

In determining the dischargeability of a tax during the prepetition period, the bankruptcy court found the prepetition tax to be an eighth priority that was not discharged.10

The Second Circuit court held that a trustee is responsible for making estimated corporate tax payments when such payments are required under I.R.C. section 6154.11

In In re Higgins,12 the court held that a recapture of investment tax credit on the sale of an asset in a chapter 7 case was not a tax incurred by the estate because the tax did not relate to the estate’s use of the property. This decision is questionable in that the tax is not due until the property is sold. The decision to sell the property was made by the trustee. In chapter 7 liquidations, a tax refund that is received after the petition is filed is considered property of the estate. Thus, it does not seem logical to claim that the tax, if owed, is to be paid by the individual, but if a refund exists, it is property of the estate.

A different decision was reached regarding a capital gain tax in In re Lambdin.13 The court held that a capital gain tax that incurred liquidation of the estate’s assets was an administrative expense and that the debtor would not be liable for this tax because it was an administrative expense of the estate.

The classification as to whether a tax is an administrative expense or an eighth-priority item is critical. For example, if a corporation, in an attempt to reach an out-of-court agreement with creditors, sells assets to make partial payments to creditors at a gain, a substantial tax liability may arise. Assume the corporation concludes that it cannot reach an out-of-court agreement and that it must file a bankruptcy petition. When should the petition be filed? Would it be best for the tax liability to be an administrative expense or an eighth-priority item? If it is an administrative expense, the tax must be paid on or before the effective date of the plan, and interest and penalties will be paid on the tax. If it is an eighth-priority item, it may be deferred up to five years from the petition date (see § 11.2(m)), and interest and penalties will most likely not occur during the case. In this case, it would be best to file the petition after the end of the taxable year in which the property was transferred. It should be noted that at least three circuits allow a corporation to bifurcate the taxes between pre- and postfiling. Taxes based on income incurred prior to filing prepetition claims and taxes based on income after the filing are administrative expenses (see § 11.2(b)(ii)). However, if this were an individual with no free assets, it may be better for the petition to be filed before any of the property is transferred and a tax liability is created (see § 4.3(h)).

A nonoperating chapter 7 trustee had no duty to pay postpetition income taxes or accrued postpetition interest on the unpaid taxes before the bankruptcy court approved the administrative claims.14 The district court noted that the trustee would have violated his Bankruptcy Code duties had he paid the taxes without bankruptcy court approval at the time he filed the 1989 return. The court explained that a nonoperating trustee’s duty to remit a tax arises when the bankruptcy court so orders.

The Sixth Circuit Bankruptcy Appellate Panel (BAP) affirmed a bankruptcy court decision by holding that section 726 of the Bankruptcy Code does not mandate disgorgement of interim compensation paid to professionals in every case of administrative insolvency.15

A U.S. bankruptcy court has held that postpetition property taxes, even though secured, are entitled to priority as an administrative expense because a postpetition real estate tax on property used by the estate is an actual, necessary cost of preserving the estate and hence an administrative expense. The trustee must exhaust unencumbered estate funds before looking to tax liens for payment of administrative expenses.16 The bankruptcy court noted that the most recently secured tax liens should be the first to be subordinated to administrative expenses. The bankruptcy court also determined that the significant event in determining if a tax is prepetition or an administrative expense is the date the tax accrues and becomes a fixed obligation.

The Sixth Circuit held that liability for payment of real property taxes did not occur until after the petition was filed, resulting in the liability for payment of taxes as an administrative expense. The Sixth Circuit determined that the taxes were incurred by the estate because no in person right to payment of the taxes existed until the taxes were actually levied after the petition was filed. Although the value and the taxability of the real property was determined prepetition, such determination merely vested in the city an in rem interest in the property, and the taxes thus were not assessed prepetition.17 In a legal memorandum,18 the IRS concluded that claims for postpetition taxes in chapter 13 bankruptcy cases should not be filed as administrative expense claims. A debtor filed a motion to modify his chapter 13 plan to add a postpetition liability for federal income taxes that are payable postpetition. The insolvency specialist agreed to allow the debtor to pay the liability through the plan and filed an administrative claim.

The IRS concluded that because postpetition tax liabilities are, in chapter 13 cases, incurred by the debtor rather than the bankruptcy estate, characterizing the liabilities as administrative expenses is inconsistent with section 503 of the bankruptcy code. The liability, according to the legal memorandum, should be collected either by filing a claim under section 1305 of the bankruptcy code or by pursuing collection outside of bankruptcy.

(i) Interest and Penalties on Administrative Tax Claims

Section 503(b) of the Bankruptcy Code provides that taxes incurred during the administration of a case and not considered an eighth priority under section 507(a)(8) of the Bankruptcy Code are administrative expenses entitled to second priority.

The bankruptcy court noted that there are three requirements that must be satisfied before penalties will be allowed as an administrative expense:19

The bankruptcy court, then, concluded that a penalty arising from the debtors’ failure to comply with IRS electronic fund transfer deposit requirements of Revenue Procedure (Rev. Proc.) 97-33 was considered an administrative expense under section 503(b)(1)(C).

A question has arisen as to whether interest on these tax claims should be allowed. In In re Flo-Lizer,20 the district court held that the government is entitled to interest on taxes and penalties as an administrative expense under section 503(b). The court noted that the wording of the statute is ambiguous on the status of interest because, although it does not specifically address interest, the list of allowable claims under the statute is not exhaustive. The court also noted that the statute’s legislative history is inconclusive and thus relied on the interpretation of the predecessor statute, under which interest was allowed as an administrative expense.

The Eleventh Circuit looked at the same issue.21 Allied Mechanical Services, Inc., filed a petition and, while operating under chapter 11, incurred withholding tax liabilities. After the chapter 11 was converted to a chapter 7 liquidation, the IRS filed an administrative claim totaling approximately $265,000 for postpetition withholding taxes, penalties, and interest. Three other circuits have concluded that section 503(b)(1)(B)(i) includes interest on postpetition taxes.22 Most of the cases were not just chapter 7 cases but were either chapter 11 or a chapter 11 converted to chapter 7. The First Circuit, in In re Weinstein, addressed the relevance or irrelevance of section 726(a)(5) of the Bankruptcy Code, providing that interest in a chapter 7 liquidation has a number five priority, with the administrative expense provisions in section 523(b), expense incurred during the administration of the case.

Interest, as well as penalties accrued on taxes classified as administrative expenses, is allowed as administrative expense. However, in In re Pool & Varga, Inc.,23 the bankruptcy court held that the debtor’s financial distress during the bankruptcy constituted reasonable cause for failure to pay income taxes and avoidance of paying related penalties. The court ruled that the financial difficulty of the debtor was not reasonable cause to avoid the penalties for failing to file a tax return. Thus, it would appear that in order to avoid penalties in a bankruptcy case where there is not enough cash to pay taxes classified as administrative expenses, the trustee or debtor in possession should file the tax return showing the amount of tax that is due. The taxpayer may indicate on the return that the tax due is an administrative expense in a bankruptcy case and that the tax will be paid when the court authorizes the disbursement.

The bankruptcy court held that the estate is liable for interest and penalties on administrative tax claims arising during the case.24 A chapter 7 case was converted to a chapter 13 case and then converted back to chapter 7. The IRS filed claims for priority taxes and interest arising during the period before the case was converted to chapter 13; and claims for administrative taxes, penalties, and interest incurred by the estate during the periods the case proceeded under chapter 13. The trustee objected to these tax claims, arguing that they represented postpetition taxes for which the estate was not liable. The court held that the taxes that accrued prior to conversion are allowable as a priority claim under section 348(d) of the Bankruptcy Code and that the estate is liable for administrative taxes, interest, and penalties incurred while the case proceeded under chapter 13 according to section 503 of the Bankruptcy Code.

In a unanimous decision, the Supreme Court held that bankruptcy courts may not categorically subordinate the IRS’s administrative expense claim for a noncompensatory tax penalty to the administrative expense claims of other creditors.25

First Truck Lines, Inc., filed for relief under chapter 11 and was subsequently converted to a chapter 7. Thomas Noland was appointed as trustee. The liquidation of the assets of the estate raised funds insufficient to pay all creditors. After the conversion, the IRS filed claims for taxes, interest, and a failure-to-pay penalty accrued during the company’s operation as a chapter 11 debtor in possession.

The bankruptcy court, while agreeing that the penalties were administrative expenses under section 503(b) of the Bankruptcy Code, justified a preference for compensating actual loss claims and subordinated the tax penalty claim to those of general unsecured creditors. The district court and the Sixth Circuit affirmed.

The Supreme Court explained that, although section 510(c) permits a bankrupt court to make exceptions to the general priority scheme when justified by particular facts or by the misconduct of a creditor, the lower court’s general, categorical modification of priorities constituted an impermissible legislative type of decision that Congress already made in establishing the hierarchy of claims in bankruptcy. The lower court’s actions, according to the Supreme Court, were directly counter to Congress’s policy judgment that a postpetition tax penalty should receive the priority of an administrative expense.

In In re North Port Associates Inc.,26 the bankruptcy court held that a secured prepetition tax penalty cannot be equitably subordinated to the claims of general unsecured creditors. In Noland27 and CF&I,28 the Supreme Court held that noncompensatory, post- and prepetition tax penalties on unsecured claims should not be equitably subordinated. The debtor argued that secured prepetition tax penalties can be subordinated because the Bankruptcy Code does not contain an explicit category and priority for such penalties. The court disagreed with the debtor, noting that to carve out the penalty portion of a secured claim and subordinate it to a nonpriority unsecured status would be an equitably oriented, judicially imposed policy decision overriding specific congressional mandate.

The Tenth Circuit held that tax debts and interest are nondischargeable under section 1141(d)(2) of the Bankruptcy Code only when a governmental entity holds an unsecured claim and not a secured claim. The IRS neither asserted a claim for gap period interest nor objected to the debtors’ confirmed plans, which made no allowance for payment of such interest. The court concluded that postpetition, preconfirmation interest accruing on a secured IRS claim in a chapter 11 case is dischargeable. The circuit court rejected the IRS’s position that gap interest survived the dischargeability provisions of section 1141(d), which exempts from discharge debts listed in sections 523 and 507. The Tenth Circuit agreed with the reasoning of the district court that because the tax claims were secured, they did not qualify as allowed unsecured claims that were exempt from discharge under section 507(a)(8) of the Bankruptcy Code.29 Other courts30 have reached a different interpretation of this issue as discussed in § 11.3(b)(viii).

The Sixth Circuit BAP affirmed a bankruptcy court decision by holding that the IRS’s claim for I.R.C. section 4971 pension excise taxes was not a postpetition claim entitled to priority as an administrative expense.31 After the petition was converted to chapter 7, the IRS moved to have the professionals disgorge the fees they received in chapter 11 on the ground that they had received more than their pro rata share. The appellate panel concluded that pension excise taxes were penalties that did not relate to a tax incurred by the estate and thus were prepetition liabilities.

In In re Schreiber,32 the bankruptcy court ruled that, because the IRS was oversecured, it is entitled to postpetition interest from the date the petition was filed until the date the secured claim is fully paid.

(ii) Bifurcation of Corporate Taxes

Section 1399 provides that a new tax entity is not created for federal income tax purposes when the corporation files a bankruptcy petition. Thus, for federal income tax purposes, the corporation in bankruptcy will determine the income tax liability in its normal manner for the entire year. However, this unresolved issue remains: How is the tax that relates to the period before the petition was filed handled for bankruptcy purposes? For example, in a year in which the petition is filed, is the tax for the entire year an administrative expense? Or should the tax liability be bifurcated—the tax liability for the period from the beginning of the taxable year to the day before the petition was filed and the tax liability for the period after the petition was filed until year-end? The tax liability for the period ending just before the petition was filed would be an eighth priority tax claim and, in a chapter 11 case, could be deferred over a period of six years from the date the tax was assessed. In contrast, the tax liability for the period after the petition is filed would be an administrative expense and thus must be paid during the administration of the case. The IRS’s position is that the entire tax liability for a year ending after the petition is filed is an administrative expense.

The Eleventh Circuit, in In re Hillsborough Holdings Corp.,33 Ninth Circuit, in In re Pacific-Atlantic Trading Co.,34 and the Eighth Circuit, in In re L.J. O’Neill Shoe Co.,35 held that the tax should be bifurcated between the prepetition and postpetition periods for the purpose of determining the priority of the tax liabilities. These courts focused on the language in section 507(a)(8)(A)(iii) describing taxes that were “not assessed before, but assessable under applicable law or by agreement, after the commencement of the case.” All three courts concluded that this language includes 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 closes; however, they realized that a literal interpretation of this phrase would also imply that postpetition taxes also fall under this section. These circuits, based on legislative history and analysis, agree that section 507(a)(8) was only intended to deal with prepetition taxes. Thus, taxes based on income earned during the prepetition period are eighth priority.

(c) “Involuntary Gap” Claims

Creditors whose claims arise in the ordinary course of the debtor’s business or financial affairs after any involuntary case is commenced, but before a trustee is appointed or the order for relief is entered by the court, are granted third priority. Thus, any taxes arising during this period would receive third priority.

(d) Prepetition Wages

Claims for wages up to $11,725 (for petitions filed before April 1, 2013) per employee earned within 180 days before the filing of the petition receive third priority. Any taxes withheld on these wages would receive the same priority according to Bankruptcy Code section 346(f). Thus, withholding taxes on wages earned prior to the 180-day period and on wages earned by individuals in excess of the $11,725 limit would not receive any priority. These claims would be classified with other general unsecured claims. Claims that fall within the 180-day period and the $11,725 limit would receive third priority. Note that this provision applies only to prepetition wages that were not paid. Wages that are received in the form of a check in a tax year and are then returned the following year as unpaid due to the filing of a chapter 11 petition were held by the IRS36 to not be income to the taxpayer. A check is treated as a conditional payment of cash—the check must be honored and paid by the bank on which it is drawn. In this case, because the checks were returned, payment was not received.

(e) Prepetition Tax Priority

Certain taxes are granted eighth priority. The Bankruptcy Code continues the policy of requiring the creditors of a bankrupt to pay the taxes owed by the debtor, because the payment of taxes reduces the amount that general unsecured creditors would otherwise receive. The Bankruptcy Code makes some modifications in the taxes that are granted priority status, and it attempts to solve some of the unresolved questions of the prior law. For a claim to receive an eighth priority, it must be a tax claim owed to the federal government or to a state or local taxing authority. The courts have ruled that an obligation to the Pension Benefit Guaranty Corporation (PBGC) is not a tax even though 29 U.S.C. section 1368(c)(2) provides that an Employee Retirement Income Security Act (ERISA) lien for employer liability is created and treated under I.R.C. section 6323 like a tax lien. Even though the PBGC claim is treated as a tax lien, “Section 1368 does not state that the underlying ERISA liability is a tax liability.”36 Often these obligations have not been perfected at the time the petition is filed and as such are unsecured claims, because they are not an eighth-priority unsecured tax claim.37

In a chapter 13 case, the bankruptcy court held that prepetition child support obligation assigned to the IRS under section 6305 is entitled to priority as if it was a tax under section 507(a)(8) of the Bankruptcy Code.38 The court noted that I.R.C. section 6305 states that the obligation is to be treated as if it were a tax under Subtitle C, and it may therefore be treated as if it were a tax under Bankruptcy Code sections 507(a)(8)(C) and (D).

The bankruptcy court, in In re Distiller’s Pride Corp.,39 has held that claims of the Bureau of Alcohol, Tobacco, and Firearms for excise taxes, interest, and penalties are allowed as priority taxes. The court ruled that the fact that the taxing authority knew of the taxpayer’s unlawful conduct but failed to notify it of such conduct did not change the nature of the tax liability.

If there are not enough funds in the estate to pay all tax claims, then the amount available is distributed on a pro rata basis. In In re Sylvania Corp.,40 a chapter 7 case, the District of Columbia (the District) filed a priority claim for unpaid sales taxes of about $133,000 and the IRS filed a priority claim for $16,500 in unpaid federal taxes when only about $21,000 was available for distribution to priority claims. The District argued that it had priority over the IRS under section 724(b) of the Bankruptcy Code because it held a senior lien under District law, but the federal government argued that it was entitled to a pro rata portion of the distribution because neither the District nor the IRS had a lien. Of course, if either had their claim secured by a lien, the entity with a tax lien would have priority.41

Section 507(a)(8)(A) was modified by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (2005 Act) to provide for a stay, any time during which an offer in compromise was pending during the 240-day time period, plus 30 days.

Section 507(a)(8) was modified by the 2005 Act to provide that any time period provided for in the taxes described in subparagraph (A) through (G) in the Bankruptcy Code will be suspended during any time period in which a governmental unit is prohibited from collecting such tax under nonbankruptcy law plus 90 days and for any time period during which collection was precluded by the existence of one or more confirmed plans plus 90 days. For example, the three years provided for priority for employment, excise, or use tax will now be extended beyond the three-year period, if collection of the tax is precluded. The majority of courts (justifiably) have allowed for tolling of priority time periods during prior bankruptcies because the stay was in effect and the IRS was limited as to the type of action it could take. This provision codifies the impact of the tolling. The added time allows the IRS time to respond once the stay has been removed.

(i) Income and Gross Receipts Taxes

Section 507(a)(8)(A) of the Bankruptcy Code contains several provisions granting priority to income and gross receipts taxes. Gross receipts are not defined in the Bankruptcy Code. A sales tax under California state law is a gross receipts tax because it is levied against the seller and not the purchaser of the goods.42 The BAP for the Ninth Circuit rejected the debtor’s contention that a sales tax in California was not a gross receipts tax because section 507(a)(8)(A) says “gross receipts”; that in order to come within the statute, California’s tax must in fact be calculated based on the total receipts of a taxpayer; and that a tax on anything less than all of those receipts is not a tax on gross receipts.

In In re O.P.M. Leasing Services, Inc.,43 the bankruptcy court was asked to determine whether a claim filed by the state under the Texas franchise tax law was entitled to priority under section 507(a)(8)(A). The state statute fixed the amount of the tax due from a corporation based on the value of its capital. However, when a company also did business in other states, only that portion of the capital allocated to Texas under the statutory formula was taxed. The capital was allocated between states based on that portion of the corporation’s gross receipts generated within Texas as compared to elsewhere.

In finding that the Texas tax was not a gross receipts tax for purposes of the bankruptcy priority provisions, the court concluded:

The mere mention of gross receipts in the § 171.106 [Tex. Tax Code Ann.] formula does not automatically activate § 507(a)(8)(A) and accord the State priority status. The State, however, makes precisely such an argument, ascribing an extraordinarily broad meaning to the word “measure” to encompass the word “allocate.” This interpretation would emasculate the words of § 507(a)(8)(A), and would render the strict construction of the § 507(a)(8)(A) priority statute meaningless. The gross receipts ratio has no impact on the measurement of the tax as it relates to capital, and thus the tax in actuality is not on or measured by gross receipts.44

Citing In re Parrish,45 the bankruptcy court held that because the trustee did not comply with the requirements of Bankruptcy Rule 6004, the assets were not sold free and clear of liens.46 Thus, the tax liens remained attached to the assets and did not attach to the sale proceeds held by the trustee. Therefore, the tax claim in bankruptcy was a priority tax and not a secured claim. The debtor purchased the four assets from the trustee of his estate.

In In re Alquist,47 the district court determined that the tax on the lump sum distribution for a profit plan was a priority tax under I.R.C. section 507(a)(8)(A)(i) and, as a result, was not dischargeable. The court rejected the argument that the proceeds were not income within the meaning of income in section 507 of the Bankruptcy Code.

The Fourth Circuit, in a brief per curiam opinion, upheld a decision of the district court, holding that the tax on a lump sum distribution from a pension plan was not dischargeable under chapter 7, because the tax was a priority tax under section 507(a)(8)(A)(i) of the Bankruptcy Code and distribution was received within three years of the bankruptcy filing.48

(A) Three-Year Period

Any tax on income or gross receipts for a taxable year ending on or before the date of the filing of the petition is given eighth priority, provided the date the return was last due, including extensions, was later than three years before the petition was filed. If a bankruptcy petition is filed on May 1, 1995, any unpaid taxes due on a 1991 tax return filed on March 1, 1992, would not be a priority item. The return due date of April 15, 1993, is more than three years prior to the petition date of May 1, 1995. If the petition were filed on April 14, the taxes would be an eighth priority even though the return was filed on March 1, because the date when the return is due is used rather than the date when the return was filed. Any tax due for a taxable period that ended after the petition was filed is not granted eighth priority but would be considered an administrative expense (second priority). The date-of-the-return test of the Reform Act replaces the section 17(a)(1) requirement of the Bankruptcy Act of “legally due and owing,” which was unclear and caused debate.49

The filing date, and not a subsequent conversion date, should be used for purposes of determining the three-year lookback dischargeability period.50

An extension that was filed for a tax year in which the couple’s tax return was filed on time was held to be valid.51 The district court disagreed with the bankruptcy court and held that:

• The “lookback” period commenced on the date the tax was “last due, including extensions,” not the date the return was filed.
• The mere fact that an extension was not used did not make it void.
• Even though the extension application failed to accurately set forth the amount of taxes due, it was only the government that could determine that the automatically granted extension was ultimately void, terminated, or revoked.
• The debtors could not raise their own noncompliance with the requirements for obtaining an extension to assert that the extension was void to attempt to discharge their tax liability through bankruptcy.

Section 507(a)(8)(A)(i) of the Bankruptcy Code provides that, if an extension has been granted, the tax will not be discharged if the last extension deadline is within three years of the bankruptcy filing. In In re Wood,52 the debtor filed his tax return on October 7, 1983, where the last extension deadline was October 15, 1983. On October 10, 1986, over three years after the tax return was filed but within the three years from the last extension deadline, a chapter 7 petition was filed. The court ruled that the taxes were nondischargeable because the bankruptcy petition was filed within three years of the due date of the last extension.

A bankruptcy court held that a debtor’s 1992 taxes were not dischargeable, because although the debtor filed his return more than three years before filing for bankruptcy, the extended due date for the return was within the three-year priority period under section 507(a)(8) of the Bankruptcy Code.53 The taxpayer filed his 1992 return in July 1993 and filed his chapter 7 petition more than three years later, on August 1, 1996. The court ruled that the plain language of the statute refers to the date the return is due, including extensions.

Because the IRS is prohibited from taking action during the time that a bankruptcy case is pending, the Supreme Court54 held that the three-year lookback period is tolled during one or more bankruptcy filings. The three-year period is extended by the time that the automatic stay was in effect for prior bankruptcy case or cases.

In Henry E. Montoya v. United States,55 the bankruptcy court also held that the time during which a prior bankruptcy case that was subsequently dismissed was pending should not be considered in determining the three-year period. The IRS argued that it was prevented from pursuing its claim because of the stay that was in effect during the prior bankruptcy, and the court agreed. In this case, the tax claim was disputed under the prior filing, and a hearing was never held on the claim before the case was dismissed.

Chapter 13 petitions were filed by individual partners. The IRS subsequently filed proofs of claim for taxes assessed against the partnership. The bankruptcy court held that because the IRS under I.R.C. section 6203 had not assessed the partners individually, they had no tax liability. The district court affirmed and noted that because the three-year statute of limitations for assessment under section 6501(a) had expired, the IRS’s claim was disallowed.56

(B) Assessed within 240 Days

A second provision is that any income or gross receipts tax must be assessed within 240 days before the petition was filed, even though the due date of the return does not fall within the three-year period discussed earlier. The purpose of the 240-day provision is to give the IRS time to take more drastic measures to collect the tax.

For federal tax purposes, the assessment date is the date that an assessment officer signs the summary record of assessment.57 For example, the tax was determined to have been assessed when notice is recorded, according to the district court in Willis E. Hartman v. United States.58

In the case of an assessment resulting from a judgment, it was determined that the date of assessment was not the date that the Tax Court enters a judgment but the date that the IRS subsequently assesses the tax resulting from the judgment.59

It is important for the debtor to determine the exact date when the tax was assessed. In the case of a federal tax, the debtor may attempt to obtain a copy of Form 23-C, Assessment Certificate, or an official statement from the IRS verifying that the debtor is listed on the summary record. A general statement as to the assessment date by a representative of the taxing authority may not be adequate. The Ninth Circuit BAP held that the court had to determine when the tax was assessed. In King,60 the court ruled that the tax was not assessed less than 60 days after the issuance of the notice of the proposed additional tax. This date was within 240 days before the petition was filed and, as a result, the tax was not discharged.

The 240-day period is determined beginning on the day before the bankruptcy petition was filed and counting backward for 240 days. If the 240th day is a Saturday, Sunday, or legal holiday, then the preceding day would be used. If the assessment was made on or after that date, it is still in effect.

(1) Offer in Compromise

If during this 240 day period an offer in compromise is made, the time from when the offer is made until it is accepted, rejected, or withdrawn is not counted. Furthermore, the tax will automatically be given priority if the petition is filed within 30 days after the offer was rejected or withdrawn or if the offer in compromise is still outstanding, provided the offer in compromise was made within 240 days after the assessment. Section 108(c) of the Bankruptcy Code provides that if nonbankruptcy law fixes a period in which action may be taken against the debtor, the period will be extended until the end of such period plus 30 days. However, if a bankruptcy petition was filed during this time period, it may be extended for an additional six months, as provided under section 6503.

A question has arisen as to the timing of the offer in compromise to determine whether the period is tolled. Section 507(a)(8)(A)(ii) of the Bankruptcy Code provides, in reference to a priority tax, that a tax is a priority tax and thus is not subject to discharge if “assessed within 240 days, plus any time plus 30 days during which an offer in compromise with respect to such tax that was made within 240 days after such assessment was pending, before the filing of the petition.” In In re Aberl,61 the bankruptcy court held that the 240-day rule was tolled only by offers in compromise made within 240 days after an assessment, construing that word from the statute literally. However, in In re Cumiford,62 the district court applied the tolling provision to offers in compromise made before the assessment. The Aberl court concluded that the Cumiford decision had improperly rendered the words “after such assessment” superfluous. On appeal, the Sixth Circuit held that an offer in compromise made prior to the assessment is not impacted by the 240-day period.63

The bankruptcy court held, for purposes of the exception to discharge in section 507(a)(8)(A)(ii) of the Bankruptcy Code, that the time during which an offer was pending before the IRS did not include the time between the IRS’s receipt of the offer and the date of the taxpayer’s amendment of the offer to provide additional information necessary to make the offer valid.64

In In re Klein,65 the district court concluded that the 240-day priority period stops running when an offer is accepted for processing and starts running again when the offer is rejected, even if the taxpayer is appealing the decision of the IRS.

In In re Hobbs,66 the bankruptcy court ruled that a tax debt was dischargeable under the 240-day rule of section 507(a)(8)(A)(ii) of the Bankruptcy Code. The court rejected the IRS’s argument that an offer in compromise was still pending after the agency told the taxpayer that he would have to submit a new offer and concluded that the IRS letter terminated the offer.

In In re Callahan,67 the bankruptcy court held that I.R.C. section 507(a)(8)(A)(ii) translates into a fairly simple formula and explained the formula in its decision.

In Bilski v. Commissioner,68 the Tax Court held that the filing of a bankruptcy petition does not terminate the extension of time under Form 872-A.

(2) Impact of Bankruptcy Filing

The Sixth Circuit BAP held that the period in which the IRS must collect taxes is suspended during a debtor’s prior bankruptcy case under section 6503(h), even when the debtor had previously agreed to an extension of the deadline under section 6502(a)(2).69 The Sixth Circuit BAP explained that a bankruptcy filing can extend a deadline in two ways: (1) under 11 U.S.C. section 108(c) or (2) under applicable nonbankruptcy law. The BAP held that section 108(c) did not alter the applicable nonbankruptcy statute (section 6503(h)) in this case. The court rejected the debtor’s argument that the IRS waived the application of section 6503(h) when it failed to incorporate that section into the debtor’s initial waiver agreements.

If the petition is filed 240 days after the assessment, the tax does not have any priority unless it falls within the three-year period.

As noted, because the IRS is prohibited from taking action during the time that a bankruptcy case is pending, the Supreme Court70 held that the three-year lookback period is tolled during one or more bankruptcy filings. The three-year period is extended by the time that the automatic stay was in effect for prior bankruptcy case or cases.

(C) Tax Is Assessable

The third provision grants priority to any income or gross receipts tax that has not been assessed but that is assessable. Thus, even though a tax was due more than 3 years ago, it is still granted priority, provided the tax is assessable. Taxes that are nondischargeable under Bankruptcy Code section 523(a)(1)(B) and (C) are excluded from this provision. Examples of taxes that qualify under this provision are claims still being negotiated at the date of petition, previous years’ taxes for which the taxpayer has extended the statute of limitations period, taxes in litigation where the tax authority is prohibited from assessing the tax, or any other unassessed taxes that are still open under the statute of limitations.71

An assessment does not become effective until the issue is resolved if there is a protest before the expiration of a time period the taxpayer has to file a protest. The Ninth Circuit, in a per curiam opinion, has ruled that the California Franchise Tax Board (FTB) did not violate a bankruptcy discharge order by attempting to collect the debtor’s taxes, because the deficiencies were not assessed until after the debtor filed for bankruptcy.72

Under California law, a taxpayer has 60 days in which to file a protest against a notice of proposed assessment. If no protest is filed, the assessment becomes final at the expiration of the 60-day period. FTB sent the taxpayer a notice of proposed tax assessments for the years 1983 and 1984 on February 23, 1988. A letter of protest to the FTB was sent on April 21. The cover letter accompanying the protest referred to both tax years, but the protest itself referred only to 1984. The FTB received the protest on May 5, 1989. The taxpayer filed a chapter 7 petition and received a discharge. Subsequently, the FTB attempted to collect the 1983 and 1984 taxes, and the taxpayer filed a motion in the bankruptcy court to have the FTB held in contempt for attempting to collect the 1984 tax debt that was discharged.

The bankruptcy court denied the motion on the ground that the protest prevented the taxpayer’s assessment from becoming final and thus the tax was not discharged. The Ninth Circuit BAP reversed on the ground that the protest was not timely because the FTB did not receive it until after the 60-day period had expired. The FTB appealed. The Ninth Circuit determined that the FTB followed its internal procedures to conclude that the filing date of the protest was the date that appeared at the top of the protest letter. Because the protest was considered timely, the Ninth Circuit concluded that the assessment was not made until after the taxpayer filed for bankruptcy and that the taxes were not dischargeable.

The Ninth Circuit held in Rhode v. United States73 that extensions not signed by the I.R.S. are ineffective. The Rhode decision was distinguished from Holbrook v. United States74 and Commissioner v. Hind.75

In Rhode, the Ninth Circuit noted that Treasury Regulations (Treas. Reg.) section 301.6502(a)(2)(i) provided that the period of limitation may, prior to expiration, “be extended for any period of time agreed upon in writing by the taxpayer and the district director. The extension shall become effective upon execution of the agreement by both the taxpayer and the district director.” The court noted that the language dealing with agreement had no counterpart in prior regulations and was not considered in Holbrook or Hind. The court, as noted later, also referred to the form as suggesting that an agreement existed. Section 6487 does not state that the agreement must be made between the representative of the California State Board of Equalization (SBE) and the taxpayer, but it does refer to the “period agreed upon” and the form indicates that the SBE has accepted the item to which the taxpayer has agreed.

The district court held, in Howard v. United States,76 that a tax under section 6672 of the I.R.C. was not assessable because no one had signed a Form 2750 waiver on behalf of the IRS, even though the taxpayer did sign the form. A second extension on Form 2750 was signed by a representative of the IRS, but the court held that the second Form 2750 could not extend the limitations period because “section 6501(c)(4) of the Internal Revenue Code requires subsequent extension agreements to be executed before the previously agreed upon period expires.”

The bankruptcy court held, in In re Blake, Jr.,77 that if a debtor executes a Form 872-A (an open-ended extension of the statute of limitations on assessment) and the form is not terminated, any tax liability arising from the taxable periods covered by the extension will not be discharged, regardless of the age of the tax. In the case of a state tax, the assessibility of the tax will be determined by the applicable state law.78

A tax pending determination by the Tax Court at the date the petition is filed will be granted eighth priority. If the Tax Court has decided the issue against the taxpayer before a petition is filed and if no appeal is made, the tax will receive eighth priority even though no assessment has been made as of the petition date. The Bankruptcy Code ends the practice under prior law where once the case was resolved in Tax Court and the assessment restriction was removed, the taxpayer could file a petition before the IRS could make the assessment and thus would avoid the tax being considered as a priority claim. If, of course, the assessment is made before the petition is filed, the 240-day rule is in effect. Thus, tax claims due for petitions filed within 240 days after the assessment are eighth priority, and tax claims due where the petition is filed more than 240 days after would not receive priority unless the three-year period discussed earlier applies.

A question has arisen as to the impact of a dismissed bankruptcy case on the provisions of section 507(a)(8)(A) of the Bankruptcy Code. Does one count the time that a petition was filed and subsequently dismissed? Section 108(c) of the Bankruptcy Code provides:

Except as provided in section 524 of this title, if applicable nonbankruptcy law, an order entered in a nonbankruptcy proceeding, or an agreement fixes a period for commencing or continuing a civil action in a court other than a bankruptcy court on a claim against the debtor, or against an individual with respect to which such individual is protected under section 1201 or 1301 of this title, and such period has not expired before the date of the filing of the petition, then such period does not expire until the later of—

Courts79 have generally held that section 108(c) works to extend the time under section 507 of the Bankruptcy Code for the tax to be a priority item. The time that a debtor is in chapter 11 would not be counted. It would appear that this provision would apply to the three conditions (tax due within three years, due within 240 days after assessment is made, or still assessable) under which an income or gross receipts tax would be considered a priority item under section 507(a)(8)(A) of the Bankruptcy Code.

(ii) Property Taxes

Property taxes assessed and last payable without penalty within 1 year before the petition is filed are granted eighth priority. Note that the time period here is one year rather than the three-year period that applies to income and gross receipts tax.

(iii) Withholding Taxes

Section 507(a)(8)(C) of the Bankruptcy Code gives eighth priority to all taxes that the debtor was required to withhold and collect from others for which the debtor is liable in whatever capacity. There is no time limit on the age of these taxes. Included in this category would be withheld income taxes, state sales taxes, excise taxes, and withholdings on interest and dividend payments. Taxes withheld on wages will receive eighth priority, provided the wages were paid before the petition was filed. If not, then they will have the same priority as the wage claims. The part of the wages granted fourth priority will result in the related withholding taxes (not employer’s taxes) also being granted third priority. Taxes that relate to the wages that are classified as unsecured claims (i.e., excess over $11,725 (for petitions filed before April 1, 2013) for each employee or incurred more than 90 days before the petition was filed) will receive no priority. The eighth priority (or third, if wages have not been paid) on withholding taxes includes all taxes that have been withheld or will be withheld on wages earned prior to the petition date even though Form 941 has not been filed. Withholding taxes will be classified as an administrative expense only when they are withheld on wages earned after the petition is filed. Thus, it will often be necessary to classify part of the withholding taxes on the quarterly return as eighth priority and the other part as administrative expenses.

To properly determine the priority of withholding taxes, the financial or tax advisor must first determine when wages were paid (before or after petition date) for which withholdings were taken; if they were paid after the petition date, what is the priority of the wages? Withholding taxes on wages earned after the petition is filed are granted second priority.

Thus, withholding taxes can have second, fourth, eighth, or general creditor priority, depending on the status of the related payments. Note that the provisions discussed in this section refer only to the taxes withheld and not to the employer’s share of FICA tax.

The employee is given credit for the tax even though the taxes are not actually remitted by the employer.80 If Form 941 is past due at the time the bankruptcy petition is filed, the trustee or debtor in possession should file the return even though the prepetition withholding and employer’s taxes cannot be paid until such payment is authorized by the court or provided for in the plan.

The Supreme Court, in Harry P. Beiger, Jr.,81 ruled that taxes held in trust for a tax authority and remitted prior to the filing of the petition are not subject to recovery but, in fact, are property of the government. If the taxes have not been remitted before the petition is filed, it would appear that the debtor could petition the court to allow payment to be made before other administrative expenses are paid, because the withholdings are not an asset of the estate but property of the taxing authority.

A Ninth Circuit case and a Ninth Circuit BAP case indicate that sales taxes from the State of Washington are trust fund taxes.82 However, as noted earlier, sales taxes in the state of California are not trust fund taxes but were considered to be a gross receipts tax under section 507(a)(8)(A).83

The 20 percent backup withholding on compensation paid by an individual for the services of workers he knew lacked valid Social Security numbers and valid immigration status was allowed as a priority tax claim.84

The Eleventh Circuit, in a brief per curiam affirmance, held that an individual’s liability for unpaid trust fund taxes was not discharged in bankruptcy. The Eleventh Circuit ruled that sections 507(a)(8)(C) and 523(a)(1)(A) of the Bankruptcy Code except from discharge a debt for a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.85

In a chapter 13 case, the bankruptcy court held that a prepetition child support obligation assigned to the IRS under I.R.C. section 6305 is entitled to priority as if it were a tax under section 507(a)(8) of the Bankruptcy Code. The court noted that I.R.S. section 6305 states that the obligation is to be treated as if it were a tax under Subtitle C, and it may therefore be treated as if it were a tax under Bankruptcy Code sections 507(a)(8)(C) and (D).86 Note this case was filed before the effective date of the Bankruptcy Reform Act of 1994. The Act provides, in section 507(a)(7) of the Bankruptcy Code as amended, that unpaid child support may be a priority item.

(iv) Employer’s Taxes

An employment tax on wages, salary, or commission earned before the petition was filed receives eighth priority, provided the date the last return was due, including extensions, is within three years before the filing date. Taxes due beyond this date are considered general claims and are dischargeable. Note that this relates to the employer’s share of the tax and not the taxes withheld. Thus, as with the withholding tax, it will be necessary to determine the wages that were earned prior to the petition date because employer’s taxes on these wages have an eighth priority (see the next paragraph). Employer’s taxes on wages earned after the petition is filed are administrative expenses—second priority.

Section 507(a)(8)(D) indicates that employment taxes on wages earned from the debtor before the filing of the petition are an eighth priority, “whether or not actually paid before such date.” However, it would appear that this provision applies only to wages that are actually paid before the petition is filed. I.R.C. section 3111(a) and most, if not all, state laws provide that employment taxes arise only when the wages are paid.87

On wages not paid before the petition was filed, it was the intent of Congress to grant eighth priority only to the employer’s share of the tax due on wages that receive third priority. The employer’s tax on wages that are not granted priority would thus be a general claim, as would the wages. However, section 507(a)(8)(D) of the Bankruptcy Code does not address the issue even though it was the intent of Congress.

A problem arises as to how to handle the quarterly tax returns that should be filed by the employer, such as Form 941. Representatives for the Special Services area of the IRS have suggested that the taxpayer file two tax returns in the quarter that the bankruptcy petition is filed: one for the period prior to the filing of the petition and one for the period from the date the petition is filed to the end of the quarter. Those taxes reported on the quarterly return for the period prior to the filing of the petition would be prepetition taxes; those reported on the return for the balance of the quarter following the filing of the petition would be considered administrative expenses. This might help the IRS separate the prepetition taxes from the postpetition taxes, but it does not solve all of the identification problems. For example, if prepetition wages are paid several months (or even years) after the end of the quarter in which the petition was filed, the withholding taxes and employer’s taxes are still prepetition taxes, even though they are listed on a subsequent quarterly tax return.

Section 507(a)(8)(D) of the Bankruptcy Code allows as a priority tax “an employment tax on a wage . . . of a kind specified in paragraph (3) of this subsection [priority wage] earned from the debtor before the date of the filing of the petition . . . for which a return is last due, under applicable law or under any extension, after three years before the date of the filing of the petition.”

In Eliawira Ndosi v. State of Minnesota,88 the Eighth Circuit looked at the meaning of the phrase “earned from the debtor.” Eliawira and Barbara Ndosi were officers and controlling owners of Ndosi Enterprises, Inc., a Minnesota corporation. The company failed to pay to the state unemployment insurance contributions on wages paid to employees during 1988 and 1989. Under state law, Eliawira and Barbara Ndosi were notified that they were personally liable for over $21,000 of unpaid insurance contributions. Three months later, Eliawira and Barbara Ndosi filed a chapter 7 bankruptcy petition and subsequently filed a complaint to determine the dischargeability of personal liability for the corporation’s unemployment insurance obligations. The bankruptcy court held that the Ndosis’ personal liability was dischargeable because it did not arise from wages “earned from the debtor” within the meaning of 11 U.S.C. section 507(a)(8)(D). The district court and the Eighth Circuit affirmed the decision of the bankruptcy court.

The Eighth Circuit noted that the language of section 507(a)(8)(C) of the Bankruptcy Code supports a strict interpretation of the phrase “from the debtor,” finding that section 507(a)(8)(C) renders nondischargeable any debts for tax for which the debtor is liable in whatever capacity. According to the Eighth Circuit, Congress could have used similar language in section 507(a)(8)(D) but elected not to do so.

(v) Excise Taxes

For an excise tax to qualify as a tax priority, the transaction creating the tax must have occurred before the petition was filed. In addition, if the excise tax is of the type that requires a tax return, it may receive eighth priority if the day the return is last due (including extensions) is within three years before the petition was filed. If no return is required, the three-year limitation begins on the date the transaction occurred89 (Bankruptcy Code section 507(a)(8)(E)). This group of taxes includes sales taxes, use taxes, estate and gift taxes, gasoline taxes, and other federal, state, or local taxes defined by statute as excise taxes.

Considerable conflict exists as to whether the penalty imposed under section 4971(a) is an excise tax under section 507(a)(8)(E) of the Bankruptcy Code or a penalty. In United States v. Reorganized CF&I Fabricators of Utah, Inc.,90 the Supreme Court held that the funding-deficiency tax in section 4971(a) is not an excise tax for priority purposes under 11 U.S.C. section 507(a)(8)(E). The Court concluded that Congress had created not an excise tax but a penalty—an exaction imposed by statute as punishment for an unlawful act. The Court noted both the absence from section 4971 of the word “excise” and the established principle that characterizations in the Internal Revenue Code are not dispositive in the bankruptcy context. Thus, because of the punitive function of the section 4971 exaction, the Court held that the IRS’s claim was not entitled to priority under section 507(a)(8) of the Bankruptcy Code. The claim would not be a priority under section 507(a)(8)(G) because the penalty was not for actual pecuniary loss. The claim would be an unsecured claim and not subject to equitable subordination.

The bankruptcy court recommended that the district court grant a debtor a refund of interest paid on a section 4975 assessment for prohibited transactions involving an employee stock ownership plan (ESOP), because the section 4975 excise tax is a penalty.91 Thus, interest begins to accrue 10 days after the IRS issues notice and demand, not as of the tax periods for which the penalties are assessed. Section 4975(a) is indistinguishable from section 4971 in its purpose, legislative history, and structured levels of sanctions. The bankruptcy court noted that it is the nature of the transaction that determines the assessment, in each statute, and it is clear that both statutes exist to punish the parties initiating the transaction.

The circuit courts do not agree on whether an excise tax under I.R.C. section 4971 is a priority tax or a penalty. In In re Mansfield Tire & Rubber Co.,92 the excise tax was held to be a priority item. Mansfield asked the Supreme Court to hear the case; certiorari was denied in February 1992.

The Sixth Circuit looked at two questions:

The challenged claims stem from assessments made under I.R.C. section 4971(a) and resulting from the debtors’ failure to meet minimum funding requirements for a pension plan.

The Sixth Circuit refused to allow a federal tax that is called an excise tax to be classified any other way by the bankruptcy courts. The cases that were used by other courts to hold that the bankruptcy court can examine the nature of the tax were not federal tax claims. The court stated: “We do not hold that any exaction deemed an excise tax by a body other than Congress is entitled to the same deference. In cases of state and local exactions it may be appropriate to more closely examine the particular governmental claim to determine whether it truly is in the nature of a ‘tax’ as that term is used by Congress.”

The trustees relied on City of New York v. Feiring,93 In re Kline,94 and In re Unified Control Systems, Inc.95 The Fourth and Fifth Circuits held that excise taxes under 1954 I.R.C. section 4941 were really penalties for purposes of determining their eligibility for priority distribution under the Bankruptcy Act. The Sixth Circuit, in Mansfield, noted that those cases were wrongly decided to the extent that they held that the federal courts should look beyond the characterization of Congress to determine whether an exaction is a “tax” entitled to priority under federal bankruptcy law.

The court in Mansfield noted that reliance on Anderson and other Supreme Court decisions for the issue before us is based on misreading the holdings of those cases. Anderson, according to Sixth Circuit, concerned whether a New Jersey franchise tax was entitled to preferential treatment under section 64a of the Bankruptcy Act, which provided priority for “all taxes legally due and owing by the bankrupt to the United States, state, county, etc.” The court held that whether a debt is a “tax” within the Bankruptcy Act cannot be controlled by the label applied by a nonfederal governmental unit. The reasoning in Anderson was tied to the fact that a state-defined “tax” was at issue.

Unfortunately, the Kline court and others have cut loose the Anderson holding from its moorings by reading the Anderson decision as giving license to question every debt that is labeled a “tax,” even where the “tax” designation has been made by Congress. Similarly, in none of the other Supreme Court cases relied on by the Kline court96 did the Court indicate that Congress’s characterization of the federal exaction as a “tax” is not conclusive for purposes of bankruptcy.

The trustees also argued that, in In re Jenny Lynn Mining Co.97 and United States v. River Coal Co.,98 the Sixth Circuit looked beyond the characterization of certain payments to determine whether the payments were “taxes” for purposes of bankruptcy law. The Sixth Circuit stated: “[N]either Jenny Lynn Mining nor River Coal concerned the issue presented in this case, nor do those cases suggest that we should independently decide whether that which Congress has designated a ‘tax’ is a ‘tax’ for bankruptcy purposes.”

Excise taxes imposed on termination of a qualified pension plan are a priority tax. In In re C-T of Virginia, Inc.,99 the IRS imposed a tax under I.R.C. section 4980 for a reversion of assets following the termination of its qualified pension plan. C-T of Virginia filed a bankruptcy petition, and the unsecured creditors’ committee argued on behalf of the debtor that the I.R.C. section 4980 tax is a penalty that is not entitled to priority under section 507(a)(8)(E) of the Bankruptcy Code. The government, however, argued that the tax is an excise tax and, thus, is entitled to priority.

The bankruptcy court, in holding that the claim is not entitled to priority, noted that there were no prior court decisions on whether the I.R.C. section 4980 tax was intended for the purpose of raising revenue or any other public purpose. The court determined that legislative history suggests that the tax was intended to discourage employers from terminating overfunded retirement plans and using the excess funds for nonretirement purposes. Thus, according to the court, the tax is not a pecuniary loss penalty because it is imposed whether or not there has been any loss to the government.

However, on appeal, the district court100 held that the I.R.C. section 4980 tax had more indicia of an excise tax than a penalty.

The Fourth Circuit101 held that the premiums payable to the state’s West Virginia Workers’ Compensation Fund are excise taxes entitled to priority in bankruptcy. The Fourth Circuit court indicated that the premiums employers must pay under the workers’ compensation law are burdens imposed for a public, governmental purpose, which is to allocate the burden of the costs of injured employees and their dependents among employers rather than among the general public. The Fourth Circuit court ruled that the single-purpose nature of the workers’ compensation premiums did not render them something other than taxes.

The Ninth Circuit held that a prepetition obligation owed to the State of California for payments paid to injured employees because the debtor did not provide workers’ compensation insurance is not an excise tax. The Ninth Circuit noted that the claim was not an excise tax, regardless of the language used to describe the obligation. State terminology does not control the dischargeability of a debt.102 The First Circuit concluded that a prepetition claim for an assessment against a debtor hospital was an excise. State law requires that certain hospitals participate in a pool that funds care to indigent and unsecured patients. The unpaid prepetition assessments against a debtor hospital were classified as an excess tax with priority under section 507(a)(8)(E). The First Circuit followed the process developed by In re Lorber Indus. of California103 and In re Suburban Motor Freight104 by answering a group of questions to arrive at the decision that the claims were or were not tax claims.

(vi) Customs Duties

Section 507(a)(8)(F) of the Bankruptcy Code provides that a customs duty arising from the importation of merchandise will receive priority if (1) entered for consumption within one year before the bankruptcy petition is filed, (2) covered by an entry liquidated or reliquidated within one year before the date the petition was filed, or (3) entered for consumption within four years before the petition date, but not liquidated by that date, if the Secretary of the Treasury certifies that the duties were not liquidated due to an investigation into assessment of antidumping or countervailing duties, fraud, or lack of information to properly appraise or classify such merchandise.

(f) 100 Percent (Withholding Tax) Penalty

Businesses that are in financial trouble often delay paying employment taxes. Their intent is to submit the payments as soon as conditions improve. The problem is that conditions do not improve. Additional pressures are placed on the debtor by major creditors demanding payment. Again, the taxes withheld are not remitted. At the time the business files a bankruptcy petition, the unpaid tax withholdings are significant. At this stage, corporate officers often find out that they can be personally liable for their taxes. I.R.C. section 6672 provides:

Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. No penalty shall be imposed under section 6653 for any offense to which this section is applicable.

The amount of the penalty is equal to 100 percent of the tax that should have been withheld and remitted to the IRS. For example, in the case of employment taxes, it includes the income taxes and the employee’s share of Social Security taxes withheld. Any interest and penalties associated with these taxes are not subject to the 100 percent provision. Note that the penalty does not mean that the taxes are paid twice, but that the liability for these taxes may be transferred to responsible persons of the corporation. IRS Policy Statement P-5-60 states:

The 100-percent penalty (applicable to withheld employment taxes or collected excise taxes) will be used only as a collection device. If a corporation has willfully failed to collect or pay over employment taxes, or has willfully failed to pay over collected excise taxes, the 100-percent penalty will be asserted against responsible officers and employees of the corporation only if such taxes cannot be collected from the corporation itself. . . . When the person responsible for withholding, collecting and paying over taxes cannot otherwise be determined, the Service will look to the President, Secretary and the Treasurer of the Corporation as responsible officers.

If the responsible person subsequently files a bankruptcy petition, the I.R.C. section 6672 penalty is a priority tax claim and is not dischargeable.

For example, in Robert Allen Garrett v. Commissioner,105 the bankruptcy court, citing United States v. Sotelo,106 held that the I.R.C. section 6672 penalty is nondischargeable. In In re Smith,107 Leonard Smith’s employer failed to pay over income and FICA taxes, and the IRS assessed penalties against Smith, under I.R.C. section 6672. Smith filed a chapter 7 bankruptcy petition and asked the court to determine the liability amount and dischargeability of the debt. The bankruptcy court dismissed the complaint without prejudice, explaining that I.R.C. section 6672 taxes are not dischargeable in bankruptcy pursuant to United States v. Sotelo108 and Smith v. United States.109

In In re Dewberry,110 Dewberry filed a complaint in district court when an I.R.C. section 6672 assessment was converted to the bankruptcy court after Dewberry filed a bankruptcy petition. Dewberry argued that proper notice and demand had not been sent, that the assessment was made outside the statute of limitations and that the IRS did not follow its own internal procedural requirements.

The court, noting the government’s admission that notice and demand had not been sent to Dewberry’s last known address and that proper notice and demand probably had not been made until January 1990, granted Dewberry’s motion insofar as it requested a partial abatement of interest.

The court found that the assessment, made in September 1986, was timely and that the IRS’s internal procedural requirements are directory rather than mandatory. Thus, the IRS’s failure to follow them did not require an abatement of the assessment.

In In re Robinson,111 the bankruptcy court refused to remove the stay and allow the IRS to file against Robinson and another individual a complaint resulting from the 100 percent penalty under section 6672 of the Bankruptcy Code. The bankruptcy court concluded that it would be unfair to Robinson and his creditors to require Robinson to go through the delay and extra expense of additional litigation that would result if the stay was removed.

The Supreme Court denied certiorari in an Eighth Circuit case. The Eighth Circuit, reversing a district court, held that the assessment of a section 6672 penalty against a bankrupt taxpayer was not voided by the IRS’s issuance of a notice of proposed assessment that violated the automatic stay.112

The bankruptcy court held that the IRS’s claim for a section 6672 penalty is entitled to secured status in a chapter 13 case because under sections 523(a)(1)(A) and 507(a)(8)(C) of the Bankruptcy Code the penalty was excepted from discharge in the debtor’s prior, no-asset chapter 7 case.113 The taxpayer argued that because the tax lien was securing only exempt property, it was discharged in the chapter 7 case. The bankruptcy court noted that the debt survived the discharge because a section 6672 penalty is the kind of tax debt required to be collected or withheld and for which the debtor is liable under section 507(a)(8)(C).

(i) Responsible Person

Westfall114 identified two elements that must be established before the IRS will assert the 100 percent penalty: responsibility and willfulness. He stated:

Responsible person is defined as one who had the duty to perform or the power to direct the act of collecting, accounting for and paying over the taxes. The responsible person may be an officer or employee of the corporation, a member or employee of a partnership, a corporate director or shareholder, or another person with sufficient control over funds to direct their disbursement. In some situations, responsible persons are not directly affiliated with the delinquent business. For example, if a bank or other financial institution furnishes funds to a business and directs how these funds are to be distributed, the IRS may find the bank liable for the penalty since it directed that the business not pay over the employment taxes.115

Normally, the IRS makes every effort to determine the individual or individuals who were obligated to see that the taxes were withheld, collected, and paid over to the government. The Appellate Court for the Federal Circuit held in Godfrey116 that an outside director who did not have signatory authority over corporate accounts and who did not participate in the day-to-day fiscal management of a corporation was not personally responsible for the withholding of taxes. The Appellate Court held that even though Godfrey was elected chairman of the board of a financially troubled corporation and actively attempted to negotiate a recapitalization arrangement, he took no part in the decisions regarding the payment or deferral of corporate debt or the preparation of withholding statements. The court stated that the test as to whether an individual is responsible for the taxes hinges on whether the person has the power to control the disbursement of corporate funds on a daily basis.

The Seventh Circuit has held that the State of Illinois had a valid claim for a responsible-person penalty against the bankrupt president of a now-defunct corporation that failed to pay use tax on its purchase of an airplane for over $12 million that it brought into the state.117 The company—Chandler—never paid Illinois use tax, filed a use tax return, or registered the plane. By the time the state tax authority discovered the company owed use taxes, the corporation was defunct and the president was in bankruptcy.

The First Circuit held that the president of a corporation is not personally liable under Massachusetts state law for unpaid state corporate taxes, because exclusive authority for tax payments was given to the treasurer of the corporation.118 The corporate treasurer had exclusive responsibility for payment of corporate taxes and other legal and financial matters, while the president was responsible for day-to-day restaurant management.

In Mercantile Bank v. United States,119 the district court noted that for a third-party lender to qualify as a person under section 6672, the lender must have the power to see to it that the taxes are paid. The court added that the lender must assume control over how the employer’s funds are spent and over the process of deciding which creditors of the employer are paid and when. The court then rejected the IRS’s contention that the terms of the loan and security agreement were sufficient to make the bank a person for purposes of section 6672. The court distinguished this decision from Commonwealth National Bank v. United States,120 on the basis that the third-party lender in Commonwealth required the third-party lender to actually exercise control over the employer’s funds whereas in this case, the bank had the power to control. The court held that the mere existence of the power to control is insufficient and that the bank, in deciding which checks not to pay, had simply applied its normal check return policy and did not exercise its power under the loan agreement to control the debtor’s business.

The Fourth Circuit has held that a receiver, appointed prior to the effective date of the Bankruptcy Code, is liable for unpaid prepetition employment taxes, income taxes of the bankrupt and postpetition employment taxes. The receiver was held to be personally liable for these taxes under the insolvency statutes.121

(A) Willfulness

Willfulness is defined as meaning, in general, a voluntary, conscious, and intentional act. The willfulness requirement of I.R.C. section 6672 is generally satisfied if there is evidence that the responsible person had knowledge of payments to other creditors after the person was aware of the failure to remit withholding taxes. It is not necessary to have evidence that a withholding tax return should have been filed at the time when the responsible officer knew that other creditors were being paid. Liability under I.R.C. section 6672 can arise from a misuse of withheld funds before the date when the corporation is required to pay over the funds.122

Once it is established that a person is responsible for the withholding tax, courts have generally taken the position that the responsible person has the burden of disproving willfulness.123 For example, in Smith v. United States,124 the Eleventh Circuit held that Smith had the burden of disproving willfulness. The Eleventh Circuit then noted that Smith had to prove that he did not pay any creditors after he became aware of the withholding tax problem. Smith testified that employees were paid every Friday until the bankruptcy filing. Thus, Smith had to prove that he did not know of the payroll tax problem until after the bankruptcy filing. However, Smith testified that he became aware of the company’s failure to remit its payroll deductions several weeks before the petition was filed.

The Thibodeau court stated that the willfulness requirement is also met if the responsible officer shows a reckless disregard of a known or obvious risk that trust funds may not be remitted to the government.125 In Smith, the court held that Smith recklessly disregarded an obvious risk that the government would not receive the withholding taxes to which it was entitled when he refused to listen to another employee’s pleas that Smith look into the company’s financial problems. The court noted that a responsible person cannot avoid liability by showing that he closed his eyes to the company’s problems. Accordingly, the court concluded that Smith also was willful because he disregarded the risks brought to his attention by another employee.126

Courts have generally not accepted the argument that if a company has sufficient funds on hand to meet its withholding tax obligations, willfulness has been disproved. In Thibodeau, the court held that the failure to segregate withholdings from other corporate assets is an indication of willfulness.127 The Thibodeau court also held it irrelevant that the corporation declared bankruptcy before the taxes were actually due.

In In re Vaglica,128 the Fifth Circuit held that Charles Vaglica acted willfully under I.R.C. section 6672 and was responsible for unpaid withholding taxes. Vaglica filed a bankruptcy petition, and the IRS filed a proof of claim for the 100 percent penalty under I.R.C. section 6672 against Vaglica for unpaid withholding taxes owed by Vaglica’s wholly owned corporation. The company received several delinquency notices but elected to pay creditors instead of paying the withholding taxes to the IRS. Vaglica objected to the IRS’s claim on the basis that he did not willfully avoid paying withholding taxes. The bankruptcy court overruled his objection, and the district court affirmed. Willfulness requirement is satisfied if the responsible person becomes aware of unpaid withholding taxes and then pays other creditors.

The Tenth Circuit, affirming a district court opinion, held that the taxpayer is liable for the “responsible person” penalty under I.R.C. section 6672 and that he acted willfully in failing to remit his company’s withholding taxes shortly before the company filed for bankruptcy.129 Prior to the filing of the petition, the taxpayer had attempted to pay the overdue taxes with checks that were dishonored. The taxpayer asserted that he did not know the checks would be dishonored and that the IRS should have resubmitted the checks. The taxpayer also asserted that he was not the person responsible for paying the company’s trust fund taxes for part of the period at issue, because the company had filed for bankruptcy before the taxes were due.

The Tenth Circuit stated that its consideration of willfulness begins with the responsible party’s actions from the moment the employees’ net wages are paid and taxes are withheld. The court noted that, rather than segregate the trust fund taxes, the taxpayer had used them to cover the company’s operating expenses, which had the effect of treating the government as a partner in his failing business and increasing the risk that the company would be unable to remit the funds when due. The Tenth Circuit pointed out that the taxpayer’s filing of a bankruptcy petition on the company’s behalf two days prior to the quarter’s end did not change his status as the person responsible for collecting the taxes in the first instance.

(ii) IRS Procedure

When the IRS believes that a company’s employment taxes are not going to be paid, it begins an investigation to determine the responsible person(s). The IRS may:

After the investigation has been completed, the IRS sends letters to the responsible persons advising them of their liability for the penalty, requesting their agreement, and informing them of their appeal rights. A person may contest the proposed assessment by filing a written protest for a hearing, if the tax owed for any year or period exceeds $2,500. The letter of protest should identify the item being contested and include a statement of facts supporting the objection. If the taxpayer is unsuccessful in the protest, any subsequent appeal will be handled by the appeals office of the IRS, which is separate from the collections office.131

In cases where a chapter 11 petition is filed, the IRS may make an immediate assessment against the responsible person or wait until the tax issues are resolved in the case. The assessment will be made, but collection of this penalty may be delayed, pending a determination of whether the corporation will be able to pay the tax based on the confirmed plan of reorganization. If the plan proposes to pay the entire tax plus all penalties and interest upon confirmation, then the assessment will generally be held back to see whether the payment is received. If the plan calls for the trust portion of withholding tax to be paid over five years from the assessment date, the IRS will often elect to go ahead and collect the trust portion from the responsible person. In In re William Netherly,132 the bankruptcy court cannot enjoin the IRS from collecting the trust portion of withholding tax from Netherly, the president and responsible person, even though the confirmed plan provided for deferred tax payments of $4,925 (currently $11,725, until April 1, 2013) per month including interest.

In Arve Kilen v. United States,133 the bankruptcy court held that it is possible for the bankruptcy court to determine a responsible person obligation for unpaid withholding taxes before the IRS assesses the tax. In United States v. David R. Kaplan,134 the district court also held that the bankruptcy court had jurisdiction to determine the responsible person under I.R.C. section 6672.

Citing Abbott Laboratories v. Gardner,135 the court noted that the case was ripe for determination. The court indicated that the harm to Kilen (funds would go to pay unsecured creditors and he would still be personally liable for the trust fund taxes) outweighed any perceived problems with speculation or contingency.

Even if the government does not use its full power or exercise due diligence to collect the withholding tax, the responsible person is still liable for the tax. The district court held, in V.A. Davel,136 that the liability of the responsible person is independent of the employer-corporation’s obligation to remit the employee withholdings. In Robert W. Sawyer,137 the court held that the IRS is not required to proceed against the corporation for delinquent employee withholding taxes before collection of those taxes from a corporate officer. The district court’s decision was reversed on an unrelated procedural issue and the taxpayer was allowed to present evidence as to the reason why the willfulness standard under I.R.C. section 6672 was not satisfied.138

The responsible person may find that if a proposed or confirmed plan does not call for full payment of the tax upon confirmation, then the IRS immediately assesses the penalty and issues an account to the field to effect collection. This can include the filing of a Notice of Federal Tax Lien against the responsible person or persons and the seizure of assets or levying the bank accounts, wages, or other cash assets of the person. Even if payment through the plan of reorganization will eventually fully pay the tax, the penalty will be assessed because the government has no guarantee that these deferred payments will ever be completed. If, eventually, the government does receive its full payment through the plan, then the responsible person from whom the penalty was collected can file a claim with the government for refund of the penalty payments. This policy should not be interpreted as being all-inclusive and unbending.

If the plan proposes to pay the entire tax plus all prepetition penalties and interest upon confirmation, the assessment will most likely be made, but collection will generally be held back until it is determined whether the payment will actually be made.

In a bankruptcy case, the IRS may complete the investigation to determine the responsible persons and mail letters to these individuals. Their action normally stops at this point unless the statutory period for assessment is about to elapse. With respect to any taxable period within the calendar year, the statute is open for three years from April 15 of the following year or from the date the return was filed, whichever is later. For example, if Form 941 was timely filed for the first quarter of 20X4, the statute would start running on April 15, 20X5. The statutory period does not start to run until the return is filed.

If, in a bankruptcy case, the statutory period is about to expire, the IRS may request a written agreement with the responsible person or persons to extend the statutory period. If the individual refuses to sign the extension, the IRS will normally make an assessment before the statutory period expires. The IRS has 10 years to collect the tax after the assessment is made.

(iii) Designation of Payments

Unless the taxpayer designates how payments are to be made, the IRS will most likely apply payment to the non–trust funds portions first. If a plan of reorganization provides for only the payment of taxes plus interest to the date of the petition, the IRS will apply payment to the non–trust funds first and then to interest, before applying any to the trust part. In United States v. DeBeradinis,139 the court held that, if payments are not designated as to how they are to be allocated, the IRS may designate the collections according to its policy. If the plan calls for the IRS to receive full payment of all taxes, penalty, and interest, payment may be applied in the following order:

The IRS will not follow the listed order if the taxpayer specifically designates that the payment is to be handled differently. IRS Policy Statement 5-14140 states that the taxpayer has no right of designation in the case of collections resulting from enforced collection measures.

However, in a bankruptcy filing, the Supreme Court141 ruled that a bankruptcy court can direct the IRS to apply a debtor’s payment to trust fund employment taxes, even though doing so might leave the government at risk for non–trust fund taxes. The Court did not decide whether tax payments were voluntary or involuntary but rather held that a bankruptcy court’s broad “authority to modify creditor-debtor relationships”142 entitled it to direct the debtor’s payments toward withholding taxes, even though doing so might endanger the government’s collection of other debtor liabilities. Thus, in chapter 11 plans providing for trust taxes to be paid first, it is irrelevant whether the payments are involuntary or involuntary.

However, prior to the decision of the Supreme Court bankruptcy courts were not in agreement as to the extent a bankruptcy case causes the payments to be involuntary. The IRS is expected to continue to argue that they are involuntary, except in cases like Deer Park, as discussed below.143

The Tax Court, in Amos v. Commissioner,144 stated: “An involuntary payment of Federal Taxes means any payment received by the agents of the United States as a result of distraint or levy or from a legal proceeding in which the government is seeking to collect its delinquent taxes or file a claim thereof.” Whether the payments are voluntary or involuntary was examined in at least four other circuit court decisions. The Third Circuit held, in In re Ribs-R-Us,145 that payments of taxes by a debtor in a chapter 11 reorganization are involuntary. The Eleventh Circuit concluded that the decision as to whether tax payments made under a chapter 11 reorganization plan are voluntary (thereby allowing taxpayer allocation) is best made on a case-by-case basis with consideration of each bankruptcy plan as a whole.146 The Ninth Circuit ruled, in In re Technical Knockout Graphics, Inc.,147 that preconfirmation tax payments are involuntary. Thus, the IRS may allocate them as it directs.

In a legal memorandum to district counsel, the chief, branch 3 (general litigation), has advised that the IRS can disregard the trustee’s designation of payments after a chapter 13 bankruptcy has been dismissed but may not want to reapply payments retroactively.148

In a chapter 13 filing, the IRS filed a proof of claim, including (1) a secured claim for taxes from 1986 through 1989; (2) an unsecured priority claim for taxes from 1995 to 1997; and (3) an unsecured general claim for penalties for 1982 and 1983. The individual made eight payments of $100, and the trustee designated each payment for 1986. Eight months later, the individual voluntarily dismissed the chapter 13 filing. District counsel wanted to know if the IRS could disregard the trustee’s designation and apply all or part of the $800 in its “best interest.”

The IRS noted that in a chapter 11 case, U.S. v. Energy Resources Co., Inc.,149 the bankruptcy court has authority to designate how payments are to be applied, even if they are involuntary payments. The issue, according to the IRS, was not clear in chapter 13 cases. The court noted that both the legislative history of section 349(b) of the Bankruptcy Code and In re Nash150 support the argument that after a chapter 13 case is dismissed, the trustee’s designation of payments is no longer effective. The IRS noted, however, that whether payments that were received before the bankruptcy’s dismissal may be retroactively reapplied was not clear and that it might not be in the IRS’s best interest to redesignate payments retroactively. Although the IRS concluded that it was not prohibited from retroactively applying the payments, it determined that the decision should be made on a case-by-case basis.

In In re Deer Park Inc.,151 the Ninth Circuit allowed the debtor to allocate payments. An involuntary chapter 11 proceeding was filed against Deer Park Inc., developer of a ski resort. The proof of claim filed by the IRS included a claim for withholding taxes for which Deer Park’s president, Gerald Stoll, was liable. Based on comments from an IRS agent, the plan was modified to apply the payments it received under the plan to Deer Park’s trust fund tax liability.

The Ninth Circuit affirmed and cited United States v. Energy Resources Co.,152 where the Supreme Court held that a bankruptcy court has the authority to order the IRS to apply payments to trust fund liabilities if the court determines that the allocation is necessary to the success of a reorganization plan. The Ninth Circuit noted that most of the IRS’s arguments were rejected in Energy Resources. The court also rejected the IRS’s argument that Energy Resources does not apply to a chapter 11 plan of liquidation, citing In re Gregory Engine & Machine Services Inc.153 The court reasoned that such an allocation provides an incentive for officers and managers to assist in a debtor corporation’s reorganization. The Ninth Circuit then ruled that the bankruptcy court did not err in finding that Stoll’s participation was essential to the success of the plan. The court noted that, because of his experience with Deer Park, his contacts, and his commitment to the fulfillment of the plan’s contingencies, Stoll was the person most likely to make a reopening of Deer Park succeed.

In In re Flo-Lizer Inc.,154 the district court let stand an order where the bankruptcy court ordered the IRS to allocate trust fund payments to withholding taxes in a chapter 11 liquidation case.

In In re M.C. Tooling Consultants Inc.,155 the bankruptcy court determined that the allocation of trust fund payments was necessary for an effective reorganization. The court noted the president’s testimony that, following the filing of the bankruptcy petition, he was so harassed by the IRS about his personal liability for the taxes that he could not concentrate on business operations.

The district court held, in In re Suburban Motors Freight Inc.,156 that the bankruptcy court should not have directed the allocation of tax payments in a chapter 7 case. Suburban Motors Freight Inc. failed to pay withholding taxes from March 1986 through January 1987. In November 1991, the company filed a chapter 7 petition five months after the IRS assessed a 100 percent penalty against the company’s president under I.R.C. section 6672. The president filed a motion requesting the bankruptcy court to direct the trustee to distribute part of the estate’s funds to pay the IRS’s claim for the trust fund part of the claim. The bankruptcy court ordered the trustee to make a partial distribution to all undisputed tax claims, including the trust fund liability, and to pay all priority wage claims.

The district court held that the bankruptcy court was not entitled to direct the allocation of Suburban’s tax payment, because Suburban had not shown the need for a reorganization or similar purpose.

In In re T. Craft Aviation Service Inc.,157 the bankruptcy court relieved the IRS of the obligation to allocate the funds as previously instructed, because the allocation request was for a mandatory injunction and it was improper to bury the request in the trustee’s final report. Because improper notice was given, the court examined the Supreme Court’s ruling in United States v. Energy Resources Co. Inc., in which the Supreme Court held that the bankruptcy court could direct the allocation of tax funds because such an order was necessary to ensure the success of the chapter 11 reorganization. The Supreme Court, “[o]pining that permitting the bankruptcy court to exercise such authority permits the creation of tax-dodgers havens by shifting the burden of paying taxes from the corporate principals to the general unsecured creditors,” also noted that there is no reorganization plan in a chapter 7 proceeding. The Supreme Court concluded that an allocation order by the bankruptcy court is not proper.

The bankruptcy court denied a couple’s application to reallocate to nondischargeable tax debts the payments the bankruptcy trustee made to the IRS in the couple’s chapter 7 case.158 The court held that payments made by a chapter 7 trustee are involuntary payments, and as a result, the debtor may not direct that such payments be allocated to a specific tax obligation or tax period. The court refused to apply United States v. Energy Resources Co. to chapter 7 proceedings and distinguished liquidating distributions in chapter 7 from payments made to reorganize a debtor under chapters 11 and 13.

The Eleventh Circuit, reversing both the district and bankruptcy court decisions, held that the federal income tax return filed by a couple qualified as a refund claim but that the couple was not entitled to direct the IRS’s application of the overpayment.159 The taxpayer directed that the overpayment be made to a tax liability for 1989. The IRS applied it to the tax liability for 1986.

The Eleventh Circuit noted that Treas. Reg. section 301.6402-3(a)(5) demonstrates that the IRS does not apply the voluntary payment rule to overpayments. The decision by the Eleventh Circuit was consistent with the Second Circuit’s ruling in Kalb v. United States.160 In Kalb, the Second Circuit held that I.R.C. section 6402(a) clearly gives the IRS discretion to apply a refund to any liability of the taxpayer.

The Third Circuit determined that the bankruptcy court did not have the authority to authorize the IRS to allocate trust payments not properly allocated at the time of the payment of trust fund taxes by a responsible officer on behalf of the corporation that was not in bankruptcy.161 The Third Circuit concluded that under section 105(a) of the Bankruptcy Code, such retroactive allocations of trust payments by a nondebtor were justified.

In In re Ramos,162 the bankruptcy court held that payroll trust fund taxes paid because of a levy were involuntary and the IRS could allocate the payment to interest and penalties first. The court noted that the IRS had no obligation to benefit the debtor in its allocations.

If an asset that has previously been tendered to the IRS as payment of trust funds is liquidated during the bankruptcy proceeding, the debtor, according to In re Vermont Fiberglass, Inc.,163 should not be able to designate how the proceeds are allocated. Of course, officers, directors, and responsible employees want the first payment to cover the trust fund portion of the tax claim, because they can be held personally liable for these taxes.

Restitution payments made as a result of being convicted of tax evasion were held to be involuntary payments granting the IRS the right to allocate the payments.164

(iv) Enforcement of Liability against Officers

It appears that, in general, a corporation in bankruptcy cannot prevent the IRS from enforcing the tax liability against the responsible persons. Most courts are now holding that the individual and the corporation are two separate entities, and one entity cannot litigate the tax liabilities of the other even though the corporation has a stake in the outcome of the proceedings against its officer and such proceedings may imperil the reorganization of the debtor. In Bostwick v. Commissioner,165 the court held that the bankruptcy court had the power, but in In re Becker’s Transportation, Inc.,166 the court held that it was the intent of Congress not to permit bankruptcy courts to issue such injunctions. However, in a subsequent case,167 the Eighth Circuit held that the bankruptcy court could not enjoin the IRS. The Seventh Circuit168 also held that the bankruptcy court cannot enjoin the IRS from assessing a penalty against the owners of a business in chapter 11 for failure of the business to remit withholding taxes. The circuit court determined that enjoining the IRS from assessing the 100 percent penalty would facilitate the reorganization of the debtor. The appeals court held that there was no indication in the Bankruptcy Code that Congress intended to override the Tax Anti-Injunction Act (I.R.C. section 7421).

Several bankruptcy courts have, however, enjoined the IRS from deducting the withholding tax penalty from principals of corporate debtors because their action would detrimentally affect the debtors’ reorganization.169 The IRS is appealing most of these decisions. In Driscoll’s Towing Service, the judge determined that an injunction order was appropriate because the plan confirmed by the court provided for (1) a waiver of personal liability of the debtor’s principals at the successful completion of the plan’s payment provisions and (2) abatement of claims during the pendency of payments.170 The district court, however, reinstated the 100 percent penalty, stating that the bankrupt corporation lacked standing to contest the tax liability of its principals.171

In In re Earnest S. Regas Inc.,172 the chapter 7 trustee and the IRS reached an agreement where the trustee was to disburse a certain amount of the tax claim in complete satisfaction of all of the corporation’s tax liabilities. The court subsequently issued an order that reflected the nature of the agreement but also stated that the payment to the IRS would fully discharge the corporation’s officers and directors from any additional tax liability owed by the debtor.

The government noticed the error and agreed with the trustee to an amendment to the order. When the IRS attempted to collect the unpaid taxes from various responsible persons under I.R.C. section 6672, Yvonne Regas moved to enforce the first court order. The bankruptcy court held that the amendment to the order was void because proper notice had not been sent to creditors and other interested parties.

The government appealed and the district court reversed the bankruptcy court’s denial of the government’s motion to correct the order. The district court rejected the bankruptcy court’s finding that the original order did not contain a “clerical” error that could be simply corrected under rule 60 of the Federal Rules of Civil Procedure. The district court found that the government and the trustee clearly did not intend the agreement to contain such language. As with most other district courts, this court ruled that the bankruptcy court lacked jurisdiction to order such a result because the original order had the effect of determining the tax liability of nondebtors.

In Charles E. Bradley et al. v. United States,173 the “responsible person” is liable for interest that accrues during the bankruptcy case on an I.R.C. section 6672 tax penalty. From 1979 through 1981, Maxim Industries, Inc. failed to pay its trust fund taxes. The IRS assessed the 100 percent penalty under I.R.C. section 6672 against Charles Bradley and David Agnew for the trust fund taxes.

After its reorganization, the company paid the taxes and interest, except for the interest that accrued during the time the bankruptcy was pending. The IRS attempted to recover that portion of the interest from Bradley and Agnew. The district court held that Bradley and Agnew were liable for the interest that accrued during the case.

The Second Circuit affirmed the district court’s holdings. The court held that, even though Maxim’s tax liability was settled, the penalty under I.R.C. section 6672(a) was still appropriate, because the assessment is not derived from, or dependent on, an employer’s outstanding tax obligation. It is assessed because of the failure of the responsible person to perform a statutory task. The Second Circuit noted that the liability for interest that accrued on the section 6672 penalty is similarly independent of the employer’s liability for interest.

The determination of the responsible person and of the amount of the tax occurs outside the bankruptcy court proceedings. If, however, the responsible person files a bankruptcy petition, the bankruptcy court will determine the amount of the tax as well as the responsible person.174

(g) Tax Penalty

The priority granted a tax penalty depends on its nature. A tax liability that is called a penalty but in fact represents a tax to be collected is granted eighth priority. These penalties are referred to in Bankruptcy Code section 507(a)(8)(G) as “compensation for actual pecuniary loss.”

In Hanna v. United States,175 the Eighth Circuit held that penalties that are for “compensation for actual pecuniary loss” are entitled to the same priority as the tax to which they relate. Other prepetition penalties, including fines, forfeitures, and punitive damages, are not granted eighth priority, and in situations involving chapter 7 liquidations they are paid only after all timely filed general unsecured claims have been satisfied (Bankruptcy Code section 726(a)(4)). Only amounts paid for postpetition interest and amounts paid to the debtor receive a lower priority in liquidation cases. If the tax penalty imposed by the IRS or other taxing units is penal in nature, it is not entitled to priority but would be considered along with other unsecured claims.

The tax penalty may be subordinated to the general unsecured creditors. Section 510(c) of the Bankruptcy Code provides in part:

(c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may

It would appear that tax penalties for nonpecuniary losses might be subordinated. Equitable subordination in bankruptcy may be appropriate if the claimholder is guilty of inequitable conduct or if the claim itself is of a status susceptible to subordination. In the case of a nonpecuniary loss, courts have held that the claim is to be subordinated. Several courts have allowed the subordination.176

The Supreme Court held that a bankruptcy court’s categorical subordination of the IRS’s section 4971(a) claim resulting from the debtor’s failure to meet minimum funding requirements for a pension plan was erroneous.177 The bankruptcy court, as well as the district court and the Tenth Circuit, had held that the IRS’s claim for the penalty should be subordinated under section 510 of the Bankruptcy Code to the claims of other general unsecured creditors. The Supreme Court noted that the equitable subordination of the tax claim to all other unsecured creditors was the same type of categorical reordering of priorities that the Court had recently invalidated in United States v. Noland.178 For a discussion of Noland, see § 11.2(b)(ii).

The bankruptcy court recommended that the district court grant a debtor a refund of interest paid on a section 4975 assessment for prohibited transactions involving an ESOP, because the section 4975 excise tax is a penalty.179 According to the bankruptcy court, section 4975(a) is indistinguishable from section 4971 in its purpose, legislative history, and structured levels of sanctions.

In the case of a tax as opposed to a penalty, the Sixth Circuit, in Mansfield Tire,180 declined the appellees’ invitation to extend equitable subordination under section 510(c) of the Bankruptcy Code to include subordination of federal tax claims in the absence of some inequitable conduct on the part of the government, because claims for federal taxes are not claims of a type that is otherwise “susceptible to subordination.”

The Sixth Circuit noted that the “courts are not free to independently decide whether the ‘essential characteristic’ of a federal exaction is that of a tax or a penalty in order to invoke equitable subordination. If Congress has decided that a particular levy is a ‘tax’ rather than a ‘penalty,’ for purposes of priorities in bankruptcy the matter is settled.” As noted earlier, the Sixth Circuit held that the penalty under I.R.C. section 4971 was a tax.

An I.R.C. section 6698 penalty imposed for a late-filed partnership information return does not relate to a tax and therefore is not dischargeable under section 523(a)(7)(A) of the Bankruptcy Code.181 In reaching this decision, the district court noted that the dischargeability of the late-filing penalty imposed on the taxpayer depends on whether the penalty is tied to a designated tax and whether the tax is dischargeable. The court held that the penalty does not relate to a tax and remanded for further findings on whether the taxpayer had reasonable cause for the delinquency.

The bankruptcy court largely sustained a chapter 11 corporation’s objection to the IRS’s claim for penalties under section 6721, finding that the company did not intentionally disregard its duty to file information returns. Under I.R.C. sections 6721 and 6722, a penalty of $50 per return may be imposed for a simple failure to file or to include all required information and a greater penalty of $100 per return for intentional disregard for the filing rules. The court noted that the distractions facing the debtor corporation’s employees during the first three months of 1995—lawsuits, bankruptcy, and management changes—are a factor to consider in judging the debtor’s failure to timely file the information returns. The court stated that “[t]his is not a case where Debtor’s business was running smoothly and the filing requirements were merely ignored or treated frivolously.”182

The bankruptcy court held that a couple’s liability for the section 72(t) penalty for early withdrawal from a retirement plan was not discharged in their chapter 7 bankruptcy. The tax was not discharged because the obligation is a nonpecuniary loss penalty that became due less than three years before they filed for bankruptcy.183

The bankruptcy court noted that the fact that the exaction imposed by section 72(t) is labeled as a tax is not dispositive for purposes of section 523. Citing United States v. Reorganized CF&I Fabricators of Utah Inc.,184 the bankruptcy court noted that the court must consider the purpose of the exaction. The bankruptcy court also noted that the Tenth Circuit held that the section 72(t) exaction is a penalty.185 The bankruptcy court held that the penalty is not excepted from discharge under section 523(a)(7), because it is not compensation for pecuniary loss, it is not attributable to a dischargeable tax, and it became due within 3 years before the taxpayers filed for bankruptcy.

In a chapter 7 case, the bankruptcy court held that a couple’s 1990 tax liability was not discharged under section 523(a)(1)(B)(i) of the Bankruptcy Code, because they never filed a return. However, because the return was due more than three years before the taxpayers filed for bankruptcy, the bankruptcy court held that the penalties on that deficiency were dischargeable under section 523(a)(7) of the Bankruptcy Code.186

The bankruptcy court rejected the taxpayers’ argument that the failure to file a proof of claim barred its claim because the IRS was not required to file a proof of claim in the taxpayers’ no-asset case.

In United States v. Arthur Carol Sanford,187 the Eleventh Circuit held that the bankruptcy court did not have the power to partially disallow any of the penalties under I.R.C. sections 6651(a)(1) and (2) and 6654. The court noted that each penalty for each year is fully enforceable unless the taxpayer shows reasonable cause for failure to comply, in which case the penalty is unenforceable. According to the court, section 502(b)(1) of the Bankruptcy Code provides that a claim is not allowed in bankruptcy if it is unenforceable against the debtor outside of bankruptcy, but it does not vest the bankruptcy court with any equitable powers to reduce the penalties under I.R.C. sections 6651 and 6654.

In a chapter 7 liquidation case, as noted above, the penalties may not be paid. In Simonson v. Granquist,188 the Supreme Court held that a provision like section 726 of the Bankruptcy Code prohibits the allowance of certain penalties without considering whether such penalties are secured by liens. Based on this ruling, it would appear that penalties that are not for actual pecuniary loss are not collectible by the IRS or other taxing authorities, once debts in a chapter 7 case are discharged. The IRS has, however, taken the position that the prepetition penalties, as well as prepetition taxes, survive a discharge in bankruptcy of an individual even though the government cannot collect the penalty in bankruptcy.189

In a situation where the IRS and California Franchise Tax Board were ordered to return limited liability company (LLC) payments made by an LLC to cover the tax of its owner, the taxpayer (owner) was held not to be liable for the penalties under section 6661(a). The bankruptcy appeals panel concluded that the taxpayer had made a reasonable attempt to comply with the I.R.C.190

(h) Interest

Interest stops accruing when the petition is filed for purposes of determining prepetition liabilities. Interest that has accrued on prepetition taxes is considered part of the debt and would receive the same priority as the taxes received to which the interest applies. The list of tax claims in section 507(a)(8) of the Bankruptcy Code does not specifically include interest, but it has been held191 that there is no indication that Congress intended to treat interest on a tax claim differently from the tax claim itself. The failure to include the interest in the list of eighth-priority items does not indicate that it should be excluded. Other courts have also held that prepetition interest is part of the tax claim.192

The Fifth Circuit, affirming decisions of the bankruptcy and district court, held that the interest paid under section 6621(c) above the rate of interest required under section 6621(a) is excepted from discharge under chapter 7 and is not a penalty.193 In In re Tuttle, the Bankruptcy Court stated:

Since the new Bankruptcy Code went into effect, a number of courts have applied the reasoning and result of Bruning not only to chapter 7 cases, but also to chapter 11 cases. See, for example, Johnson v. IRS (In re Johnson), 146 F.3d 252 (5th Cir. 1998) (chapter 7); Hardee v. IRS (In re Hardee), 137 F.3d 337 (5th Cir. 1998) (chapter 7); Burns v. United States (In re Burns), 887 F.2d 1541 (11th Cir. 1989) (chapter 7); Hanna v. United States (In re Hanna), 872 F.2d 829 (8th Cir. 1989) (chapter 7); Ward v. Board of Equalization (In re Artisan Woodworkers), 204 F.3d 888 (9th Cir. 2000) (chapters 11 and 12); Fullmer v. United States (In re Fullmer), 962 F.2d 1463, 1467-68 (10th Cir. 1992), overruled in part on other grounds in Raleigh v. Illinois Dept. of Revenue, 530 U.S. 15, 120 S. Ct. 1951, 147 L. Ed. 2d 13 (2000) (chapter 11). However, having considered a number of provisions in the new Code, particularly some in chapter 11 and chapter 13, this Court is convinced that the courts have been too hasty in applying Bruning, a liquidation case, to reorganization [**7] cases. Instead, the Code specifies how tax claims that would be nondischargeable in chapter 7 are to be paid in chapters 11 and 13 reorganizations, and it does not require gap interest to be paid.

The court noted that under Supreme Court precedent, a penalty is a fixed ad valorem amount, taking no account of time. The Fifth Circuit concluded that the increased rate of interest under section 6621(c) is truly interest because it is compounded daily and accrues only while the taxes remain unpaid and because the increase over the regular rate is not so significant as to be confiscatory in nature.

The Fifth Circuit agreed with the Seventh Circuit that interest is part of the underlying tax debt and is not a penalty.194 Because the interest was assessed within 240 days of the taxpayer’s bankruptcy filing, the court held that it was excepted from discharge.

The Tax Court refused to follow the provisions of In re Hardee in a nonbankruptcy situation.195 However, on appeal, the Fifth Circuit reversed the decision of the Tax Court as it related to the interest issue.196

On a prepetition tax that is nondischargeable, postpetition interest, according to 11 U.S.C. section 501(b)(2), will not be allowed. However, the IRS will attempt to collect the interest and has been successful in most cases because of the decision of the Fifth Circuit in In re Hardee. The Tenth Circuit decision in In re Fullmer and others have relied on the Supreme Court’s decision in Bruning. Several courts that ruled that the interest may not be assessed by the IRS have been reversed. The bankruptcy court in the case of In re Tuttle after explaining in detail why the interest between the petition date and the confirmation date should not be allowed, then concluded that the court must rule that this interest was not discharged by confirmation of debtor’s plan. Further, the IRS was not equitably estopped from collecting the gap interest by agreeing to the treatment it received under debtor’s plan.197

In In re Robert B. Quick, Jr.,198 the bankruptcy court held that the IRS can recover the postpetition interest and penalties assessed against the taxpayer on a tax claim that was not fully paid before the chapter 13 case was converted to chapter 7. The court found that, because the Quicks had not fully paid the tax liability prior to the dismissal of the chapter 13 case, the claim became nondischargeable and, consequently, personal liability for the interest survived the bankruptcy. The bankruptcy court noted that, because a decided case involving a conversion from a chapter 13 to a chapter 7 proceeding could not be found, the reasoning in Bruning v. United States,199 which held that the “‘traditional rule which denies postpetition interest as a claim against the bankruptcy estate’ did not apply to ‘discharge the debtor from personal liability for such interest,’” would be followed.

The court ordered the IRS to establish how the interest and penalty were calculated. If they were not calculated on the postpetition declining balance, the IRS must explain why deductions should not have been made for the payments made by the chapter 13 trustee.

In In re Adelstein,200 the bankruptcy court held that the IRS is not to collect interest and penalties due to a delay in making payments on a settlement agreement reached in bankruptcy.

The IRS attempted to collect postpetition penalties and interest on a debt owed from the settlement agreement reached a year earlier, because of the delay in payment. The bankruptcy court ordered the settlement enforced and held that Adelstein was not liable for postpetition interest or penalties. The court noted that the settlement did not specify a time by which the taxes had to be paid and that the settled-on amount was all the IRS was due.

Treas. Reg. section 301.6611-1(h)(2)(v) was modified in 1994 to provide that interest is due as it accrues on a daily basis rather than when it is assessed. A bankruptcy court held that the IRS’s claim for interest accruing on its unsecured priority claim from the filing of a chapter 11 petition to confirmation of the debtors’ plan survives bankruptcy and can be asserted against the debtors personally, even though no provision for such interest was included in the confirmed plan.201

The BAP202 found that the IRS was entitled to “gap” interest accrued between the date of the debtor’s bankruptcy filing and the date of confirmation of her chapter 11 plan. The BAP noted that it was bound by the existing Tenth Circuit precedent.203 The court did not accept the argument that the IRS was bound by the terms of the plan, which did not provide for “gap” interest. Rather the court found that under section 1141(d)(2) of the Bankruptcy Code, the interest was the nondischargeable personal liability of the debtor.

Interest that accrues during bankruptcy proceedings on a prepetition debt would, according to section 726(a)(5) of the Bankruptcy Code, receive payment only after all other creditors’ claims have been satisfied. The same general rule would apply in chapter 11 cases. In the case of secured debt, postpetition interest will be allowed, according to Bankruptcy Code section 506(b), to the extent that the value of the property exceeds the amount of the claim.

The Sixth Circuit held that interest on both secured and unsecured claims accrues until the claims are fully paid.204 Because both the secured and unsecured claims were determined not to be impaired under the plan, the Sixth Circuit noted that the interest limitations under section 506(b) do not apply.

(i) Postpetition Interest on Secured Tax Claims

In United States v. Ron Pair Enterprises, Inc.,205 the Supreme Court reversed the Sixth Circuit Court of Appeals and held that section 506(b) of the Bankruptcy Code entitled a creditor to receive postpetition interest on a nonconsensual, oversecured claim allowed in a bankruptcy proceeding.

Ron Pair Enterprises, Inc. (RPEI) had filed a petition for a chapter 11 reorganization on May 1, 1984, in the U.S. Bankruptcy Court for the Eastern District of Michigan. The government filed timely proof of a prepetition claim of $52,277.03, consisting of assessments for unpaid withholding and Social Security taxes, penalties, and prepetition interest. The claim was perfected through a tax lien on property owned by RPEI. The First Amended Plan of Reorganization (filed on October 1, 1985) called for full payment of the prepetition claims but did not provide for postpetition interest on that claim. Timely objection was filed by the government, claiming that section 506(b) of the Bankruptcy Code allowed recovery of postpetition interest because the property securing the claim had a value greater than the amount of the principal debt. The parties stipulated at the bankruptcy court hearing that the claim was oversecured, but the court overruled the government’s objection. On appeal, the U.S. District Court for the Eastern District of Michigan reversed the bankruptcy court’s judgment, stating that the plain language of section 506(b) entitled the government to postpetition interest. Subsequently, the Sixth Circuit Court of Appeals reversed the district court.206

Section 506(b) of the Bankruptcy Code, which was enacted as part of the extensive 1978 revision, governs the definition and treatment of secured claims. Section 506(b) provides:

To the extent that an allowed secured claim is secured by property the value of which . . . is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs or charges provided for under the agreement under which such claim arose.

A claim is secured only to the extent of the value of the property on which the lien is fixed; the remainder of that claim is deemed unsecured. Two types of secured claims exist: (1) voluntary (or consensual) secured claims (those created by agreement between the debtor and creditor and called a “security interest” by the code), and (2) involuntary secured claims, such as judicial or statutory liens, which are fixed by operation of law and do not require the debtor’s consent. Because the government’s claim here was a nonconsensual claim, the court focused on whether Congress intended that all oversecured claims be treated the same way for postpetition interest.

The result of the paying of interest is to reduce the amount that is generally available for the payment of unsecured creditors. However, the courts justified the payment of postpetition interest on the assumption that the benefit of the secured creditors’ bargain needed to be protected (e.g., see United States v. Harrington207). Prior law allowed postpetition interest to be paid on both consensual and nonconsensual claims in situations where the debtor ultimately proved to be solvent and in cases where the secured creditor’s collateral produced income postpetition.208

The court held that the holder of an oversecured claim is entitled to postpetition interest and, additionally, to the right to the specified fees, costs, and charges. Recovery of postpetition interest is unqualified, whereas recovery of the fees, costs, and charges is allowed only if they are reasonable and provided for in the agreement under which the claim arose. In the absence of an agreement, postpetition interest is the only additional recovery available. This reading of section 506(b) of the Bankruptcy Code is also mandated by its grammatical structure. The phrase “interest on such claim” is set aside by commas and separated from the reference to fees, costs, and charges by the conjunctive words “and any.” The phrase therefore stands independent of the language that follows.

The pre-code practice of denying postpetition interest to holders of nonconsensual liens but granting it to consensual lienholders was an exception to the exception for oversecured claims and was based on the rule that the running of interest ceased when the bankruptcy petition was filed. This practice was recognized by only a few courts, and its application depended on particular circumstances. The “rule” was never extended to other consensual liens that were not “tax liens” and was only a guide to the trustee’s exercise of power in the particular circumstances of the case.

The impact of the Ron Pair Enterprises decision may be significant in bankruptcy cases where there is a substantial tax liability. Interest over a period of several years on a material tax claim will result in unsecured creditors’ receiving less. The IRS and other taxing authorities will most likely be encouraged by this decision to timely file tax lien notices in the proper location.

In In re Shelus,209 a chapter 13 case, the court allowed the IRS to receive postpetition interest payments because there was a properly perfected tax lien on the residence and the tax claim did not exceed the value of the taxpayer’s equity in the residence.

The IRS, prior to the Supreme Court decision in Ron Pair Enterprises, issued Revenue Ruling (Rev. Rul.) 87-99,210 which holds that postpetition interest and pecuniary and nonpecuniary loss penalties may be claimed against the bankruptcy estate in a bankruptcy proceeding commenced on or after October 1, 1979, in general receiverships, or in cases involving assignment for the benefit of creditors. This ruling will not interfere with the priority of tax claims in either assignment or bankruptcy cases. For example, nonpecuniary loss penalties may not, as a result of this ruling, be considered a priority tax under section 507 of the Bankruptcy Code. However, these penalties may be an unsecured claim according to this ruling.

In issuing this ruling, the IRS (1) noted that, under section 506(b) of the Bankruptcy Code, postpetition interest has been held to be recoverable on an oversecured claim,211 and (2) claimed that postpetition interest is to be allowed when other postpetition claims for interest are allowed—when the estate has funds to pay all claims or when the value of the security interest in the debtor’s property is greater than the debt. At the time the IRS issued Rev. Rul. 87-99, it was in conflict with the Sixth Circuit’s decision in Ron Pair Enterprises. However, when the Supreme Court overturned this decision, the position of the IRS became fully enforceable.

In a receivership case involving an insurance company, the court ruled that the company was liable for postpetition interest on a federal tax lien.212

(i) Accruing Interest Expense

A business should evaluate its condition in a bankruptcy case to determine whether interest should be accrued and deducted for tax purposes. Bankruptcy Code section 506(b) provides that interest accruing after the petition is filed on prepetition secured claims will be allowed to the extent that the value of the property exceeds the amount of the claim. Thus, an accrual-basis taxpayer should consider the propriety of deducting the interest expense, as would be the case if the petition had not been filed. The fact that the payments are not current should not necessarily affect the decision to accrue the interest expense for tax purposes.

In the case of unsecured claims, the decision as to whether interest should be accrued depends on the extent to which all creditor claims are satisfied. Bankruptcy Code section 726(a)(5) provides that interest accruing during the proceeding on prepetition debt can be paid only after all other creditors’ claims have been satisfied. Interest may also be paid in a chapter 11 case if unsecured creditors receive full payment of their claims. Thus, if it appears that all creditors’ claims will be satisfied, the debtor should consider the propriety of accruing interest expense on prebankruptcy debt for tax purposes. If stock is going to be issued for debt, the right to deduct interest expense depends on the going-concern value of the debtor. To the extent that the debtor is solvent based on going-concern values, it would appear that interest could be deducted.

(j) Interest Receivable

As noted in § 11.2(h), interest is not paid on unsecured prepetition debt during the bankruptcy proceeding. The Bankruptcy Code does not, however, address the issue of whether interest on a receivable from the IRS should be paid. In In re Pettibone Corp.,213 the district court ruled that the IRS did not owe interest on prepetition overpayments during the bankruptcy proceeding. It should be noted, however, that this ruling was made in reference to the netting of prepetition claims and prepetition overpayments. As a general rule, it would be expected that the filing of a bankruptcy would not impact the amounts of claims that are owed to the company in bankruptcy.

(k) Interest Paid by Guarantor

Often a shareholder of a closely held corporation will be required by a bank or other creditor to guarantee notes or other debt of the corporation. If the corporation files a bankruptcy petition and is subsequently discharged of its debt, and the guarantor must make the debt payments, interest paid by the individual is deductible as interest under I.R.C. section 163(a), according to Benjamin Stratmore v. Commissioner.214 The court ruled that the status of the debt at the time the interest is paid, not when the debt was originally incurred, determines the tax consequence of the interest payment. Note that the interest in question was postdischarge interest. It appears that interest occurring prior to the discharge date is not deductible by the individual as interest expense.

(l) Erroneous Refunds or Credits

Section 507 of the Bankruptcy Code provides that a claim from an erroneous refund or credit of a tax will be treated in the same manner as the claim for the tax to which the refund credit applied. Thus, a refund received in error for income tax paid in 1995 will receive eighth priority if the tax liability incurred in 1995 would receive that priority. This provision would also apply to “quickie refunds” based on net operating loss carrybacks under I.R.C. section 6411.215

The bankruptcy court disallowed the IRS’s claim for interest on a section 6672 penalty against a woman, because the combined payments made by the woman and her ex-husband fully satisfied the assessment and the assessment was not revived when the IRS issued an erroneous refund to the ex-husband.216 The taxpayer and her ex-husband fully satisfied the assessment for a section 6672 penalty. When the IRS credited the payment made by the taxpayer, it attributed it to her ex-husband and entered an incorrect date, causing the computer to compute the interest liability as zero. The result was an automatically generated refund sent to the taxpayer’s ex-husband in the amount of $12,600. The IRS subsequently released its tax lien against the property. The district court reversed217 the bankruptcy court’s order by following the Fifth Circuit decision in US Life Title Ins. Co. on behalf 218 and holding that under joint and several liability of I.R.C. section 6672, the tax liability is not paid until the statute of limitations period expires.

The bankruptcy court held that tax assessments are extinguished upon full payment and are not revived by erroneous refunds.219 When the IRS issues an erroneous refund, the IRS must pursue an erroneous-refund action or make a new assessment, according to the bankruptcy court. The court did note, however, that Bilzerian and other cases following that rule involved income taxes, not responsible-person penalties. However, the court applied the rule to the responsible-person penalty and noted that in section 6672 penalty cases, the IRS is fully paid when the combined payments made by all responsible persons satisfies or exceeds the penalty amount. The court rejected the IRS’s claim that it may collect the full amount from all responsible persons.

The Seventh Circuit held that an erroneous refund resulting in an overpayment of taxes resulted in the IRS having a tax claim for the unpaid taxes.220

Citing McCollum v. United States,221 the bankruptcy court held that the IRS may be bound by the error of its agent when the error prejudices the taxpayer. The court found it clear that the taxpayer was prejudiced by the IRS’s error, because the IRS continued to compute interest on penalty that was already fully paid.

(m) Chapter 11 Reorganization

Section 1129(a)(9) of the Bankruptcy Code states that a plan must provide for the payment of all taxes with priority before the plan must be confirmed. Taxes classified as administration expense and involuntary gap must be paid in full with cash on the effective date of the plan. Employees’ withholding taxes on wages granted third priority are to be paid in full with cash on the effective date of the plan or, if the class has accepted the plan, with deferred cash payments that have a value equal to the claims. Note that the third priority applies only to the employees’ share. The employer’s share (nontrust part) is an eighth priority.

The 2005 Act, section 710, amends the Bankruptcy Code to provide that the payments under section 1129(a)(9) must be regular installments in cash of a total value as of the effective date equal to the allowed amount of the claim, must not exceed a five-year period from the order for relief, and must be in a manner not less favorable than the most favored nonpriority unsecured claim other than administrative convenience claims. Because of the difficulty of establishing the time of assessment, especially for some state and local taxes, both the National Bankruptcy Review Commission (NBRC) and the Tax Advisory Committee recommend that the six-year period begin with the date of the order for relief. The six-year period was subsequently reduced to five years from the date the order for relief is issued, and payments were changed to require them to be in a manner not less favorable than the most favored unsecured creditor claims. With these changes, the modification to this section is no longer a change that eliminates the inequities of the current law but a law that provides additional benefits to the taxing authorities at the expense of creditors, employees, and others that have an interest in the reorganization of the business.

The 2005 Act adds a new section 511 to the Bankruptcy Code that provides if interest is required on a tax claim, including tax claims qualifying as administrative expenses, or to enable a creditor to receive the present value of the allowed amount of a tax claim, the rate of interest shall be the rate determined under applicable nonbankruptcy law. In the case of interest paid under a confirmed plan, rate of interest is the rate determined as of the calendar month in which the plan was confirmed.

Prior to the effective date of the new section 511, the Bankruptcy Code did not specify the interest rate that is to be used for tax claims that are entitled to interest, but it did indicate that a market rate should be used. Judicial consensus is that the federal statutory rate is relevant in determining the appropriate market rate of interest. To avoid the wasting of both judicial and debtor resources by litigating the rate, the NBRC followed the recommendation of the Tax Advisory Committee that the rate be fixed at the statutory rate under section 6621(a)(2), without reference to section 6621(c) and that it should be the rate in effect as of the confirmation date. The rate under section 6621 was included in early proposed modifications to the code but was subsequently modified to include the rate in section 1274(d), but did not indicate if the rate should be compounded quarterly or yearly. Section 1274 appeared to be a reasonable substitute. Subsequent drafts provided that section 1274 would apply to federal taxes, and other taxing units would use the rate under nonbankruptcy law. Section 704 as passed eliminates any reference to the Internal Revenue Code by providing that nonbankruptcy law applies to all taxes where interest is required.

Although the rate for federal taxes approximates market value, the rate for state and local taxes could be in excess of 20 percent, resulting in state and local taxing authorities receiving interest in excess of the market rate at the expense of other creditors. There is no logical reason for making a change such as this. Additionally, the change violates the general philosophy underlying bankruptcy law that creditors should not receive consideration in excess of the value of such claim.

The Internal Revenue Manual222 has the following statement regarding the plan treatment of priority claims in chapter 11 plans:

Thus, the rate of interest determined pursuant to section 6621 of the Internal Revenue Code passed on the date that the plan is confirmed will be used in determining the amount of the priority tax payments. That rate replaces the market rate that existed prior to the 2005 Bankruptcy Act.

The requirements of section 1129(a)(9) are modified to also apply to secured taxes that are entitled to priority absent their secured status.

A secured tax claim is not bound by the six-year period in section 1129(a)(9) of the Bankruptcy Code. In In re Thomas J. Rotella,223 the bankruptcy court allowed a secured debt to be paid over a period greater than six years from the date of assessment. The IRS objected to a chapter 11 plan where the secured part of a tax claim of $46,237 would be amortized over 30 years and the unsecured priority portion would be paid in six equal annual payments. The bankruptcy court confirmed the chapter 11 plan over the objections of the IRS but ordered that the interest rate paid to the IRS be changed to 9 percent from 8 percent as proposed in the plan (the interest paid to other creditors with secured claims against the taxpayer’s residence, which was property in which the IRS had a lien).

The bankruptcy court held that the IRS must apply a check received from the taxpayers as provided for in the chapter 11 plan, even though the debtors had defaulted on that plan.224 Citing United States v. Energy Resources Co.,225 the bankruptcy court noted that the question of whether a payment is voluntary or involuntary is irrelevant to payments made under a chapter 11 plan. The court concluded that a debtor’s default on a chapter 11 plan does not cause the debtor’s obligations to revert to their prepetition status.

However, the court held that an IRS levy on bank accounts was not a payment on the chapter 11 plan because the taxpayers at that time owed postconfirmation taxes and the levy clearly stated that it sought taxes due under the plan and postpetition taxes.

Other tax claims that do not qualify as tax priority items would receive treatment similar to that for other unsecured claims. Furthermore, the Reform Act226 contained a provision that exempts bankruptcy proceedings from section 3466 of the Revised Statutes of the United States,227 which provides that, in case of insolvency, debts due to the U.S. government must be satisfied before others are paid. This section does, however, continue to apply to common-law assignments for benefits of creditors and to equity receiverships under state laws. For secured tax claims, the claims must be paid in full on confirmation or paid in deferred payments over a reasonable period of time with the present value of the payments equal to the amount of the claim. Also, interest will be allowed to accrue during the proceedings to the extent that the value of the security exceeds the tax claims. The lien will be retained by the IRS until the claim is paid.

The Eleventh Circuit, reversing the district court and the bankruptcy court, has ordered that payment of unclaimed funds in a bankruptcy case be returned to the debtor, not to the United States Treasury, pursuant to 28 U.S.C. section 2042.228

(n) Dismissal of Bankruptcy Petition

One justification of dismissal of a chapter 11 petition is that the petition was filed solely for tax intent. The district court reversed a bankruptcy court’s dismissal of a woman’s chapter 11 case, rejecting the lower court’s finding that the woman was attempting to avoid her tax liabilities.229

A U.S. district court has held that a bankruptcy court did not clearly err in dismissing a couple’s chapter 11 proceeding based on their failure to pay postpetition income taxes while operating their farm as debtors in possession.230 The court noted that the failure of a debtor in possession to pay postpetition taxes has been held to constitute cause for conversion or dismissal.

(o) Chapter 12 and Chapter 13 Adjustments

Some provisions that apply to chapter 12 and chapter 13 proceedings are similar to Bankruptcy Code section 1129 (chapter 11 reorganization), which requires that priority items be provided for in the plan. Section 1322 (for chapter 13) and section 1222 (for chapter 12) of the Bankruptcy Code state that the plan must provide for the full payment, in deferred cash payments, of all claims entitled to priority under Bankruptcy Code section 507(a)(8), unless the holder of a claim agrees to different treatment. Payments in chapter 13 must be made for a period of at least five years, if the debtor fails to satisfy the means test. Thus, all taxes with priority will be paid in full. In another chapter 13 case, In re Chukwuemeka M. Ekeke,231 the bankruptcy court dismissed the case because the plan failed to provide for 100 percent payment of a priority tax claim. Note that no interest is to be paid on these claims; it is not necessary that the present value of the future payments equal the claim but only that the total future payments equal the debt. For example, in In re Elmer E. Palmer,232 the court ruled that no provision under chapter 13 refers to the government’s right to receive the time value of money. In In re Allan Wayne Hieb,233 the chapter 13 plan provided for the payment of $16,642 of unsecured priority tax claims over 63 months. The IRS claimed that it was entitled to present value payments on the principal amount, as if a chapter 7 liquidation were taking place. The court held that payment for interest is not required under section 1322(a)(2) of the Bankruptcy Code. However, interest would be required under section 1325(a)(4) if the IRS would receive 100 percent from a chapter 7 liquidation, which was not the case here.

Because the chapter 12 confirmation requirements are similar to those of chapter 13, interest would most likely not be included in priority tax payments in a chapter 12 case. In chapter 11 proceedings, the present value of future payments is compared with the value of the claim.

Section 1322 of the Bankruptcy Code provides that the time period for future payments must not exceed three years, unless the court approves a longer period, and in no case will the period exceed five years. A similar provision applies for chapter 12 cases except that the payment period may be longer under two exceptions:

In In re David Brian Burgess,234 the bankruptcy court allowed a tax allocation made by the IRS to stand in a chapter 13 case. The IRS held a secured interest in property that had a value less than the amount of the claim for taxes, interest, and penalties. The IRS apportioned its claim to the collateral pursuant to its tax lien by applying the tax, interest, and penalty from 1988 first and then apportioning the remaining collateral to tax and interest for 1989. As a result of this process, part of the payment was allocated to cover penalties. The debtor objected on the basis that the IRS lien should first secure the payment of all taxes, the remaining taxes and all interest should be an unsecured priority claim, and all penalties should be treated as an unsecured general claim.

The bankruptcy court held that the IRS acted within its discretion in apportioning its claim to the debtor’s collateral. The court rejected the application of United States v. Energy Resources Co.,235 noting that the Supreme Court merely held that a bankruptcy court has the equitable power to direct how the IRS applies the debtor’s payment if it is necessary for the success of a plan of reorganization and cannot be applied to allow the apportioning of tax liabilities from secured to unsecured in order to discharge a larger portion of the liability.

The bankruptcy court refused to allow a couple to become charitable after filing bankruptcy.236 The Smihulas filed a chapter 13 petition scheduling approximately $61,000 of unsecured consumer debt. Their chapter 13 petition plan provided for monthly payments of $865 to their creditors. The Smihulas then tried to convert their chapter 13 case to chapter 7 and changed their plan to reflect a new $700 monthly charitable contribution in place of payments to creditors.

The bankruptcy court held that because the Smihulas’ charitable giving began after they filed for bankruptcy, the court had the authority to deny chapter 7 relief. The court, in considering the following statutory language of section 707(b), as amended by the Religious Liberty Act, “the court may not take into consideration whether a debtor has made, or continues to make, charitable contributions,” concluded by examining legislative history that “the amendment was not intended to allow debtors to begin making charitable contributions on the eve of bankruptcy.”

Wilbur Westberry filed a chapter 13 petition in 1997 and scheduled $34,500 of unpaid 1988 taxes jointly owed with his wife who did not file for bankruptcy.237 The IRS began its collection of the tax by levying her wages. The bankruptcy court granted the motion made by the husband for the enforcement of the codebtor stay under section 1301. The bankruptcy court concluded that because Mr. Westberry’s 1988 income was used exclusively for household purposes, the resulting tax indebtedness qualified as consumer debt under the profit-motive test.

On appeal, the district court reversed holding that federal income and self-employment taxes are involuntarily imposed and thus are not incurred for a personal, family, or household purpose under sections 101(8) and 1301 of the Bankruptcy Code. The court also noted that federal tax liability results from earning money, not through consumption.

A U.S. bankruptcy court238 held that a chapter 13 bankruptcy estate does not have to pay capital gains taxes arising from the postpetition sale of the debtor’s interest in property. The court noted that the chapter 13 estate does not exist as a taxable entity and that the debtor, not his estate, is burdened by and benefits from gains and losses. The court rejected the debtor’s position that, because it was unfair for the capital gains tax burden to fall upon him personally, the chapter 13 trustee be required to reserve the estimated taxes and, after receipt of the tax return, to either pay the taxes or release the funds for payment to the debtor to pay the taxes.

A taxpayer scheduled an unsecured IRS claim for $338,000. The IRS filed a proof of claim—agreeing with the fact that the claim was unsecured—for $461,000, asserting that the claim was a priority claim. The bankruptcy court concluded that the taxpayer’s tax claim exceeded $250,000 and that it was noncontingent and liquidated.239 Citing In re Mazzeo,240 the court stated that a section 6672 “responsible person” penalty is not contingent merely because the individual disputes it. The court also held that the claim was liquidated because its value was easily ascertainable and exceeded $250,000. The court explained that the existence of a dispute, without more, is insufficient to render a tax claim unliquidated.

The district court, affirming a bankruptcy court decision, held that a debtor’s confirmed chapter 12 plan and order discharging the IRS’s secured tax lien is final because the IRS had notice of the plan and failed to object to it.241

(p) Impact of Plan on Tax Liability

In In re Frank Todd,242 the bankruptcy court held that the IRS does not have an unsecured claim if it fails to timely object to an improper plan. The bankruptcy court confirmed a chapter 13 plan that provided for the surrender of a parcel of real property to its three lienholders, which included the IRS, in settlement of all obligations. The IRS did not object to the plan when it was confirmed. Later the IRS claimed that it had an unsecured claim for that portion of the tax deficiency not satisfied by the property sold. The court concluded that even though the bankruptcy plan was improper under Bankruptcy Rule 3007, the government was bound by the plan because it failed to timely object.

In In re DePaolo,243 the district court held that when the IRS fails to object to a reorganization plan, it is barred from asserting additional liability. Hugh DePaolo filed a chapter 11 petition and subsequently filed a plan of reorganization that provided for the payment in full of the IRS’s income tax claim for the 1986 and 1987 tax years in monthly installments over the course of six years. The IRS filed four proofs of claim with respect to its 1986 claim and indicated that the claim was for $26,724.

The IRS did not object to the reorganization plan and did not appeal the confirmation of the plan. After confirmation, the IRS filed amended proofs of claim reflecting payments received under the plan. In October 1989, the bankruptcy court entered its final decree and ordered the case closed. Subsequently, the IRS completed an audit and issued DePaolo a deficiency notice, asserting additional taxes for 1986 as well as penalties for subsequent years. The government attempted to increase the amount of the 1986 tax claim to $38,725.

DePaolo instituted an adversary proceeding against the IRS and sought a declaratory judgment that the increased tax claims for 1986 and 1987 were barred by res judicata and estoppel. The bankruptcy court granted the IRS summary judgment because the tax at issue was a new tax that had not been previously treated under the debtor’s confirmed chapter 11 plan. DePaolo appealed. The district court reversed the bankruptcy court’s decision and held that the government’s claim was barred by res judicata. The district court rejected the government’s contention that the confirmation of DePaolo’s plan was not a final judgment on the merits, noting that the IRS had actively participated in the bankruptcy proceedings, had not objected to the reorganization plan, and had not appealed the bankruptcy court’s confirmation of the plan.

The Tenth Circuit reversed on the basis because the tax at issue was new tax that had not previously treated under the debtor’s plan. Additionally, the Tenth Circuit held that the confirmation did not fix nondischargeable tax liabilities.244

In Grogan v. Commissioner,245 Grogan objected when the IRS filed a proof of claim after the plan confirmation hearing but before the bar date; the claim was much larger than the amount provided for in the plan. Grogan argued that confirmation of the chapter 13 plan, to which the IRS did not object, bound the IRS to the amounts listed in the plan.

The bankruptcy court overruled Grogan’s objections by holding that the IRS was not bound by the amounts listed in the confirmed plan. The court noted that the claims bar date is often scheduled after the date of confirmation and that, if a debtor wants to ensure the finality of the confirmation order, the debtor can (1) make adequate provision in the plan for creditors with priority claims or (2) file a claim on behalf of a creditor. The court concluded that to limit the IRS to an amount determined solely by the debtor while the time to file proofs of claims had not yet expired would violate fundamental principles of bankruptcy claims practice.

In Frank Thompson v. United States,246 the district court ruled on a similar issue. The IRS filed a proof of claim in a bankruptcy case, including a $59,200 priority unsecured claim for employment taxes. Frank Thompson proposed a plan stating that the IRS’s unsecured priority claim would be paid in full and that the unsecured claim would be treated in a class with other nonpriority unsecured claims that were impaired. The plan was subsequently modified to eliminate the IRS’s unsecured claim. The notice of modification, which was sent to the IRS, did not mention the modification that would eliminate the unsecured claim. The IRS did not object and the court confirmed the plan.

Thompson then attempted to reduce the claims of the IRS based on the terms of the plan, arguing that the IRS should be barred from challenging the plan, the modification, or the confirmation order because the IRS never filed an objection. The court ruled Thompson’s modification was inadequate because the IRS did not receive adequate notice.

The district court affirmed. The court found that the notice of modification was misleading and, as a result, the IRS did not receive adequate notice. The court explained that, under section 502(a) of the Bankruptcy Code, a claim is deemed allowed unless an objection is filed. No objection was filed by Thompson until after the plan was confirmed.

In In re Austin,247 the bankruptcy court held that the IRS must wait, along with other creditors, for plan distribution. Donald Austin filed a chapter 11 petition and was held to be the responsible person for unpaid payroll taxes owed by Diamond Manufacturing Co. and Rose Marine Inc., both chapter 7 debtors. The IRS filed an administrative claim in Austin’s case for $443,000 in postpetition taxes, and moved for immediate payment of the claim under section 503 of the Bankruptcy Code.

Austin and Signet Credit Corporation objected, indicating that they had proposed a competing plan providing for payment of administrative claims in full. Austin argued that the government should be required to look to the chapter 7 estates of Diamond and Rose first. Signet objected to the government being paid before everyone else while a valid plan was pending.

The bankruptcy court rejected the IRS’s motion, explaining that sufficient funds seemed to exist in Austin’s bankruptcy estate to pay administrative claims. The court indicated that the IRS would not be prejudiced by waiting, along with other creditors, for an orderly distribution to be made pursuant to a confirmed plan of reorganization.

The court failed to accept the government’s argument that it had effectively financed the debtor’s operations since 1985. The bankruptcy court explained that Austin’s liability was derivative, and until the possibility and result of some payment on the IRS’s claim by Diamond and Rose was resolved, it was not inequitable to require all parties to wait for payment until a plan of reorganization was confirmed.

(q) Taxes on Liquidation Sales

The Supreme Court, in In re China Peak Resort,248 upheld the authority of the states to impose a sales or use tax on a bankruptcy liquidation. This decision reverses the results of a 32-year-old Ninth Circuit case referred to as Goggin II,249 which prohibited a tax on a liquidation sale.

The Court concluded that “whatever immunity the bankruptcy estate once enjoyed from taxation on its operations has long since eroded and . . . there is now no constitutional impediment to the imposition of a sales tax or use tax on a liquidation sale.”