U.S. v. Hall, (CA 9 8/16/2010) 106 AFTR 2d 2010-5848, cert granted 6/13/2011
The Supreme Court has agreed to review a 2010 decision of the Court of Appeals for the Ninth Circuit which concluded that capital gains taxes arising from the post-petition sale of farm assets weren't dischargeable under Chapter 12 of the Bankruptcy Code. The Ninth Circuit decision was contrary to the taxpayer/debtor-friendly decisions of the Eighth and Tenth Circuits and created a split in the circuits.
Background. Under Chapter 12 of the Bankruptcy Code (11 U.S.C. §§1201-31), family farmers and fishermen are allowed to reorganize their business affairs while keeping creditors at bay. In such bankruptcy cases, the debtor must file a plan of reorganization providing for full deferred payments of all claims entitled to priority under §507 of the Bankruptcy Code unless the claim is one owed to a governmental unit that arises as a result of the sale, transfer, exchange, or other disposition of any farm asset used in the debtor's farming operation, in which case the claim is treated as an unsecured claim that isn't entitled to priority under §507. (§1222(a)(2)(A)) Among the claims entitled to priority under §507 are: (1) various taxes incurred on or before the date of the filing of the petition, i.e., prepetition income tax; (§507(a)(8)(A)) and (2) administrative expenses allowed under §503(b), which the Ninth Circuit noted arguably includes the tax on the gain from the sale of a farm because §503(b)—which is cross-referenced by §507(a)(2)—allows for administrative expenses including any tax incurred by the estate. (§507(a)(2))
In Knudsen v. IRS, (CA 8 2009) 104 AFTR 2d 2009-6384, the Eight Circuit concluded that capital gains taxes arising from the post-petition sale of farm assets were dischargeable under the §1222(a)(2)(A) exception. In so concluding, the Court expressly declined to give weight to Code Sec. 1398 and Code Sec. 1399. Code Sec. 1399 provides that no separate taxable entity results from the commencement of a case under title 11 of the United States Code, i.e., the bankruptcy title, except in any case to which Code Sec. 1398 applies—that is, any case under Chapter 7 (relating to liquidations) or Chapter 11 (relation to reorganizations) in which the debtor is an individual. The Tenth Circuit Bankruptcy Appellate Panel also agreed with the Eighth Circuit's decision in Knudsen without further analysis. (IRS v. Ficken (In re Ficken), (Bktcy CA 10 2010) 105 AFTR 2d 2010-2265)
Facts. In August 2005, Lynwood and Brenda Hall filed a petition under Chapter 12 of the Bankruptcy Code. Shortly afterwards, the Halls moved to sell their farm for $960,000, which the bankruptcy court approved. In December 2005, the Halls proposed a plan of reorganization, under which they sought to pay off their outstanding liabilities using the proceeds from the sale. IRS objected to the proposed plan, asserting a federal income tax of $29,000 on the capital gain from the sale. The Halls amended their proposed plan to treat the $29,000 tax as an unsecured claim to be paid to the extent funds were available, with the balance discharged. IRS objected. The bankruptcy court sustained IRS's objection. (In re Hall, (Bktcy Ct AZ 2007) 100 AFTR 2d 2007-6229) The district court reversed, and IRS appealed.
Ninth Circuit's conclusion. The majority opinion of the Ninth Circuit concluded that the postpetition tax on the sale of the farm at issue wasn't dischargeable under the §1222(a)(2)(A) exception because it wasn't “incurred by the estate.” Code Sec. 1399 provides that a Chapter 12 estate cannot incur taxes. Since the Chapter 12 estate wasn't a taxable entity, it couldn't get the benefit of §1222(a)(2)(A), which provides that the tax on the gain from the sale of a farm during bankruptcy is dischargeable and payable in less than full.
The Court recognized that this conclusion necessarily implies that the debtor was responsible for any taxes incurred after the bankruptcy petition was filed in a Chapter 12 case because the Chapter 12 trustee, the only other potentially responsible party, wasn't liable for the tax. The Court found that the omission of any provision in the Code requiring the trustee to pay taxes in cases to which Code Sec. 1398 doesn't apply, such as Chapter 12 cases, implies that the trustee doesn't pay taxes in such cases. Further, the debtor remains in possession in Chapter 12 bankruptcy absent extraordinary circumstances. (§1203)
The Ninth Circuit was unpersuaded by the Eighth's Circuit's reasoning in Knudsen. The Court was similarly unimpressed by the Halls' arguments. They argued that, despite Code Sec. 1399, the fact that a bankruptcy estate existed and could hold property meant that it could incur taxes. They argued that the key was when the tax was incurred and not whether the estate could incur a tax because “incurred by the estate” in §503(b) must necessarily mean incurred post-petition because a bankruptcy estate couldn't exist until after a bankruptcy petition was filed. Finally, they argued that the legislative history supported their conclusion, but the Court determined that it couldn't ignore clear statutory text because of legislative floor statements.
Supreme Court to resolve issue. On June 13, the Supreme Court granted certiorari of the Hall case. Thus, the circuit split will be resolved.
References: For tax claims and tax determinations in bankruptcy, see Federal Tax Coordinator 2d ¶C-9800 et seq.; United States Tax Reporter ¶68,726; TaxDesk ¶577,501 et seq.; TG ¶3200 et seq.