Tenth Circuit Holds Post-Petition Sale Of Farm Wasn't Dischargeable Under Chapter 12

In Re: Dawes, (CA 10 6/23/2011) 107 AFTR 2d ¶2011-975

The Court of Appeals for the Tenth Circuit has concluded that capital gains taxes arising from the post-petition sale of farm assets weren't dischargeable under Chapter 12 of the Bankruptcy Code.

Observation: Even before this case, there was a split among the circuits, which the Supreme Court agreed to resolve. Specifically the Supreme Court has agreed to review a 2010 decision of the Court of Appeals for the Ninth Circuit, which reached the same result as the current case, and which is contrary to a taxpayer/debtor-friendly decision of the Eighth Circuit.

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, which provides 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), including any tax incurred by the estate. (§507(a)(2))

Facts. Decades ago, the Daweses pleaded guilty for failing to file income tax returns in’81 through’83. They also failed to pay all their taxes for still more years, including’86–'88 and’90. IRS ultimately obtained a judgment declaring that the Daweses had fraudulently conveyed certain assets in an effort to avoid their creditors and that those unlawful conveyances were null and void. This result was previously affirmed by the Tenth Circuit, after which the government proceeded to execute its judgment, notifying the Daweses that it intended to take possession of various pieces of their property. But before it could do so, they declared bankruptcy, seeking the protections of Chapter 12.

After declaring bankruptcy, the Daweses, with the permission of the bankruptcy court, sold several tracts of farm land. This sale created income tax liabilities. The Daweses proceeded to submit a bankruptcy reorganization plan in which they proposed to treat their newly incurred tax liabilities as general unsecured claims. As unsecured claims, the taxes would be entitled to no priority, paid only to the extent funds might be available after priority claims were satisfied, and any remaining unpaid portion would be eligible for discharge. IRS opposed the plan, but lost before the bankruptcy court and then on appeal before the district court. It then appealed to the Tenth Circuit.

Dispute over whether taxes were incurred by the estate. The Daweses argued that, because the federal income taxes at issue were owed to IRS as a result of a farm asset sale and were “incurred by the estate,” they could be treated as general unsecured claims. The Tenth Circuit began its analysis by noting that one who has incurred an expense is liable for it.

The Court resolved the issue by looking to the Code to determine how tax liability is allocated between a debtor and an estate. It pointed out that in individual Chapter 7 and 11 bankruptcies, the trustee is charged with filing a separate return on behalf of the bankruptcy estate and paying from that estate any resulting taxes. (Code Sec. 1398(c), Code Sec. 6012(a)(8), Code Sec. 6012(b)(3), Code Sec. 6012(b)(4), and Code Sec. 6151(a)) Those taxes are incurred by the estate because the estate is obligated by federal law to pay them. But in Chapter 12 and 13 bankruptcies, the debtor, not the bankruptcy estate, bears the sole responsibility for filing and paying post-petition federal income taxes. (Code Sec. 1399, Code Sec. 6151(a)) Only the debtor, not the estate, is liable for the payment of these taxes. The Court said this answers the question posed by §503(b): because a Chapter 12 or Chapter 13 estate isn't liable for post-petition federal income taxes, the estate does not incur such taxes. Those taxes aren't in the bankruptcy at all but remain the personal obligation of the debtor during, after, and apart from the bankruptcy. Accordingly, it reversed the district court and held that the Daweses' post-petition income tax liabilities were not eligible for treatment as unsecured claims under §1222(a)(2)(A) as proposed in their reorganization plan.

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.