Farm in Chapter 11 Bankruptcy Can't Convert to Chapter 12 to Obtain More Favorable Treatment of Capital Gains

(Parker Tax Publishing July 2019)

A bankruptcy court rejected a farm's request to convert its Chapter 11 bankruptcy to Chapter 12 bankruptcy and to change its tax classification from a partnership to a corporation in order to allow the farm's capital gains tax liabilities to be discharged as a general unsecured claim. The court held that the farm was not eligible for Chapter 12 when it filed its petition and that changing its tax classification would violate the Bankruptcy Code and would be detrimental to the farm's creditors. In re Schroeder Brothers Farms of Camp Douglas LLP, 2019 PTC 210 (Bankr. W.D. Wis. 2019).

Background

Schroeder Brothers Farms of Camp Douglas LLP (Schroeder), a Wisconsin farm, filed a Chapter 11 bankruptcy petition in November of 2016. The bankruptcy court confirmed the plan in June of 2018. The plan contained a liquidation provision requiring Schroeder to verify each month that it made the required payments under the plan for the preceding month. If Schroeder defaulted and did not cure the default within 30 days, a committee of unsecured creditors could appoint a liquidating trustee.

In August of 2018, Schroeder notified the committee that it was unable to make the monthly payments under the plan. The committee informed Schroeder of its intent to move for the appointment of a liquidating trustee. The committee proposed a carveout provision providing that no less than 10 percent of aggregate gross proceeds of assets sold by the liquidating trustee would be allocated for the payment of allowed administrative expenses and unsecured claims. If gross sale proceeds equaled or exceeded the sum of secured claims and the carveout amount, then the carveout provision would not apply.

Schroeder objected to the motion for appointment of a liquidating trustee. It asserted that, since August of 2018, the value of its encumbered real property, equipment, and cattle had declined. Schroeder argued that a sale of its assets would result in capital gains taxes and would likely be insufficient to pay the resulting taxes and fees. Schroeder asked the court to convert the bankruptcy to a Chapter 12 bankruptcy and to allow it to file an IRS Form 8832, Entity Classification Election, to change its tax classification from a partnership to a corporation in order to take advantage of 11 U.S.C. Sec. 1232, which treats certain capital gains tax liabilities of a Chapter 12 debtor as a general unsecured claim.

Observation: Congress added 11 U.S.C. Sec. 1232 to the Bankruptcy Code to overrule Hall v. U.S., 2012 PTC 110 (2012). In Hall, the Supreme Court ruled that an individual debtor cannot treat post-petition taxes as an administrative expense of the bankruptcy estate and must pay the post-petition taxes as they become due. 11 U.S.C. Sec. 1232(a) provides that any unsecured claim of a governmental unit that arises before the filing of the petition, or that arises after the filing of the petition and before the debtor's discharge, as a result of the sale of any property used in the debtor's farming operation (1) will be treated as an unsecured claim arising before the date on which the petition is filed, (2) will not be entitled to priority, (3) will be provided for under a plan, and (4) will be discharged.

Chapter 12 is generally available only to family farmers with debt under $4,411,400 when the case is filed. Schroeder conceded that it was ineligible to be a Chapter 12 debtor when it filed its petition but that, as its total debts were now below $4 million, it was now eligible. Schroeder asserted that it was eligible to elect to be taxed as a corporation and that, if an election were made, Chapter 12 would allow the corporation's taxes to be discharged as an unsecured claim. Schroeder argued that the best approach in the instant situation was to deny the committee's motion for the appointment of a liquidating trustee, allow the conversion to Chapter 12, and confirm a Chapter 12 plan incorporating liquidation provisions.

The committee responded that Schroeder could not convert to Chapter 12 because it was ineligible when it filed its petition and post-petition changes in the amount of debt do not affect eligibility. The committee also argued there was no equitable ground on which the court should convert the case. The committee noted that potential capital gains taxes were a non-issue because the debtor is an LLP, i.e., a pass-thru entity, and its the partners, not the partnership, that are liable for any taxes arising from the sale of assets. BMO Harris Bank N.A., the primary secured creditor, joined the committee's objection, contending that the proposed conversion was prohibited under the Bankruptcy Code and that, even if allowed, it would be inequitable because Schroeder had no realistic probability of successfully reorganizing and the creditors had negotiated the liquidation provision in the plan with this scenario in mind.

Analysis

The bankruptcy court denied Schroeder's motion to convert to Chapter 12 and held that permitting Schroeder to change its entity tax classification would violate the Bankruptcy Code. The court found that Schroeder had to qualify as a family farmer as of the original petition date in order to be allowed to convert to Chapter 12 and that Schroeder's debt exceeded the statutory limit when it filed its petition. The court noted that Schroeder had conceded as much and found that conversion did not change the date from which the court determines eligibility to convert.

The court also found that allowing Schroeder to elect to be taxed as a corporation in order to take advantage of 11 U.S.C. Sec. 1232 would violate the absolute priority rule in 11 U.S.C. Sec. 1129(b)(2)(B), which provides that the owners of a debtor will not receive or retain under a bankruptcy plan any property because of that interest unless all general unsecured claims are paid in full. The court explained that the absolute priority rule is a mainstay of Chapter 11. The fundamental principle, according to the court, is to ensure that the plan is fair and equitable by prohibiting a court from approving a plan that gives the holder of a claim anything at all unless all objecting classes senior to him have been paid in full.

In the court's view, Schroeder's proposed tax election would benefit the partners of the LLP to the detriment of creditors by shifting funds from creditors to taxing authorities. The court found that since filing the bankruptcy, Schroeder's partners had retained the benefit of favorable tax treatment through any depreciation or other losses, and the partners were seeking to effect a change in the tax treatment of the LLP, saddling Schroeder with substantial estimated capital gains taxes. The partners would receive a tax benefit through favorable tax treatment, the court said, and would shift the unfavorable treatment to the detriment of creditors. The court also reasoned that allowing the change in election would result in an unfair surprise to the creditors, who had relied on the disclosure statement and the plan, which did not include a change in tax treatment.

For a discussion of Chapter 12 bankruptcy, see Parker Tax ¶16,120. The tax classification election rules are discussed in Parker Tax ¶29,501.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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