Court Addresses Priority of Income Taxes Incurred in Year of Bankruptcy

(Parker Tax Publishing August 2020)

In a case of first impression, a district court reversed a bankruptcy court's holding that a corporate debtor's straddle year should be bifurcated into pre- and post-petition periods and that income taxes resulting from pre-petition events are accorded general unsecured treatment while income taxes resulting from post-petition events are granted administrative priority treatment. The court held that the applicable substantive tax law determines when a tax is incurred and, under Code Sec. 441, corporate federal income tax liability accrues and becomes a fixed liability on the last day of the tax period; therefore, the tax at issue was incurred by the estate post-petition and was entitled to priority as an administrative expense. In re Affirmative Insurance Holdings Inc., 2020 PTC 220 (D. Del. 2020).

Background

Affirmative Insurance Holdings Inc. and certain affiliated debtors (Debtors) filed for chapter 11 bankruptcy in October 2015. Prior to filing for bankruptcy, the Debtors had sold or otherwise disposed of substantially all of its material assets. The bankruptcy court later entered an order converting the case to chapter 7 and, thereafter, a trustee was appointed.

In 2016, the trustee filed the Debtors' federal tax return for the 2015 calendar year. The Debtors' full year consolidated taxable income was realized principally from pre-petition activities. Based on their taxable income, the Debtors had a full tax year obligation of $792,113, plus penalties and interest. The IRS filed an administrative expense claim for taxes for the Debtors' tax year ending 2015. The trustee objected and sought an order disallowing administrative expense priority for the IRS's claim and reclassifying the entirety of the IRS's claim as a general unsecured claim.

The bankruptcy court sustained the trustee's objection in part. It noted that, before the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the Third Circuit held that such straddle tax years must be bifurcated into priority and unsecured claims. Nothing in the plain meaning of the statute or legislative history of BAPCPA, the court said, would justify departing from this approach and administrative priority should be applied only to obligations resulting in or arising from a benefit received after the bankruptcy estate came into existence. Applying the bifurcated approach, the bankruptcy court held that pre-petition events that incur tax liability during straddle years are afforded general unsecured status, whereas post-petition events that incur tax liability during those same straddle years are afforded administrative priority. The IRS appealed the bankruptcy court's decision.

Under 11 U.S.C. Sec. 507, there are ten priorities of expenses and unsecured claims against an estate. Section 507(a)(2) gives second priority to administrative expenses allowed under 11 U.S.C. Sec. 503(b). For taxes to warrant administrative priority, they must satisfy 11 U.S.C. Sec. 503(b)(1)(B), which generally provides that any taxes "incurred" by an estate are administrative expenses are entitled to second priority under Section 507(a)(2).

The IRS argued that under Code Sec. 441(b)(1), a corporation's entire annual income tax accrues on the last day of the tax year. According to the IRS, because a corporation has only a single tax liability for a tax year, the entire tax is "incurred by the estate" on that day. The IRS argued that the bankruptcy court erred in its failure to consider the language of Code Sec. 441 in determining when a corporation's federal income tax is incurred. The IRS further argues that BAPCPA clarified that a tax year cannot be bifurcated. The trustee responded that income tax is incurred daily, based on each day's events and transactions, and that a single yearly tax liability must be apportioned between pre-petition and post-petition days, events, and transactions. The trustee maintained that any portion of the tax traceable to events or transactions before the petition date, when no estate yet existed, was not "incurred by the estate." The trustee argued that, since the tax period did not end before the filing of the bankruptcy petition, the tax incurred in the pre-petition portion of the straddle year was not entitled to priority status.

Analysis

The district court reversed the bankruptcy court after finding that the tax at issue in the IRS's claim was incurred by the estate post-petition and should be entitled to priority as an administrative expense.

The court noted that under Hall v. U.S., 2012 PTC 110 (S. Ct. 2012), the determination of whether and when a tax is incurred by estate must be made based on the underlying substantive tax law. The court stated that, under federal tax law, a taxpayer is liable for a tax when the tax accrues and becomes a fixed liability. The court then found that, under Code Sec. 441(b)(1), a corporation's income tax accrues and becomes a fixed on the last day of the tax year, because it is only then that all events giving rise to an income tax have occurred (both those creating income and those creating deductions). The court reasoned that until midnight on December 31, a corporation could still, for example, incur operating expenses or make charitable donations that would eliminate any liability that would otherwise arise from income earned during the preceding 12 months. The court further observed that, under Code Sec. 11, tax is imposed for an entire year, not on individual events, and that corporate tax liability is determined by, in part, netting all the year's income with all the year's deductible expenses, then applying the applicable tax rate.

Applying these provisions, the court held that the Debtors' 2015 taxable income could only be calculated at the end of the tax year after all income and deductions from income were known. The court said that, in other words, until December 31, 2015, the Debtors' did not have taxable income because not all possible events had occurred. The court reasoned that, while a major source of income came from a June 30, 2015, sale, which was before the October 14, 2015, petition date, it was irrelevant whether that income was recognized on one day during the year or on 365 separate days, because the Internal Revenue Code considers aggregate amounts, not individual income events or deductions, during the year.

The court did not agree with the IRS, however, that the effect of the 2005 amendments under BAPCPA was to make straddle year taxes entirely post-petition claims. The court agreed with the IRS that the policy of the Bankruptcy Code is to give priority to tax claims that the government, as an involuntary creditor, has not had a reasonable opportunity to collect. But the court found no legislative history to support the government's reading that Congress intended to make straddle-year taxes entirely post-petition claims. The court found that the scant legislative history of BAPCPA makes no mention of the treatment of straddle-year taxes.

For a discussion of the tax treatment of income, deductions, and credits of a bankruptcy estate, see Parker Tax ¶16,150.

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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