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IRS's Claim for Employer Shared Responsibility Payment Has Priority In Bankruptcy

(Parker Tax Publishing March 2022)

A bankruptcy court held that the IRS's claim against a Chapter 11 debtor for the employer shared responsibility payment (ESRP) under Code Sec. 4980H(b) is entitled to priority treatment under 11 U.S.C. Section 507(a)(8)(E) as an excise tax rather than as a penalty. The court also determined that for purposes of 11 U.S.C. Section 507(a)(8)I(i) the "transaction" that gives rise to the ESRP occurs when an employee who is not offered the minimum level of insurance coverage enrolls in a qualified health plan. In re Creative Hairdressers, Inc., 2022 PTC 55 (Bankr. D. Md. 2022).


Before declaring bankruptcy in 2020, Creative Hairdressers, Inc. (CHI) was one of the nation's largest independent family-owned chains of hair salons, operating approximately 800 hair salons under the Hair Cuttery, Bubbles, and Cielo brands. CHI employed over 10,000 full- and part-time employees. At the onset of the COVID-19 pandemic in March 2020, state and local governments ordered non-essential businesses like hair salons to close. As a result of the sudden closure of CHI's stores, CHI was almost immediately depleted of liquidity, and filed bankruptcy soon thereafter.

CHI was partially self-insured as defined by the Patient Protection and Affordable Care Act (the ACA) and qualified as an applicable large employer (ALE) under the ACA. CHI offered minimum essential health insurance coverage to at least 95 percent of its employees, but some employees were allowed a tax credit or cost-sharing reduction for any of the following reasons: (1) the coverage did not provide minimum value; (2) the coverage was not affordable; or (3) the employee was not offered coverage. Under Code Sec. 4980H(b), if an employee of an ALE receives a premium tax credit (PTC) or cost-sharing reduction, then the IRS may charge the employer a shared responsibility payment (ESRP) based on the number of employees who receive credits or cost-sharing reductions.

For the 2016 tax year, the IRS charged CHI an ESRP for the employees that were allowed a tax credit or cost-sharing reduction under the ACA. Beginning in 2017, CHI did not offer a health plan offering minimum essential coverage to salon employees. As a result, CHI also accrued ESRP charges for 2017 and 2018. The IRS sent CHI a Letter 226-J, ESRP Preliminary Contact, notifying CHI of its liability for the ESRP for the 2016 tax year on December 19, 2018. For the 2017 tax year, the IRS notified CHI of the ESRP in a Letter 226-J dated October 3, 2019.

On April 23, 2020, CHI filed for bankruptcy under Chapter 11 of the Bankruptcy Code. The IRS asserted a priority claim for the ESRPs under 11 U.S.C. Section 507(a)(8)(E), which gives priority status to allowed claims for excise taxes on a "transaction" occurring within three years of the filing of the bankruptcy petition. CHI objected to the IRS's assertion of a priority claim, arguing that the ESRP is not an excise tax but rather a penalty that is not entitled to priority status.

The term "excise tax" is not defined in the Bankruptcy Code. In U.S. v. Reorganized CF & I Fabricators of Utah, Inc. (CF&I), 518 U.S. 213 (S. Ct. 1996), the Supreme Court had to decide whether fees assessed against a debtor for failing to make annual minimum funding contributions to a pension plan, as required under Code Sec. 4971(a), were an excise tax or a penalty. The Court stated that a tax is an enforced contribution to provide for the support of government, while a penalty is an exaction imposed by statute as punishment for an unlawful act. The Court concluded that the pension provision was obviously penal in nature after finding that the 10 percent exaction was not created to support the government and the legislative history indicated that the previous statutory penalties did not incentivize employers to fully fund their plans.

In National Federation of Independent Business v. Sebelius (NFIB), 2012 PTC 167 (S. Ct. 2012), the Supreme Court affirmed the use of this "functional approach" analysis in deciding whether the ACA's individual shared responsibility payment (i.e., the individual mandate) was authorized under Congress's taxing power. It determined, using the functional approach, that the individual mandate had attributes of a tax - it was paid to the Treasury; set in proportion to taxable income, dependents, and the like; and governed by Treasury regulations. The Court next discussed the "functional approach" standard and the cases that applied the standard as confirmation that statutory labels cannot be relied upon to establish whether an exaction is a tax for constitutional purposes.

In Liberty University, Inc. v. Lew (Liberty), 2013 PTC 191 (4th Cir. 2013), the Fourth Circuit addressed whether the ESRP was a constitutional tax. Relying on NFIB, the Fourth Circuit concluded that the ESRP functioned as a tax and not a penalty. The Fourth Circuit found that the ESRP produces at least some revenue for the government and that it has other functional characteristics and looks like a tax in many respects. The court noted that it is paid into the Treasury, found in the Internal Revenue Code, and enforced by the IRS, which must assess and collect it in the same manner as a tax. The Fourth Circuit also noted that the ESRP does not punish unlawful conduct and leaves ALEs with a choice for complying with the law - provide adequate, affordable coverage to employees or pay a tax.


The bankruptcy court held that the ESRP is an excise tax rather than a penalty for purposes of Section 507(a)8)(E). The court noted that, strictly speaking, the holding of Liberty was not determinative in this case since the Fourth Circuit was required to determine whether the ESRP should be invalidated as an unconstitutional exercise of Congressional authority. The court also observed that an exaction could be a tax for constitutional purposes but a penalty under Section 507(a)(8)(E). Accordingly, the specific holding of Liberty - that the ESRP is a tax for constitutional purposes - did not itself foreclose a court from reaching a different conclusion on the question whether the exaction is an excise tax under Section 507(a)(8)(E).

Nevertheless, the court found that while the specific holding of Liberty may not be determinative, the Fourth Circuit's conclusions in reaching the determination that the ESRP is a tax controlled. The court noted that in Liberty, the Fourth Circuit expressly concluded that the ESRP does not punish unlawful behavior and that it is proportionate rather than punitive. The court also noted that the Fourth Circuit stated that the ESRP possesses the essential feature of any tax and produces at least some revenue for the government. In light of these conclusions, the court concluded that the ESRP is an excise tax under Section 507(a)(8)(E).

Next, the court had to determine the extent to which the IRS's claim was for an excise tax on a transaction occurring during the three years immediately preceding the petition date as provided in Section 507(a)(8)(E)(i). The court determined that the "transaction" that triggers the ESRP is the underinsured employee's act of enrolling in a qualified health plan. The court reasoned that, while the amount of the ESRP is not finally determined or imposed until a later date, the transaction occurs under Sec. 507(a)(8)(E) when an employee who is not offered the minimum level of insurance coverage and who meets certain financial standards enrolls in a qualified health plan. Enrolling underinsured or uninsured employees in qualified health plans, the court noted, is the very purpose of the ACA. The petition date was April 23, 2020, so the court concluded that any ESRP amounts arising from employee enrollments in a qualified plan prior to April 23, 2017, were excluded from priority and would be deemed general unsecured claims.

The court rejected the IRS's contention that the transaction that triggers the ESRP occurs when the IRS sends the Letter 226-J since the ESRP does not arise until that letter is sent. The court said that the transaction date cannot be predicated on action by the taxing authority. The court also found that the IRS's position could have devastating consequences in a bankruptcy case since considering that, in this case, the IRS sent the Letters 226-J close to two years after the relevant tax years. The court also disagreed with the IRS's alternative contention that the transaction date is April 15 of the year following the period in question, since that is the date by which the Forms 1040 on which employees claim the PTC are due. The court said that employees file returns on many dates other than April 15 in a given year and that there was no significance to that date, and claiming a credit on a Form 1040 would not be considered a "transaction" in the usual sense of that word.

For a discussion of discharging taxes in a bankruptcy, see Parker Tax ¶16,160. For a discussion of the employer shared responsibility payment, see Parker Tax ¶191,130.

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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