A Presentation To The Spring Meeting of Commercial Law Committee Of The Missouri Bar May 9, 2014 Jefferson City, Missouri

Hon. Cynthia A. Norton 1 Bankruptcy Judge Western District of Missouri A Presentation To The Spring Meeting of Commercial Law Committee Of The Missouri Bar May 9, 2014 Jefferson City, Missouri A GENERAL DISCUSSION OF 505 AND ITS IMPLICATIONS Introduction and Background Section 505 of the Bankruptcy Code grants bankruptcy courts broad jurisdiction over the adjudication of tax disputes. 11 U.S.C. 505(a). Until the Supreme Court s decision in Arkansas Corp. Commission v. Thompson, 313 U.S. 132 (1941), bankruptcy courts were generally thought to have the full power to examine the validity and amount of taxes that were entitled to priority, and, conversely, to withhold payment on such taxes if the court found the tax exceeded what was owed. 2 This included determining property values for the purposes of taxation. 3 The authority theoretically stemmed from the language in 64a(4) in the Bankruptcy Act of 1898 which defined priority distribution. Arkansas Corp., 313 U.S. at 138. The language provided for tax debts legally due and owing by the bankrupt to the United States or any State to be paid at fourth priority, and, that in case any question arises as to the amount or legality of any taxes, such question shall be heard and determined by the (bankruptcy) court. Id. (citations omitted). The Supreme Court rejected the interpretation of 64a(4) and held that bankruptcy courts did not have the power to redetermine and revise the property value finally fixed by a state. 1 With much thanks to my Law Clerk, Katherine Rea, who researched and drafted the bulk of these materials, with assistance Law Clerk Diane Carter, and judicial intern, Kelly Postlewait. ( Collier s ). 2 4 Collier on Bankruptcy 505.LH[1][a] (Alan N. Resnick & Henry J. Sommer eds., 16th ed.) 3 Id. 1

Arkansas Corp., 313 U.S. at 139. The Court reasoned that once the state tax commission a quasi-judicial agency - made its final judgment, and that judgment was not appealed, the amount legally due and owing was finally determined by a court and therefore not subject to review. Arkansas Corp., 313 U.S. at 141. The only review the bankruptcy court could engage in was whether the taxing authority made an improper arithmetical computation or exceeded its statutory jurisdiction. Arkansas Corp., 313 U.S. at 143-44. The Court noted that nothing in the language of the bankruptcy statute [I]ndicates that taxpayers in bankruptcy or reorganization are intended to have the extraordinary privilege of two separate trials, one state and one federal, on an identical issue of controverted fact the value of the property taxed. Arkansas Corp., 313 U.S. at 142. Congress amended the Bankruptcy Act of 1898 in 1966 to resolve some of the jurisdictional and authority issues that remained after Arkansas Corp. 4 The current language in 505(a) stems from the amendment: (1) Except as provided in paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction. (2) The court may not so determine (A) the amount or legality of a tax, fine, penalty, or addition to tax if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case under this title; (B) any right of the estate to a tax refund, before the earlier of (i) 120 days after the trustee properly requests such refund from the governmental unit from which such refund is claimed; or (ii) a determination by such governmental unit of such request; or 4 Id. 2

(C) the amount or legality of any amount arising in connection with an ad valorem tax on real or personal property of the estate, if the applicable period for contesting or redetermining that amount under applicable nonbankruptcy law has expired. 11 U.S.C. 505(a)(2005)(emphasis added). In addition to incorporating portions of the old law, the Bankruptcy Act of 1978 also added subsection (b) to 505. 5 This subsection permits trustees to request a determination of unpaid taxes of the estate incurred during the administration of the case by submitting a tax return for the relevant tax. The subsection then provides that the trustee, debtor, estate, and any successor of the trustee will be discharged of any tax owed during the administration of the estate if the taxing agency does not comply with the required procedures in 505(b)(2). These procedures drastically reduce the amount of time the taxing authority has to determine if the tax return should be examined and determine if the tax return is correct. 6 In order to assist government agencies in complying with the statute, subsection (b) also requires the clerk of the bankruptcy court in each district to maintain a list where taxing agencies may designate an address for where a debtor or trustee may make a request for a determination of taxes. Finally, subsection (c) provides that after a tax court has determined tax owing, the governmental unit charged with collecting the tax may assess it against the estate, debtor, or successor to the debtor without violating the automatic stay. Notably, the language in 505 is permissive, not mandatory. Thus much of the caselaw seeks to determine the limits on the court s jurisdiction to determine tax liability and whether the court should abstain. The following materials will discuss the breadth of the court s jurisdiction 5 11 Collier s TX5.04[3]. 6 11 Collier s TX5.04[3][b]. 3

to determine tax liability, situations when the court should abstain, and procedural considerations for 505 actions. 1. Must the Debtor have filed for a refund in order for the Court to have Subject Matter Jurisdiction over the refund? It depends. In United States v. Kearns (In re Kearns), 177 F.3d 706 (1999), the Eighth Circuit addressed the jurisdictional breadth of 505 with regards to refunds. Prior to filing for bankruptcy, the Debtor had made three unauthorized distributions to himself from a trust. Kearns, 117 F.3d at 708. After the Debtor filed bankruptcy, the IRS filed a proof of claim for the Debtor s 1989 tax liability - the year the Debtor made the unauthorized distributions. Id. The IRS characterized the distributions as embezzlement income and calculated that the Debtor owed $142,718 in taxes because of the increased income. Id. The Debtor objected to the IRS s claim, arguing that the funds were not embezzlement due to a settlement agreement the Debtor entered into with the other trust beneficiaries. Id. The Court disagreed with the Debtor and characterized the funds as embezzlement, but noted that the Debtor had made restitution to the victims in the years 1990-94, which would give rise to deductions on the IRS s claim. Id. The IRS objected that the Court lacked subject matter jurisdiction to consider the restitution deductions because the Debtor had not filed for a refund for the years 1990-94 with the IRS, and the statute of limitations for filing for a refund had passed. Id. The bankruptcy Court rejected the IRS s argument and permitted the offset. Kearns, 177 F.3d at 709. On appeal, the Eighth Circuit agreed with the bankruptcy Court. Kearns, 177 F.3d at 710. The Eighth Circuit stated that by filing the proof of claim, the IRS committed to resolving the issue of the Debtor s tax liability for the stated year in bankruptcy Court. Kearns, 177 F.3d at 711. The deductions from the different years were intimately related to the adjudged tax 4

liability. Kearns, 177 F.3d at 710. The Court cited to the legislative history behind 505 as supporting the bankruptcy Court s jurisdiction over potential tax offsets to claims filed by taxing authorities. Id. The Court similarly rejected the IRS s argument that the statute of limitations deprived the bankruptcy Court of subject matter jurisdiction: [I]f, when the claims of the IRS and a debtor involve the same tax liabilities, it is without purpose and irrational to deny jurisdiction over refunds absent a formal request by the debtor, it would be doubly so to apply a statutory bar to the debtor s claim for determination of tax liability. Kearns, 177 F.3d at 711. It is important to recognize the limitation in this case. There was no dispute that the Court had jurisdiction to adjudicate the 1989 tax year. Because that jurisdiction was proper, the Court was able to adjudicate the tax years that affected the tax liability for the year in dispute, despite the fact that the Debtor did not request the IRS to reconsider those taxes within the necessary time period. The case does not provide Courts with jurisdiction over all tax disputes regardless of the statute of limitations. Indeed, 505(a)(2)(C) specifically bars the bankruptcy Court from determining taxes when the statute of limitations under applicable nonbankruptcy law has expired, and 505(a)(2)(B) specifies that trustees must properly request refunds from governmental units in order for the estate to recover the refund. 2. When has a tax been contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction? Section 505(a)(2)(A) also bars bankruptcy Court from redetermining tax liability when the tax liability was previously contested and adjudicated. A tax has been contested and adjudicated when the tax court has entered a final order. Harker v. United States (In re Harker), 357 F.3d 846 (8th Cir. 2004). This includes a determination by a quasi-judicial body such as an administrative board of review. In re Ishpeming Hotel Company, 70 B.R. 629 (Bankr. W.D. Mich. 1986). At least one Court has held that settlements barring further state Court litigation 5

would also bar relitigation in bankruptcy Court. IRS v. Teal (Matter of Teal), 16 F.3d 619 (5th Cir. 1994). A Court may, however, have jurisdiction if there is an appeal of the order pending. In re B&B Marine Sales & Service, 149 B.R. 465 (Bankr. N.D. Ohio 1992). The principals applied to cases discussing whether the tax has been contested and adjudicated are similar to res judicata and Rooker-Feldman principals. E.g., Baker v. IRS (In re Baker), 74 F.3d 906 (9th Cir. 1996). 3. Whose liability can the Court determine? Some Courts have held that 505(a) s broad authorization encompasses not only the taxes of the Debtor, but also the obligations of third parties. These Courts have found that extending jurisdiction to non-debtors is consistent with the general policy of the Bankruptcy Code that the bankruptcy Court should have the power to resolve all disputes affecting the debtor s estate. For example, a Court has jurisdiction to hear a complaint by the Debtor s President against the IRS regarding personal tax liability. H&R Rice Company, Inc. et. al. v. United States (In re H&R Ice Company, Inc.), 24 B.R. 28 (Bankr. W.D. Mo.1982). In a California case, the Court held that 505(a) provided it with jurisdiction to determine taxes of the Debtor s creditors. In re Major Dynamics, Inc., 14 B.R. 969 (Bankr. Cal. 1981). Most Courts, however, interpret 505(a) s jurisdictional grant to be limited to tax determinations for debtors and debtors in possession. E.g., In re Brandt-Airflex Corp., 843 F.2d 90 (2d Cir. 1988); In re LaSalle Rollling Mills, Inc., 832 F.2d 390 (7th Cir. 1987); In re Booth Tow Services, Inc., 53 B.R. 1014 (W.D. Mo. 1985). The Eighth Circuit has not weighed in on the issue. 4. But Judge, I don t want to be in bankruptcy Court! Although 505(a) grants discretionary jurisdiction to the bankruptcy court to determine tax liabilities, in certain scenarios the court may choose to abstain. In re Zendeli, No. 10-60669, 6

2012 WL 1565305, at *2 (Bankr. W.D. Mo. 2012) (slip opinion). When deciding whether to adjudicate a tax liability issue Courts generally consider the traditional abstention factors: (1) the complexity of the tax issue to be decided; (2) the asset and liability structure of the debtor; (3) the length of time required for trial and decision; (4) judicial economy; (5) the burden on the court s docket; (6) prejudice to the debtor; and (7) potential prejudice to the taxing authority responsible for collection from inconsistent judgments. Id.; In re Goins, 437 B.R. 372, 375 (Bankr. E.D. Mo. 2010); See, e.g., In re Gilliam, No. 2:09-0079-MBS, 2009 WL 4051074, at *2 (D.S.C. Sept. 25, 2009); In re Indianapolis Downs, LLC, 462 B.R. 104, 114 (Bankr. D. Del. 2011). One of the most common reasons for abstention by the Court is when the bankruptcy case is a no-asset case. Courts generally view abstention as appropriate in these cases because there is no bankruptcy purpose in retaining jurisdiction. In re Edwards, No. 92-42953-293, 93-4035- 293, 1996 WL 652837, at *1 (Bankr. W.D. Mo. Aug. 30, 1996). Determining tax liability in bankruptcy Court would not serve to further judicial economy because the estate will not benefit. Id. Of course, if the Court need also determine whether the tax debt is dischargeable, it may be a better exercise of judicial efficiency for the Court to determine both the tax and the dischargeability. See id. For example, in Zendeli, the IRS argued the Chapter 7 debtor lacked standing to challenge its claim regarding trust fund taxes since there was no possibility of a surplus, or, in the alternative, that the Court should abstain from determining liability. In re Zendeli, 2012 WL 1565305, at *1. Although the Court found that the Debtor had standing because it had an interest in the dischargeable nature of the claims, it abstained from hearing the matter. Id., at *2. The Debtor s liability for the tax debts involved a variety of entities and trusts, and was alleged to be 7

close to $500,000. Id. The Court reasoned that judicial economy would be better served if a tax Court or other Court familiar with tax issues determined liability. Id. This was true despite the Debtor s stated preference of having the liability determined in bankruptcy Court, because the parties all agreed that the estate s funds were only sufficient to go to the secured or priority taxes. Id. Similarly, in Goins, the Court refrained from deciding a dispute involving trust fund recovery penalty taxes where the extent of the Debtor s tax liability failed to benefit the estate. 7 In re Goins, 437 B.R. at 375. The taxes arose from a law firm in which the Debtor had a mere 5% ownership interest and exercised no control. Id. at 374. In deciding to abstain, the Court noted it would not have jurisdiction over the other partners of the firm, and thus would be unable to determine the full extent of the firm s tax liability. Id. In contrast, [a]ny suit in District Court can properly include or join all potentially responsible parties to the litigation. Id. Finally, because the case was a no-asset case, time spent in bankruptcy Court would be an inefficient use of this Court s time, resources, and would unjustifiably burden this Court s docket. Id. at 375. Congress s grant of jurisdiction over tax issues under 505 was for the benefit of the bankruptcy estate; it therefore follows that if there is no benefit, the Court should abstain. Id. Bankruptcy Courts appear to be trending toward abstention in complex 505 matters. 8 Some Courts consider this show of deference to tax Courts as a means of conserving judicial resources. See In re Dees, 369 B.R. 676, 679 (Bankr. N.D. Fla. 2007). A New York Court 7 But see In re Weiss, No. 06-21677, 2013 WL 6726502 (Bankr. D. Kan. Dec. 19, 2013) (slip opinion) (Court refused to abstain where the determination of tax liability was material to the Debtor s fresh start); In re Melvin, 410 B.R. 705, 708 (Bankr. M.D. Ala. 2009) (Court proceeded in tax determination of no asset case noting the broad reach of 505 and the absence of any statutory exceptions). 8 Elizabeth Weller, Does the Bankruptcy Court Really Have Unlimited Authority to Redetermine Taxes?, XXIX ABI Journal 9; 12, Nov. 2010, at 68, 69. 8

abstained where a tax determination involved valuing a Texas oil refinery. See In re Lyondell Chemical Co., No. 09-10023 (REG), 2010 WL 1544411 (Bankr. S.D.N.Y. April 19, 2010). Other Courts have refused adjudication where the cases involved unsettled tax issues. See generally In re Leland, 160 B.R. 834 (Bankr. E.D. Cal. 1993). 5. Jurisdiction is proper and the bankruptcy Court has decided to determine liability. Now what? Section 505 does not specify what procedures a party should go through to being a 505 action. It does not require a taxpayer to file a return before requesting the bankruptcy Court to determine liability, although one Court has held that a return must be filed for there to be a controversy for the Court to adjudicate. In re Grand Chevrolet, Inc., 153 B.R. 296 (C.D. Cal. 1993). In addition, 505 is not listed in Fed.R.Bankr.P. 7001, so it should be initiated by motion as a contested matter rather than brought as an adversary. Finally, because 106(a) of the bankruptcy Code abrogates governmental sovereign immunity with regards to 505 actions, it is not necessary for the governmental unit to have filed a proof of claim before requesting the bankruptcy Court to determine tax liability. See Bostwick v. U.S., 521 F.2d 741 (8th Cir. 1975) (under previous bankruptcy Act, the bankruptcy Court had jurisdiction to determine tax liability even though the United States had not filed a proof of claim); Bucher v. Dakota Fin. Corp. (In re Whitaker), 474 B.R. 687 (B.A.P. 8th Cir. 2012) (Section 106(a) abrogates immunity with regards to governmental units). Some Debtors have attempted to use 505 to bind taxing authorities through the language in their plans without bringing a motion. E.g., IRS v. Taylor (In re Taylor), 132 F.3d 256 (5th Cir. 1998). The Taylor Court rejected this approach, stating that the lack of a motion initiating 505 action was more than a procedural defect. 132 F.3d at 263. Rather, the 505 motion, like an objection to claim, puts the parties on notice that litigation is required to resolve 9

a dispute as to the amount of the debt. Taylor, 132 F.3d at 262. Confirmation notices do not provide the same effect and therefore do not bind creditors whose debts would otherwise have ridden through the bankruptcy. Id. The Court declined to hold that a Debtor must have a separate 505 hearing, but rather that confirmation alone does not invoke the tax determination process. Id. 6. Who bears the burden of proving tax liability? Prior to 2000, there was some dispute over who carried the burden of proof when a Debtor disputed taxes. E.g., In re Brown, 82 F.3d 801 (8th Cir. 1996); Resyn Corp. v. United States, 851 F.2d 660 (3d Cir. 1988). This dispute arose mainly in the context of the claims resolution process, but cast doubt on burden-shifting in a 505 action. The Supreme Court resolved this dispute in 2000 with its decision is Raleigh v. Illinois Dept. of Revenue. 530 U.S. 15 (2000). The Debtor in Raleigh had once been the president of a defunct Illinois corporation called Chandler Enterprises. Raleigh, 530 U.S. at 17. Prior to its winding up, Chandler Enterprises had bought an airplane out-of-state and moved it to Illinois, triggering Illinois use tax. Raleigh, 530 U.S. at 18. Under Illinois law, the notices sent out to corporations and liable officers for tax liability are prima facie evidence of a penalty due and shift the burden of proof and persuasion to the allegedly delinquent taxpayer. Raleigh, 530 U.S. at 19. However, at trial, the liquidating trustee tried to argue that the bankruptcy Code shifted the burden of proof to the taxing authority. Raleigh, 530 U.S. at 22 23. In rejecting the trustee s argument, the Court first noted that the basic federal rule in bankruptcy is that state law governs the substance of claims unless there is a federal interest that requires a different result. Raleigh, 530 U.S. at 20 (citations omitted). The Court then reiterated 10

its long-held position that laws governing burdens of proof are substantive rather than procedural. Raleigh, 530 U.S. at 21. Without clear evidence from Congress that it intended to shift the burden of proof evidence Congress was able to manifest in other parts of the Code the Court would not create an exception to the state law rules governing the underlying claim. Raleigh, 530 U.S. 20 27. While this case was decided in the context of a dispute over a claim, there is nothing in the Code that would indicate it would not also apply to a tax dispute under 505. 7. Expediting Tax Determination Section 505(b)(2) provides for trustees in cases under any chapter to request an expedited determination of tax liability for the administration of the estate. The clerk of court is required to maintain a database of addresses where governmental authorities may designate a specific address for requests under 502(b)(2) and describe where further information regarding the requests can be found. 11 U.S.C. 505(b)(1). After the taxing authority has received the request, it has 60 days to determine if the return has been selected for examination, and 180 days to determine the tax. 11 U.S.C. 502(b)(2)(A). The Court may extend the time for the taxing authority to determine the tax for cause. 11 U.S.C. 502(b)(2). If the return is not selected for examination, the tax is discharged upon payment of the liability shown on the return, unless the return is fraudulent. Id. With regards to the IRS, this shortens the time period where the IRS can examine returns from three years to 180 days. 9 Additionally, if the trustee disagrees with the taxing authority s determination of tax, the bankruptcy Court may determine the tax. 11 U.S.C. 502(b)(2)(C). The 9 Thomas M. Horan and Nicholas T. Verna, A Trustee s Guide to Bankruptcy Code 505, NABTalk Spring 2014, pp. 17 19. 11

trustee s payment of the tax as determined by either the bankruptcy Court or the taxing authority also discharges the trustee from further liability. Id. While there is not a lot of case law interpreting this section, there are a few cases that illustrate how 505(b)(2)(C) is applied. For example, one Court has held that the bankruptcy Court will retain jurisdiction to determine taxes in a Chapter 11 case post-confirmation pursuant to 505(b)(2)(C) if the Plan provides for it. 10 Agway, Inc. v. Internal Revenue Service (In re Agway, Inc.), 447 B.R. 91 (N.D.N.Y. 2011). This enabled the Chapter 11 trustee to finalize the distributions under the Plan and close the case much quicker than it would have otherwise been able to under IRS regulations. Another example comes from In re DeCoro USA, Ltd., where the Debtor asked the Court to enter an order determining it was due a tax refund, but the Court declined to do so because the Debtor did not properly request the refund from the IRS. No. 09-10846C-11G, 2013 WL 950572, (Bankr. M.D.N.C. 2013). Section 505(b)(2) can be an important tool for expediting the determination of tax liability, even after the Plan is confirmed. However, as DeCoro illustrates, trustees and debtors in possession must be cognizant of the requirements of the statute in order to take advantage of the benefits it can provide. The Missouri Bar 2014 10 Without this retention of jurisdiction, some Courts have held there is no jurisdiction to determine tax issues under 505 post-confirmation. E.g., In re Maley, 152 B.R. 789 (Bankr. W.D.N.Y. 1992). 12