Taxes From Postpetition Farm Sale Are Not Dischargeable

By James A. Beavers, J.D., LL.M., CPA, CGMA

Bankruptcy & Insolvency

The Supreme Court ruled that taxes on gain from the sale of a farm after its owner had filed a Chapter 12 bankruptcy petition were not taxes incurred by the bankruptcy estate.

Background

Lynwood and Brenda Hall petitioned for bankruptcy under Chapter 12 of the Bankruptcy Code and sold their farm shortly after. They initially proposed a plan of reorganization under which they would pay off outstanding liabilities with proceeds from the sale. The IRS objected, asserting a federal income tax of $29,000 was due on the capital gains from the farm sale.

The Lynwoods amended their proposal to treat the income tax as a general, unsecured claim to be paid to the extent funds were available, with the unpaid balance discharged. The IRS again objected, arguing that taxes on income from a postpetition farm sale remain the debtors’ independent responsibility because they are neither collectible nor dischargeable in bankruptcy.

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The Bankruptcy Court sustained the IRS’s objection (Hall, 376 B.R. 741 (Bankr. D. Ariz. 2007)). Under Chapter 12, farmer debtors may treat certain claims owed to the government resulting from the disposition of farm assets as dischargeable, unsecured liabilities (11 U.S.C. §1222(a)). Under 11 U.S.C. Section 503(b)(1)(B)(i), these claims include a claim for “any tax . . . incurred by the estate.” The Bankruptcy Court reasoned that because a Chapter 12 estate is not a separate taxable entity under the Internal Revenue Code, it cannot “incur” taxes for purposes of Section 503(b). A district court reversed, in its opinion expressing doubt that Internal Revenue Code provisions are relevant to interpreting Bankruptcy Code Section 503(b). Based on the legislative history, the district court determined that Congress intended Section 1222(a)(2)(A) to extend to the Halls’ postpetition taxes (Hall, 393 B.R. 857 (D. Ariz. 2008)).

The IRS appealed to the Ninth Circuit, which reversed the district court (Hall, 617 F.3d 1161 (9th Cir. 2010)). The Ninth Circuit held that the Chapter 12 estate does not “incur” the postpetition federal income taxes for purposes of Section 503(b) because it is not a separate taxable entity under Secs. 1398 and 1399, and the court found that Congress has repeatedly indicated the relevance of the Code’s taxable entity provisions to the Bankruptcy Code. Although it was sympathetic to the view that the postpetition tax liabilities should be dischargeable, the court held that “the operative language simply failed to make its way into the statute.” The court concluded that because the taxes do not qualify under Section 503(b), they are not priority claims in the plan eligible for the Section 1222(a)(2)(A) exception.

The Supreme Court’s Decision

The Supreme Court, affirming the Ninth Circuit, held that a federal income tax liability resulting from individual debtors’ sale of a farm during the pendency of a Chapter 12 bankruptcy is not “incurred by the estate” and thus is not a dischargeable unsecured claim under Section 1222(a)(2)(A). In making its decision, the Court considered the plain meaning of the phrase “incurred by the estate” in context with Secs. 1398 and 1399. These Code sections set out the rules for taxation in bankruptcy and the division of the responsibilities for the payment of taxes between a bankruptcy estate and the debtor.

The Court first noted that under the definition from Black’s Law Dictionary and two general dictionaries, the word “incur” means to become liable or subject to or to bring on oneself something by one’s own action. Thus, the Court found that a “tax incurred by the estate” is a tax for which the estate itself is liable.

The Court then looked at Secs. 1398 and 1399 to determine which bankruptcy estates are liable for federal income taxes. The Court found that under the two sections read together, a separate taxable bankruptcy estate is created only under Chapters 7 and 11 of the Bankruptcy Code, not under Chapters 12 and 13. Under Chapter 12, the debtor filing the bankruptcy, not the estate itself, is liable for filing a return and paying taxes resulting from a postpetition farm sale. Thus, the postpetition federal income taxes from such a sale are not “incurred by the estate” under Section 503(b) and are not collectible or dischargeable in a Chapter 12 bankruptcy.

Although the Court held that Secs. 1398 and 1399 resolved the Halls’ case, it also discussed the argument that relying on these Code sections was an improper importation of tax law into bankruptcy. The Court stated that the long-standing interplay between Bankruptcy Code Section 346 and Secs. 1398 and 1399 refuted this argument. The Court also explained that under Chapter 13, it was settled law that postpetition income taxes were not “incurred by the estate” under Section 503(b) and, because Chapter 12 was based on Chapter 13, a conflicting reading of the meaning of the phrase “could disrupt settled Chapter 13 practices.” Absent an indication from Congress that it intended a conflict between the two chapters, the Court declined to create one.

Reflections

This was a 5–4 decision by the Supreme Court, and the dissent claimed that the legislative history of the 2005 enactment of Bankruptcy Code Section 1222(a)(2)(A) indicated that the purpose of the section was to provide robust relief from tax debts. Thus, deeming Section 1222(a)(2)(A) inapplicable to postpetition debts would be contrary to congressional intent.

The majority, however, noted that the amendment’s legislative history relied on by the dissent was no more than the statements of one senator from a farm state on unenacted bills introduced in years preceding the enactment of Section 1222(a)(2)(A). The majority rightly pointed out that the amendment merely carves out an exception to the preexisting bankruptcy priority classification system—a system based on “decades-old understandings about the scope of §503(b) and the division of tax liabilities between estates and debtors” (slip op. at 16). If Congress actually intended to treat postpetition income tax liabilities as dischargeable in this case, it did not make it clear in the statute.

Hall, Sup. Ct. Dkt. 10-875 (U.S. 5/14/12)

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