Bankruptcy Resurgent?

The economic shutdown, and the ensuing recession, triggered by the COVID-19 pandemic have jeopardized the survival of many businesses and, in some cases, of entire industries.

Notwithstanding the Federal government’s efforts to mitigate the adverse consequences of this very challenging economic environment,[i] commercial bankruptcy filings under Chapter 11 of the U.S. Bankruptcy code[ii] were up 43% in June 2020 over June of last year;[iii] in May 2020, they were up 48% from last year.[iv] For the first half of 2020, total commercial Chapter 11 filings were up 26%.[v]

In reaction to these developments, and to what they may signify for the immediate future, many bankruptcy organizations[vi] have been asking Congress to consider amending those provisions of the Code that govern the taxation of cancellation of indebtedness income (“CODI”).[vii] For example, there have been requests that taxpayers be allowed to defer the recognition of such income;[viii] without such deferral, any plan of reorganization – which as a matter of course will likely include some debt cancellation – may result in a large, and immediately payable, tax bill which the debtor-business and its owners cannot satisfy. Others have suggested that the debt cancellation income be offset by reducing the taxpayer’s tax attributes.[ix]

At the moment, the Republican-controlled Senate and the Democrat-controlled House are trying to reconcile their respective versions of the next economic stimulus legislation, neither of which seems to consider the impact of CODI on a debtor-business.[x]

However, based upon the pace of bankruptcy filings described above, and assuming there will be a second wave of COVID-19 this fall[xi], along with the ensuing social-distancing-induced closures, it’s only a matter of time before Congress will have to confront – and will have to take measures to ameliorate – the impact of CODI on the tax liabilities of many debtor businesses.

Until then, the owners of a closely held business that may reasonably expect to be at risk[xii] should consult their advisers – it is never too early to start planning for the economic consequences resulting from the interplay of the tax and bankruptcy laws. It would also behoove them to understand some of the basic concepts, some of which are discussed in the decision described below.[xiii]

The Straddle Year

In October 2015, a corporate debtor (“Debtor”) filed a voluntary petition for relief under Chapter 11 of the Bankruptcy code[xiv] (the “BC”). However, prior to filing for bankruptcy, Debtor had sold substantially all of its material assets; the Bankruptcy Court (the “B-Court”) converted Debtor’s case to one under Chapter 7, and the U.S. Trustee appointed a “case” trustee (“Trustee”).[xv]

The Debtor’s tax year ended on December 31. In September 2016, Trustee filed Debtor’s federal corporate income tax return for the 2015 calendar year. Debtor’s taxable income was realized principally from its pre-petition activities.

Based on Debtor’s federal tax return for its year ending December 31, 2015,[xvi] the IRS filed an “administrative expense priority claim” in Debtor’s bankruptcy case for taxes, penalties, and interest. The events that gave rise to these asserted tax obligations occurred before the filing of Debtor’s petition in bankruptcy.

Trustee asked the B-Court to disallow the IRS’s administrative expense priority claim and to reclassify it as a general unsecured claim.

The issue before the B-Court was how to treat Debtor’s federal income tax liability for the 2015 “straddle year” – i.e., the tax year during which Debtor filed its petition for bankruptcy – for purposes of the BC’s priority rules.

The B-Court held that the straddle tax year had to be bifurcated into pre- and post-petition periods; that Debtor’s income tax obligations for its 2015 tax year had to be allocated between these two periods; and that income taxes resulting from pre-petition events during the straddle year were accorded “general unsecured [eighth priority] treatment,”[xvii] while income taxes resulting from post-petition events in that same straddle year – after the bankruptcy estate[xviii] came into existence – were granted “administrative [second] priority” treatment.

The B-Court’s determination meant that the IRS’s claim against Debtor – which was derived from pre-petition events – would be treated as a general unsecured claim; i.e., one with a relatively low probability of receiving any significant distribution from the bankruptcy estate.

The IRS Disagrees

The IRS asked the U.S. District Court (the “D-Court”) to reverse the B-Court’s conclusion that a claim for Debtor’s corporate income taxes for the straddle year was only entitled to administrative priority to the extent it was attributable to post-petition income or events.

 The IRS contended that the B-Court reached the wrong result because under applicable non-bankruptcy law – the Internal Revenue Code – a corporation’s entire annual income tax accrues on the last day of its tax year. 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 B-Court erred in its failure to consider the language of the Code in its determination of when federal income tax is incurred. The IRS asserted that both the BC and the Code distinguish income taxes, on the one hand, from transaction- or event-based taxes,[xix] on the other.

According to Trustee, the B-Court reached the correct result in holding that income tax is incurred daily, based on each day’s events and transactions, and that a single year’s tax liability must be apportioned between pre-petition and post-petition days, events, and transactions. Under this view, any portion of Debtor’s income tax traceable to events or transactions prior to the petition date, when no bankruptcy estate yet existed, was not “incurred by the estate.” Moreover, since Debtor’s tax year did not end prior to the filing of the bankruptcy petition, the tax incurred in the pre-petition portion of the straddle year was not entitled to priority status, but rather was only a general unsecured claim, notwithstanding the policy of giving preferential treatment to taxes the government has not had a reasonable time to assess or collect. According to Trustee, the distinction between income taxes and event-based taxes was irrelevant; the IRS’s claim for taxes accrued when the income was earned, at the time of the taxable event, such as the pre-petition sale of assets.

Thus, the issue before the D-Court was whether the B-Court was required to look to the underlying substantive tax law – the Code[xx] – to determine when the income tax accrued, as urged by the IRS, or whether the answer turned entirely on when individual transactions or events occurred – pre-petition vs. post-petition – as urged by Trustee’s bifurcated approach.

The District Court

The D-Court began by explaining that the BC sets out several priorities of expenses and unsecured claims against a bankruptcy estate. Second priority is accorded to certain “administrative expenses.”[xxi] To warrant administrative claim priority, the D-Court continued, the straddle year taxes must have been incurred by the estate.

Taxes “incurred by the estate” are administrative expenses, the D-Court stated, entitled to second priority. According to the D-Court, the sole issue on appeal was whether Debtor’s corporate income taxes were “incurred by the estate.”

The IRS argued that a determination of when a tax is “incurred by the estate” depends on when the estate “become[s] liable” for the tax. The IRS argued that, under the Code, a federal income tax does not become a fixed liability until the last day of the applicable tax period; the IRS asserted that this cannot occur until the last day of Debtor’s tax year.

Conversely, Trustee argued that each time a taxable event occurs during a tax year, the taxpayer “becomes liable” for any tax obligation that may arise as a result thereof, regardless of whether that the liability may be contingent, disputed, or unliquidated.[xxii]

Trustee urged that “corporate income taxes accrue – and thus are ‘incurred’ – on a daily basis as events giving rise to tax liability occur.”  According to Trustee, this construction was consistent with federal bankruptcy law “in determining when a claim arises for bankruptcy purposes.” Thus, the IRS’s claim (i.e., the right of payment of taxes on income earned pre-petition) “accrued when the income was earned.”

The D-Court noted that “The first test for administrative priority – whether a claim for taxes on income earned pre-petition in the year of bankruptcy could be considered ‘incurred by the estate’ – presents a clash between tax policy and bankruptcy policy.” Administrative priority, it stated, turns on whether and when the tax at issue was “incurred by the estate,” not whether and when the IRS’s tax claim arose. This determination, the D-Court explained, must be made based on the underlying substantive tax law.

Under substantive tax law, the D-Court continued, each type of tax is “incurred” at a different point: (1) federal income taxes are “incurred” at the end of the tax year; (2) employment taxes are incurred when wages are paid;[xxiii] and (3) excise taxes are incurred at the time of an event.

“Importing the traditional bankruptcy claims analysis,” the D-Court stated, won’t work for purposes of the priority rules because the identification of when the action which underlies a “right to payment” occurred will not necessarily comport with a determination of when the tax “accrues and becomes a fixed liability” in accordance with the relevant substantive tax law.[xxiv]

“Here,” the D-Court explained, “the Code is the substantive law creating and defining the taxes included in the IRS’s Claim.” Based on the plain language of the Code, a corporation’s federal income tax, if any, “accrues and becomes a fixed liability” on the last date of the tax year. The Code imposes a tax on “taxable income;”[xxv] taxable income, in turn, is defined as gross income, which is “all income from whatever source derived,” minus allowable deductions.[xxvi] It is only on the last day of the taxable year that all events giving rise to an income tax have occurred (both these creating income and those creating deductions).[xxvii]  A corporation’s income tax thus does not become “a fixed liability” or “inescapably imposed” until that day – December 31 for calendar year taxpayers like the Debtor.[xxviii] It is only after that moment that the corporation’s income tax liability, if any, becomes fixed and inescapably imposed.

Trustee argued that none of the foregoing compels the outcome sought by the IRS. Trustee argued that the Code does not define the terms “incurred” or “accrued” and does not address the classification or prioritization of the taxes at issue. According to Trustee, the fact that the amount of income tax due may change up until the last minute of the tax year is of no moment and does not necessarily mean that the tax is “incurred” at that point.

While the D-Court conceded that the Code does not define the terms “incurred” or “accrued,” and does not address the classification or prioritization of the taxes at issue, it rejected Trustee’s contention that the income tax at issue here was incurred prior to the end of the 2015 tax year, stating that the Code imposes a tax for an entire year, not individual events. Corporate income tax liability, the D-Court reiterated, is determined by netting all the tax year’s income with all the year’s deductible expenses, then applying the applicable tax rate. That computation is based on the sum of information at the end of the tax year.[xxix]

Applying these provisions, the D-Court concluded that Debtor’s 2015 taxable income could only be calculated at the end of its taxable year, after all income and deductions were known. Said differently, until December 31, 2015, Debtor did not have taxable income because not all possible events had occurred. While a major source of income came from sales occurring before the October 2015 petition date, it was irrelevant, the D-Court stated, “whether that income was recognized on one day during the year or on 365 separate days,” because the Code considers aggregate amounts, not individual income events or deductions, during the year. Under the substantive tax law, the Debtor’s income became taxable income only after determining all income and deductions for the taxable year, at which point the tax accrued and became a fixed liability.

Finally, Trustee asserted that applying the IRS’s interpretation would lead to an “absurd result” which would “gut the Bankruptcy Code.” According to Trustee, “if the dispositive factor in the IRS’ analysis of when a tax is ‘incurred’ turns on a[] fixed or inescapable liability, then the estate would be liable for all taxes of the [Debtor] – both pre-petition and post-petition – and elevate all of those taxes to administrative expense priority treatment.”[xxx]

Again, the D-Court disagreed, pointing out that, under this analysis, taxes for years ending on or before the petition date would not be accorded administrative expense treatment, and the attendant priority.[xxxi] What’s more, the D-Court explained, there was no support for the position that Congress intended to make straddle-year taxes entirely post-petition claims. Rather, underlying substantive tax law would determine whether and when taxes were “incurred by the estate” for purposes of the BC’s priority rules.[xxxii]

Based on the Code, federal corporate income tax liability accrues and becomes a fixed liability on the last day of the tax period – December 31, 2015 in this case.

Accordingly, the income tax at issue in the IRS’s claim was incurred by Debtor’s estate post-petition, and the tax should be entitled to priority as an administrative expense. With that, the B-Court was reversed.

Looking Ahead

It remains to be seen how the large number of bankruptcy filings already triggered by the COVID-19 economic slowdown will ultimately be resolved, and what the impact thereof will be on the timing and nature of an eventual recovery. Of course, future filings will also have to be monitored.[xxxiii]

The outcome will depend in large part upon the hopefully soon-to-be-enacted stimulus legislation, as well as upon the passage of more targeted debt-relief legislation which has probably not yet been drafted, let alone introduced.[xxxiv]

In the meantime, struggling businesses will have to do what is necessary to survive. That includes planning for a possible reorganization in bankruptcy, among the elements of which should be the preservation of tax attributes[xxxv] that may enable the business to reduce future income tax liabilities, and the reduction of CODI the tax on which would further deprive the business of needed liquidity.

Finally, the owners of a troubled business should consider their own personal exposure as “responsible persons” for the failure of the business to collect and/or remit federal and state employment taxes[xxxvi] as well as state and local sales taxes.

The best way to ensure a timely and effective response to any of these developments is for the business owners and their advisers to regularly communicate with one another.[xxxvii]


[i] For example, the Paycheck Protection Program (PPP) loans under the CARES Act. Provided certain conditions are satisfied, a PPP loan will be forgiven; the amount forgiven, however, will not have to be included by the borrower in its gross income as cancelation of indebtedness income. https://www.taxlawforchb.com/2020/04/tax-considerations-as-businesses-prepare-to-emerge-from-the-covid-19-shutdown/

Please note there were whisperings in Washington last week that an agreement between the House and Senate on the next round of stimulus legislation may allow businesses to deduct expenses that were paid with PPP loan proceeds. The following may refresh your memory: https://www.taxlawforchb.com/2020/05/ppp-loan-forgiveness-and-the-denial-of-deductions-for-covered-expenses-whats-wrong-with-the-irss-position/

[ii] A case filed under Chapter 11 of the United States Bankruptcy Code is often referred to as a “reorganization” bankruptcy.

A Chapter 11 case begins with the filing of a petition with the Bankruptcy Court. A petition may be a voluntary petition, which is filed by the debtor, or it may be an involuntary petition, which is filed by creditors that meet certain criteria.

The voluntary petition will include standard information concerning the debtor, including the location of its principal assets, the debtor’s reorganization plan, and a request for relief under the Bankruptcy Code.

Upon filing a voluntary petition for relief under Chapter 11 or, in an involuntary case, the entry of an order for relief, the debtor automatically assumes an additional identity as the “debtor in possession.” The term refers to a debtor that keeps possession and control of its assets while undergoing a reorganization under chapter 11, without the appointment of a trustee. A debtor will remain a debtor in possession until the debtor’s plan of reorganization is confirmed, the debtor’s case is dismissed or converted to Chapter 7, or a Chapter 11 trustee is appointed.

Generally, a written disclosure statement and a plan of reorganization must be filed with the court. The disclosure statement is a document that must contain information concerning the assets, liabilities, and business affairs of the debtor sufficient to enable a creditor to make an informed judgment about the debtor’s plan of reorganization. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics.

The U.S. trustee is responsible for overseeing the administration of bankruptcy cases. The U.S. Trustee may also impose certain requirements on the debtor in possession concerning matters such as reporting its monthly income and operating expenses.

Creditors’ committees can play a major role in Chapter 11 cases. The committee is appointed by the U.S. trustee and ordinarily consists of unsecured creditors who hold the seven largest unsecured claims against the debtor. Among other things, the committee: consults with the debtor in possession on administration of the case; investigates the debtor’s conduct and operation of the business; and participates in formulating a plan.

[iii] https://www.globenewswire.com/news-release/2020/07/03/2057391/0/en/Chapter-11-U-S-Commercial-Bankruptcies-up-43-in-June.html

[iv] https://www.abi.org/newsroom/press-releases/may-commercial-chapter-11s-increase-48-percent-over-last-year-total-filings

[v] https://www.wsj.com/articles/chapter-11-business-bankruptcies-rose-26-in-first-half-of-2020-11593722250

[vi] See, for example, the April 23, 2020 letter from the National Bankruptcy Conference to the House and Senate “leadership.”

[vii] In particular, IRC Sec. 108.

[viii] Remember IRC Sec. 108(i)? It allowed the deferred recognition of CODI realized in 2009 and 2010 (i.e., in connection with the Great Recession).

[ix] See IRC Sec. 108(b) and Sec. 1017; for example, the adjusted basis of the taxpayer’s property and its loss carryforwards.

[x] Their hands are full at the moment. Worse yet, we’re approaching the political rutting season.

[xi] Let’s face it, this virus continues to evolve, and people are starting to behave badly after many weeks of house-quarantine. The effects of the confluence of these factors will probably come to light later this year. https://www.hopkinsmedicine.org/health/conditions-and-diseases/coronavirus/first-and-second-waves-of-coronavirus

[xii] For example, those in the real estate industry, where debt financing is a way of life. These folks have already been hit pretty hard. Social distancing and, even more so, the advent of remote working do not bode well for the future of office buildings. Amazon and its kind have been like a punch in the gut for most bricks-and-mortar retailers and their landlords. Biden wants to eliminate the like kind exchange.

[xiii] In re Affirmative Insurance Holdings Inc., No. 15-12136-CSS (D. Del. July 27, 2020).

[xiv] 11 USC Sec. 507(a).

I find myself in a quandary. There are codes and then there are Codes. I have rarely, if ever, accorded the Bankruptcy code the honor of a capital “C” – sorry, Kristina – that distinction belongs to the Internal Revenue Code, at least insofar as U.S. law is concerned.

Justinian’s Code, which formed the basis for many of Europe’s civil law jurisdictions, also merits the initial cap “C”. Query why today’s students learn nothing of the more than one thousand years of Byzantine history?

[xv] Under Chapter 7, the case trustee administers the bankruptcy case and liquidates the debtor’s assets in a manner that maximizes the return to the debtor’s unsecured creditors. (The secured creditors are already provided for.) The trustee accomplishes this by selling the debtor’s property if it is free and clear of liens or if it is worth more than any security interest or lien attached to the property. The trustee may also attempt to recover money or property from third parties (to which the debtor has made payments) under the trustee’s “avoiding powers.” https://www.taxlawforchb.com/2017/12/revoking-s-corp-status-a-fraudulent-conveyance/

The BC governs the distribution of the property of the estate (i.e., the sale proceeds). The BC prioritizes several classes of claims; each class must be paid in full before the next lower class is paid anything. The debtor is only paid if all other classes of claims have been paid in full.

For example, higher priority is accorded to “administrative expenses,” including the actual, necessary costs and expenses of preserving the estate; lower priority is accorded to unsecured claims for income taxes owing for a taxable year ending on or before the date of filing of the petition. See BC Sec. 507(a)(2), 503(b)(1)(B)(i), and 507(a)(8)(A).

[xvi] On IRS Form 1120.

[xvii] BC Sec. 507(a)(8).

[xviii] Commencement of a bankruptcy case creates an “estate.” The estate technically becomes the temporary legal owner of all the debtor’s property. It consists of all legal or equitable interests of the debtor in property as of the commencement of the case, including property owned or held by another person if the debtor has an interest in the property. BC Sec. 541.

[xix] For example, employment taxes with respect to wages paid.

[xx] You know the one I mean. Right? Don’t make me come over there.

[xxi] BC Sec. 503(b).

[xxii] Bankruptcy policies, Trustee argued, require treating the pre-petition portion of a debtor’s tax liability for the year of bankruptcy as a pre-petition claim. The BC broadly defines a “claim” to include unliquidated, contingent and unmatured obligations. While applicable non-bankruptcy law determines whether a claimant has a substantive right to payment, when a claim arises for bankruptcy purposes, Trustee argued, is a question of federal bankruptcy law.

[xxiii] IRC Sec. 3101 and 3111; Reg. Sec. 31.3101-3 and 31.3111-3. See also BC Sec. Sec. 507(a)(8)(D), which gives priority to “an employment tax on a wage, salary, or commission … earned from the debtor before the [petition date], whether or not actually paid before such date, for which a return is last due … after three years [before the petition date].”

[xxiv] That being said, the Court observed that the time of assessment or payment may not be equivalent to the time the tax is incurred for the purpose of establishing priority under the BC. Rather, the significant fact may be the date the tax accrues.

In fact, the date a federal income tax accrues and the assessment date are not the same. Assessment usually follows the filing of a tax return several months after the end of the tax year. Assessment is the determination of liability and the administrative act that allows collection when payment is not made. IRC Sec. 6201.

[xxv] IRC Sec. 11(a). “A tax is hereby imposed for each taxable year on the taxable income of every corporation.”

[xxvi] IRC Sec. 61(a) and Sec. 63(a).

[xxvii] See Reg. Sec. 1.11-1(e), providing an example of computation of liability.

[xxviii] IRC Sec. 441(b)(1). Until midnight on December 31, a corporation can still, for example, incur operating expenses or make charitable donations that will eliminate any liability that would otherwise arise from income earned during the preceding twelve months.

[xxix] IRC Sec. 441(a): “Taxable income shall be computed on the basis of the taxpayer’s taxable year.”

[xxx] Indeed, the IRS argued that Congress intended to make straddle year taxes entirely post-petition administrative claims. The BC, it stated, has always given preferential treatment to taxes the government has not had a reasonable time to assess or collect, as the taxing authority is an involuntary creditor. Because Debtor’s straddle tax year ended after the petition date, the IRS had no opportunity to collect the tax pre-petition, as any such tax by definition cannot come due until after the petition date.

[xxxi] BC Sec. 507(a)(8)(A).

[xxxii] The D-Court agreed that the distinction between income taxes, on the one hand, and other taxes which accrue upon the occurrence of certain transactions or events, on the other, is recognized in both the BC and the Code. The key is that a determination of when a specific tax accrues and becomes a fixed liability – i.e., is “incurred” for purposes of determining its priority under the BC – must be made in accordance with the substantive tax law.

[xxxiii] There is a silver lining here. These filings may present healthier businesses an opportunity to acquire assets and customers, hire key employees, eliminate competitors, establish new locations, etc.

For others, the news may not be as sanguine. The loss of a vendor or of a customer may have serious consequences for an otherwise healthy business.

The loss of a debtor may qualify a lender for a bad debt deduction. IRC Sec. 166.

[xxxiv] The fact that we find ourselves in the midst of a very abrasive and divisive election season is unfortunate to say the least.

Let’s not forget, however, that this country has come through presidential elections under much more dire circumstances. How about the election of 1864?

[xxxv] For example, net operating losses.

[xxxvi] The employee’s share thereof.

[xxxvii] To quote Austin Powers, “Okay, people, you have to tell me these things, alright? I’ve been frozen for 30 years, okay? Throw me a freakin’ bone here. I’m the boss. Need the info.” The Spy Who Shagged Me.