A basic tenet of bankruptcy law, premised on the legal separateness of a debtor prior to filing for bankruptcy and the estate created upon a bankruptcy filing, is that prepetition debts are generally treated differently than debts incurred by the estate, which are generally treated as priority administrative expenses. However, this seemingly straightforward principle is sometimes difficult to apply in cases where a debt technically “arose” or “was incurred” prepetition, but does not become payable until sometime during the bankruptcy case.
A ruling recently handed down by the U.S. District Court for the District of Delaware highlights this issue. In In re Affirmative Ins. Holdings, Inc., 620 B.R. 73 (D. Del. 2020), the court ruled as a matter of apparent first impression at the appellate level that “straddle-year” corporate income taxes that become due during a bankruptcy case are entitled to administrative expense priority. In so ruling, the court reversed a bankruptcy court’s adoption of the “bifurcation” approach to this issue, which can have a major impact on a company’s chances for a successful reorganization.
Priority of Income Tax Claims
Section 507(a)(2) of the Bankruptcy Code provides that “administrative expenses allowed under section 503(b),” among other types of claims, have second priority of payment. Section 503(b)(1)(B) provides that an administrative expense shall be allowed for, among other items, “any tax … incurred by the estate, whether secured or unsecured, … except a tax of a kind specified in section 507(a)(8)” (emphasis added).
Section 541(a)(1) of the Bankruptcy Code provides that an “estate” is created upon the commencement of a bankruptcy case; however, the Bankruptcy Code does not define the term “incurred” as it is used in section 503(b)(1). Finding that the phrase “incurred by the estate” is “facially ambiguous,” some courts have looked to the legislative history of the enactment of the Bankruptcy Code and concluded that Congress “intended for a tax on income to be considered ‘incurred’ on the last day of the income period.” In re Pac.-Atl. Trading Co., 64 F.3d 1292, 1300 (9th Cir. 1995) (noting that compromise language proposed by the Senate Finance Committee providing that “a tax on or measured by income or gross receipts for a taxable period shall be considered incurred on the last day of the taxable period” was omitted from the final bill due to concerns over the impact of the definition of the term “incurred” upon the rule for preferences, but nevertheless indicated lawmakers’ intent that income taxes due postpetition are “incurred by the estate”).
Other courts have ruled that certain types of taxes are incurred as they accrue and become a fixed liability. See, e.g., In re Columbia Gas Transmission Corp., 37 F.3d 982 (3d Cir. 1994) (public utility taxes were incurred prepetition when the debtor filed its tax return, even though the assessment occurred postpetition; thus, taxes were not entitled to administrative expense priority); In re O.P.M. Leasing Servs., Inc., 68 B.R. 979, 983–84 (Bankr. S.D.N.Y. 1987) (concluding, without reference to the Senate Finance Committee’s proposed language, that corporate income taxes are incurred as they accrue rather than on the day they are assessed).
Section 507(a)(8) provides in relevant part that certain allowed unsecured claims of “governmental units” (such as taxing authorities) for taxes are entitled to eighth priority of payment, including claims for:
a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition … (i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition; (ii) assessed within 240 days before the date of the filing of the petition …; or (iii) … not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case (emphasis added).
The Bankruptcy Code does not define “assessment.” For federal income tax purposes, courts have almost uniformly adopted the Internal Revenue Code (“IRC”) definition, under which “[t]he date of the assessment is the date the summary record is signed by the assessment officer” following the taxpayer’s receipt of a notice of deficiency and the expiration of any period to respond. See Collier on Bankruptcy (“Collier”) ¶ 507.11[b][i] (16th ed. 2020) (citing cases and 26 C.F.R. § 301.6203-1; 26 U.S.C. § 6203). For state or local tax purposes, most courts have used the date of assessment under relevant state or local law, which varies from state to state, but generally depends on the date on which formal tax liability is finally fixed. Id. (citing cases).
Thus, certain income taxes for taxable years ending on or before the petition date are given eighth priority, whereas taxes incurred by the estate (i.e., postpetition taxes) are afforded second priority as administrative expenses. See generally id. (noting that section 507(a)(8) “applies only to taxable years ending on or before the petition date”).
Section 502(i) provides that a tax claim entitled to priority under section 507(a)(8) that “arise[s]” postpetition shall be allowed or disallowed “the same as if such claim had arisen before the date of the filing of the petition.” Section 502(i) was “intended to deal with situations where a tax is incurred prior to the filing of the petition but is not assessed or payable until after the petition has been filed.” In re Hotel Nevada Corp., 75 B.R. 174, 176 (Bankr. D. Nev. 1987); see generally Collier at ¶ 502.10 (“Properly interpreted, section 502(i) makes clear that only taxes incurred by the debtor prepetition but not becoming due and payable until after the petition is filed are allowed under section 502 just as any other prepetition claim. The allocation of such status as a prepetition claim denies administrative status.”).
Sections 502(i) and 503(b) both expressly refer to section 507(a)(8) to distinguish between taxes that should be prepetition liabilities and taxes that should be postpetition liabilities. Because tax obligations are generally determined in arrears, the existence and amount of a tax liability may be unknown until after the petition date. “If a tax claim is asserted after the commencement of the case for a time period encompassing both before and during the case, it is necessary to apply the test set forth in section 507(a)(8) to determine whether and how much of the claim should be a prepetition claim.” Collier at ¶ 507.11.
The priority status of qualifying prepetition tax claims was included in the Bankruptcy Code from previous law as part of the Bankruptcy Act of 1978, although the provision was originally designated as section 507(a)(6) and was renumbered as section 507(a)(7) in 1985 and as section 507(a)(8) in 1994.
Section 507(a)(8) was later amended in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act. Prior to 2005, it provided as follows with respect to income tax claims:
Eighth, allowed unsecured claims of governmental units, only to the extent that such claims are for—
(A) a tax on or measured by income or gross receipts—
(i) for a taxable year ending on or before the date of the filing of the petition for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;
(ii) assessed within 240 days, plus any time plus 30 days during which an offer in compromise with respect to such tax that was made within 240 days after such assessment was pending, before the date of the filing of the petition; or
(iii) other than a tax of a kind specified in section 523(a)(1)(B) or 523(a)(1)(C) of this title, not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case.
Prior to 2005, it was unclear whether the income tax liability of a corporate debtor for the year of its bankruptcy filing (“straddle year”) was entitled to priority as a prepetition unsecured claim or as an administrative expense claim. See O.P.M., 68 B.R. at 983 (ruling that a claim for taxes allocable to prepetition business activities but not due until postpetition was of the kind specified in section 507(a)(7) (now 507(a)(8)) because it was for a tax “not assessed before, but assessable, under applicable law or by agreement, after, the commencement of the case,” and that the claim was not entitled to administrative expense priority because it was not incurred by the estate).
Moreover, several federal courts of appeals held before 2005 that the income tax liability of a corporate debtor for the straddle year must be bifurcated into a prepetition component and an administrative expense component, even though the filing of a bankruptcy petition does not terminate the corporate debtor’s taxable year. See In re Hillsborough Holdings Corp., 116 F.3d 1391 (11th Cir. 1997); In re L.J. O’Neill Shoe Co., 64 F.3d 1146 (8th Cir. 1995); Pacific-Atlantic, 64 F.3d at 1292. Bifurcation of corporate straddle-year taxes arguably conflicts with certain provisions of the IRC. Although IRC § 1398 permits individual debtors in chapter 7 and chapter 11 cases to elect to bifurcate their taxable years into pre- and postpetition periods, corporate and partnership debtors are prohibited from doing so under IRC § 1399. In addition, section 346(d) of the Bankruptcy Code provides that “[f]or purposes of any State or local law imposing a tax on or measured by income, the taxable period of a debtor in a case under this title shall terminate only if and to the extent that the taxable period of such debtor terminates under the [IRC].”
In its October 20, 1997, final report entitled “Bankruptcy: the Next Twenty Years” (“NBRC Report”), the National Bankruptcy Review Commission (“NBRC”) recommended to Congress that straddle-year tax claims be treated as administrative expenses, unless a corporate debtor elected to bifurcate its straddle tax year. The NBRC Report notes that at least three proposals had been made for the treatment of corporate straddle-year tax claims: (i) the decisions in O’Neill and Pacific-Atlantic could be codified, “establishing the rule that the tax liability is apportioned between prepetition eighth priority and postpetition first priority administrative expense”; (ii) as proposed by the Internal Revenue Service (“IRS”) and the U.S. Department of Justice, the entire straddle tax year’s liability could be treated as an administrative expense, thereby overruling O’Neill and Pacific-Atlantic; and (iii) the entire straddle tax year’s liability could be treated as an administrative expense, except that corporations could be granted the same election to bifurcate the straddle tax year that is available to individuals in chapter 7 and chapter 11 cases under the IRC. The NBRC adopted the third proposal in its final report, noting that “payment of priority taxes might be a critical element in proposing a successful reorganization.” See NBRC Report, Ch. 4—Other Recommendations and Issues: Taxation and the Bankruptcy Code § 4.2.33 pp. 975-77.
In discussing O’Neill and Pacific-Atlantic, the NBRC Report stated that “[t]he legislative history indicates that Congress intended straddle tax year income taxes to be considered ‘incurred’ on the last day of the taxable period of a corporate debtor for purposes of §§ 503 and 507, the same as under the Internal Revenue Code.” However, the NBRC Report notes, the Eighth and Ninth Circuits in O’Neill and Pacific-Atlantic held that the straddle-year corporate income tax may also be “a tax of a kind specified in § 507(a)(8),” and thereby be excluded from administrative priority treatment, even though the tax is not “incurred” until after the petition date.
According to some courts and commentators, under section 507(a)(8) as amended in 2005, Congress resolved this issue by providing that income and gross receipt taxes for straddle years would be treated as postpetition administrative expense claims for the entire tax year, unless the debtor filed for bankruptcy on the last day of its taxable year. See In re Earl Gaudio & Son, Inc., 2017 WL 377918, at *5 (Bankr. C.D. Ill. Jan. 25, 2017) (“Where a Chapter 11 petition is filed during a taxable year, the tax on all income for that taxable year—without regard to whether the income was earned before or after the petition date—is considered a post-petition tax debt that is incurred by the estate”); In re FR & S Corp., 2011 WL 1261329, at *4 (Bankr. D.P.R. Mar. 30, 2011); Collier at ¶ TX4.03 (“[I]ncome and gross receipt taxes for the year of the bankruptcy filing are postpetition administrative expense claims that must be paid in full in the ordinary course, rather than prepetition priority claims that are not payable until emergence from bankruptcy”); Ginsberg, Martin and Furay, Ginsberg & Martin on Bankruptcy § 18.07 (2019) (“under new § 507(a)(8), taxes for straddle years (the year of the Chapter 11 petition for a corporate debtor) will be treated as post-petition administrative claims, not bifurcated into pre-petition and post-petition claims as was common under [pre-2005] practice”); Carl M. Jenks, The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005: Summary of Tax Provisions, 79 Am. Bankr. L.J. 893, 898 (2005) (noting that, in amending section 507(a)(8) in 2005, Congress, contrary to the recommendation of the NBRC, apparently adopted the government’s argument that the bifurcation cases should be overruled, “although the technical draftsmanship of the amendment may have left something to be desired”).
Automobile insurer Affirmative Insurance Holdings, Inc. and its affiliates (collectively, “AIH”) filed for chapter 11 protection on October 14, 2015, in the District of Delaware after selling or otherwise disposing of their assets and discontinuing operations. On March 10, 2016, the bankruptcy court entered an order converting AIH’s jointly administered chapter 11 cases to chapter 7 liquidations.
The IRS filed an administrative expense claim for corporate income tax, interest, and penalties in the amount of approximately $857,000 for the tax period ending December 31, 2015.
The trustee objected to the IRS’s claim, asserting that it was a prepetition unsecured claim because all events that gave rise to the tax arose prior to the petition date. The IRS countered that the claim was an administrative expense claim because, although the tax year straddled the petition date, the tax year in which the taxes were incurred concluded and the tax was assessed in the ordinary course after the petition date.
The Bankruptcy Court’s Ruling
The bankruptcy court undertook a two part inquiry—namely: (i) whether the IRS’s claim was a priority unsecured claim under section 507(a)(8); and (ii) if not, whether the claim was an administrative expense claim based on when the tax was incurred and by which entity.
The court concluded that the tax claim did not qualify for priority treatment under section 507(a)(8) because, in accordance with the plain meaning of that provision as amended in 2005, the tax year covered by the claim did not end on or before the bankruptcy petition date, but instead straddled the petition date.
Next, the bankruptcy court ruled that the entire tax claim was not entitled to administrative expense status under section 503(b)(1), but instead must be bifurcated into pre- and postpetition components. It explained that, in order to qualify for administrative expense priority, a tax liability must have been “incurred by the estate.” The court further noted that, although the Bankruptcy Code does not provide a definition for that concept, most courts considering the issue, including the U.S. Court of Appeals for the Third Circuit, have determined that a tax is incurred when it accrues and becomes a fixed liability, and that state law determines when a tax is incurred. See Affirmative Insurance, 607 B.R. at 182 (citing In re Barnhill’s Buffet, Inc., 2010 WL 703088, *1 (Bankr. M.D. Tenn. Feb. 24, 2010); Columbia Gas, 37 F.3d at 985-86; In re Federated Dep’t Stores, Inc., 270 F.3d 994, 1000-01 (6th Cir. 2001); Gaudio, 2017 WL 377918, at *3).
The bankruptcy court acknowledged that the 2005 amendments “had a real and substantial effect of creating a priority claim for tax years that ended on or before the petition date.” However, it wrote, “[i]n no way would this Court’s refusal to accept that the pre-petition portion of the Straddle Tax as an administrative claim, create an ambiguity with Congress’ intention in [the 2005 amendments] regarding priority claims for tax years ending on or before the petition date.”
The court explained that, in conferring administrative expense priority on certain tax claims, sections 503(b)(1)(B)(i) and 503(b)(1)(B)(ii) distinguish between “any tax … incurred by the estate” and certain tax adjustments, “whether the taxable year to which such adjustment relates ended before or after the commencement of the case.” According to the court, although these provisions are not directly relevant to this case, Congress could have used similar language in section 507(a)(8) if it had intended “to grant administrative expense priority to all straddle year taxes.”
The bankruptcy court distinguished Gaudio and FR & S—the only reported decisions addressing this issue—”based on the plain meaning of § 503(b)(1)(B) and the cannons [sic] of statutory construction.” It faulted Gaudio for focusing on the amount of taxes due in determining whether such taxes had been “incurred by the estate,” rather than on “the priority based on whether the tax was incurred, administrative priority or general unsecured as the case may be.” Instead, the court in Affirmative Insurance quoted O’Neill for the proposition that “there is nothing in either the bankruptcy or tax laws which prevents us from allowing different treatment during distribution for different portions” of the tax claims. In addition, the bankruptcy court found FR & S to be flawed because that court “could not find any legislative history or statutory language allowing for the Straddle Tax Year to be an administrative claim.” The Affirmative Insurance court also wrote that “although Congress could have expressly written such, it did not.”
The bankruptcy court ruled that “pre-petition events that incur tax liability” during straddle tax years have general unsecured status, whereas “post-petition events that incur tax liability” during the same straddle tax years have administrative priority, “in effect, bifurcating the straddle tax years into two distinct treatments under the Bankruptcy Code.”
The IRS appealed the ruling.
The District Court’s Ruling
In what it characterized as a matter of apparent first impression in the appellate courts, the district court reversed.
Noting that the sole issue on appeal was whether the taxes at issue were “incurred by the estate,” Judge Richard G. Andrews explained that, in accordance with the Supreme Court’s decision in Hall v. U.S., 566 U.S. 506, 511 (2012), “[t]he phrase ‘incurred by the estate’ bears a plain and natural reading.” Judge Andrews then concluded that underlying substantive tax law—in this case, federal tax law—determines when a tax is incurred. Because the IRC provides that a federal income tax does not become a fixed liability until the last day of the applicable tax period, Judge Andrews held that the estate incurred AIH’s tax liability when AIH’s taxable year ended postpetition. He rejected the trustee’s argument that, consistent with the principles governing when a claim “arises” under federal bankruptcy law, “corporate income taxes ‘accrue’—and thus are ‘incurred’—on a daily basis as events giving rise to tax liability is incurred.” Judge Andrews explained:
Importing the traditional bankruptcy claims analysis won’t work for purposes of § 503(b)(1)(B)(i), as identifying 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.
Citing Columbia Gas, Gaudio, and other similar cases, the district court concluded that: (i) a tax is incurred when it accrues and becomes a fixed liability; and (ii) when a federal income tax has been incurred must be determined in accordance with applicable substantive law. See In re Dawes, 652 F.3d 1236, 1239-40 (10th Cir. 2011); Columbia Gas, 37 F.3d at 985; Marion County Treas. v. Blue Lustre Prods., Inc., 214 B.R. 188 (S.D. Ind. 1997); Gaudio, 2017 WL 377918, *3; FR & S Corp., 2011 WL 1261329, at *1.
Next, the district court, applying the underlying substantive law in the case before it (the IRC), stated that corporate income tax accrues and becomes a fixed ability 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).” Thus, the court ruled, AIH’s 2015 taxable income could be calculated only at the end of its taxable year on December 31, 2015—which was postpetition.
Notwithstanding this conclusion, the district court rejected the argument that Congress intended to make straddle-year taxes entirely postpetition administrative claims when it amended section 507(a)(8) in 2005. According to the court, the scant legislative history of the 2005 amendments does not explain why the provision was amended.
The district court accordingly reversed the bankruptcy court’s decision, ruling that “the tax at issue in the IRS Claim was incurred by the estate post-petition and should be entitled to priority as an administrative expense.”
Although the bankruptcy and district courts in Affirmative Insurance reached different conclusions, they agreed that the scant legislative history of the 2005 amendments does not support the position that lawmakers intended to confer administrative expense priority on straddle-year corporate income tax claims. The district court, however, viewed the absence of any such guidance as irrelevant based on its conclusion that, in accordance with applicable substantive law, the plain meaning of the phrase “incurred by the estate” in section 503(b)(1)(B)(i) was dispositive of the issue.
Notably, the district court observed that its conclusion might have been different in a case involving taxes fundamentally different from income taxes, such as employment or excise taxes, which accrue “upon the occurrence of certain transactions or events and generally are reported on periodic (i.e. quarterly) returns.”
The debate on this issue is far from over. The chapter 7 trustee appealed the ruling to the Third Circuit on September 25, 2020. In addition, shortly before the district court issued its ruling, a Massachusetts bankruptcy court adopted the approach to straddle-year corporate income taxes applied by the Affirmative Insurance bankruptcy court. See In re Telexfree, LLC, 615 B.R. 362, 373 (Bankr. D. Mass. 2020). In that case, the court observed that “[t]he Bankruptcy Code, despite its panoply of provisions classifying all manner of tax claims, offers no precise statutory hole in which to slide the peg of straddle-year taxes.” It held that, because “federal income taxes are incurred at the time they accrue as opposed to the time payment is due for section 503(b)(1)(B) purposes,” the IRS’s claim for corporate income taxes due postpetition but based on prepetition income was not entitled to administrative expense priority, but would be treated as a nonpriority general unsecured claim.