IRS Bankruptcy Claim Reclassified as General Unsecured Claim

In re
AFFIRMATIVE INSURANCE HOLDINGS, INC., et al.,
Debtors.

IN THE UNITED STATES BANKRUPTCY COURT
FOR THE DISTRICT OF DELAWARE

Chapter 7

OPINION¹

ASHBY & GEDDES, P.A.
Ricardo Palacio
Benjamin W. Keenan
500 Delaware Avenue
Wilmington, DE 19899

Counsel to Don A. Beskrone
Chapter 7 Trustee of the Debtors

U.S. Department of Justice
Richard E. Zuckerman
Principal Deputy Assistant
Attorney General
Ward W. Benson
rial Attorney, Tax Division
P.O. Box 227
Ben Franklin Station
Washington, D.C. 20044

Dated: October 15, 2019

Sontchi, C.J.

INTRODUCTION

Before the Court is the Objection of Don. A. Beskrone, Chapter 7 Trustee, to Administrative Expense Claim Filed By the Internal Revenue Service² (the “Objection” filed by the “Trustee”). The Internal Revenue Service (“IRS”) is seeking an administrative claim, as identified by the official court registry as claim no. 87-1, for corporate income taxes for the entire 2015 calendar year (the “IRS Claim”). The Trustee asserts that all material taxable events giving rise to such taxes occurred pre-petition; and, by the time the Debtors' cases were commenced, the Debtors were little more than shells with no material operational assets and no meaningful source of revenue. The Trustee seeks to have the IRS Claim disallowed, or in the alternative, reclassified, in whole or in part, as a general unsecured claim. The Court heard argument on the Objection on March 13, 2019,³ and took the matter under advisement. This is the Court's decision thereon.

JURISDICTION

The Court has subject matter jurisdiction over this adversary proceeding pursuant to 28 U.S.C. § 1334(b). This adversary proceeding is a core proceeding pursuant to 28 U.S.C. § 157(b)(2)(A) and (B). The Court has the judicial authority to enter final judgements and orders in this matter. Venue is proper in the Court pursuant to 28 U.S.C. § 1409(a) because this is a proceeding relating to and arising under Title 11 of the United States Code, 11 U.S.C. §§ 101-1532 and the above-captioned chapter 7 case.

BACKGROUND

A. Background of the Bankruptcy Cases

In targeted geographic markets, the Debtors provided non-standard personal automobile insurance (“NSPAI”) policies to individual consumers who were unable to obtain insurance from standard automobile insurance companies due to a lack of prior insurance, driving record, financial resources, age, or other factors.

The Debtors' financial struggles arose in significant part from losses incurred from operations over the six years ended December 31, 2014, including an operating loss of $31 million for the year ended December 31, 2014. Losses stemmed from, among other causes, underwriting losses, significant revenue declines, expenses declining less than the amount of revenue declines, and goodwill impairments. The losses from operations grew out of policies written in 2012 and 2013, prior pricing issues in some states, losses from states the Debtors had exited, including Florida and Michigan, and goodwill impairment charges as a result of such losses.

The Debtors' losses from operations continued during 2015, notwithstanding actions taken to address liquidity and capital issues. Among other things, on September 30, 2013, Holdco sold its retail agency distribution business to Confie Seguros Holding II Co. and Confie Insurance Group Holdings, Inc. (the “Retail Purchaser”). From that date until June 30, 2015, the Debtors distributed NSPAI policies through an established network of independent agencies, and one unaffiliated underwriting agency writing policies in California.

On June 30, 2015, the Debtors sold their internal underwriting agencies (or managing general agency) (“MGA”) operations (the “MGA Sale”) to the Retail Purchaser, the same entity that purchased the retail distribution agencies in September 2013. Upon closing of the MGA Sale, the Debtors entered into agreements with the Retail Purchaser to provide for the continued distribution and servicing of the Debtors' NSPAI policies.

On October 14, 2015 (the “Petition Date”), each of the Debtors filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. On October 19, 2015, the Court entered an Order directing the joint administration of the Debtors' cases.⁴

As of the Petition Date, the Debtors had sold or otherwise disposed of substantially all of their material assets, had reduced their employee headcount to twenty-one (from over 1,000 in 2011), and had discontinued virtually all other operations apart from certain limited administrative services provided to their non-debtor, regulated subsidiaries.⁵ The provision of these administrative services was the Debtors' sole source of ongoing revenue upon the commencement of their bankruptcy cases.

On December 30, 2015, the Official Committee of Unsecured Committee filed the Motion for Entry of an Order Converting the Debtors' Chapter 11 Cases to Cases Under Chapter 7 Bankruptcy Code Pursuant to 11 U.S.C. § 1112(b).⁶ On March 10, 2016, the Court entered an Order Converting the Debtors' Chapter 11 Cases to Cases Under Chapter 7 of the Bankruptcy Code.⁷ Thereafter, the United States Trustee for the District of Delaware appointed Don A. Beskrone to serve as the Chapter 7 Trustee in these cases. Mr. Beskrone serves as the Trustee to the Debtors and their estates pursuant to section 702(d) of the Bankruptcy Code.

B. The IRS Claim

On or about March 29, 2016, the Clerk of the Court issued a Notice of Chapter 7 Bankruptcy Case — Proof of Claim Deadline Set⁸ (the “Bar Date Notice”). Pursuant to the Bar Date Notice, (i) the deadline for all creditors (except for governmental units) to file a proof of claim in these cases was set as July 28, 2016, and (ii) the deadline for governmental units to file a proof of claim in these cases was set as September 6, 2016.

On April 18, 2016, the IRS filed an administrative expense claim for income taxes for the tax year ending 2015⁹ (the “Original IRS Claim.”). On September 11, 2018, the IRS filed an amended administrative expense claim that amended and superseded the Original IRS Claim¹⁰ (the “IRS Claim”).

On or about September 14, 2016, the Trustee filed a federal tax return, on a consolidated basis, for the Debtors. Pursuant thereto, the Trustee set forth a “total tax” due of $792,113, and an “amount owed” of $806,454.00.

The IRS Claim asserts an administrative expense priority claim against Affirmative Insurance Holdings, Inc. in the amount of $856,704.52 on account of corporate income taxes for the tax period “12/31/2015.” The IRS Claim is comprised of the following amounts: (i) $792,113.00 (tax due), (ii) $18,566.00 (interest due), and (iii) $46,025.52 (penalty due).

The Trustee asserts that the IRS Claim does not set forth the statutory basis for its alleged classification or priority treatment, nor does the IRS assert or explain whether the IRS Claim is seeking priority treatment for an alleged administrative expense in the Chapter 7 cases. The Trustee objected to the IRS Claim asserting that the IRS is seeking administrative expense priority for the Debtors' corporate income taxes for the entire 2015 calendar year even though all material taxable events giving rise to use taxes occurred pre-petition.

DISCUSSION

A. Burden of Proof

As the IRS is seeking an administrative expense priority claim, the IRS bears the burden of proof and persuasion.¹¹ “When seeking allowance of an administrative expense under § 503(b)(1), the movant bears the burden of establishing that its claim is an actual, necessary expense of preserving the debtor's estate.”¹² If the IRS “fails to meet its burden of proof, the expense is a general unsecured claim.”¹³

B. Priority of the IRS Claim

The IRS wants to receive an administrative expense claim for the tax year that straddles the Petition Date (i.e. the tax year begins prior to the Petition Date and concludes after the Petition Date) (the “Straddle Tax Year”). In order to understand the IRS' rights to such administrative claim treatment, a review of the statutory framework for allowing and classifying priority claims is required.

In summary, Section 507(a)(2) gives second priority to “administrative expenses allowed under Section 503(b)[.]”¹⁴ Section 503(b)(1) provides that administrative expenses shall be allowed for “any tax . . . incurred by the estate, . . . [including fines and penalties,] . . . expect a tax of a kind specified in section 507(a)(8)[.]”¹⁵

Section 507(a)(8) provides, in relevant part, that allowed unsecured claims of governmental units are entitled to eighth priority treatment to the extent such claims are 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[.]”¹⁶

The Trustee asserts that the IRS Claim is neither an administrative claim nor a priority claim, but a pre-petition unsecured claim because all the events that gave rise to the tax that underlies the IRS Claim arose pre-petition. The IRS asserts that their claim is an administrative claim because although the tax year straddles the Petition Date, the tax year in which the taxes were incurred concluded and was assessed in the ordinary course post-petition.

As a result of the above, the Court will make a two-part inquiry: (i) whether the IRS Claim is a priority claim under section 507(a)(8); and (ii) if not a priority claim, the Court must determine whether the IRS Claim is an administrative claim; again necessitating a two-part inquiry of (a) when the tax is incurred and (b) by whom.¹⁷

i. The Taxes that Underlie the IRS Claim are Not Entitled to Priority Treatment under Section 507(a)(8)

Section 507(a)(8)(A)¹⁸ was amended by the Bankruptcy Abuse Prevention Consumer Protection Act of 2005 (“BAPCPA”), limiting the scope of priority treatment to tax claims for taxable years “ending on or before the date of the filing of the petition.”¹⁹ By its plain meaning, the Bankruptcy Code was amended to provide that if a taxable year ends on or before the Petition Date, such tax shall be afforded a priority claim.²⁰ “Prior to BAPCPA, the former § 507(a)(7) created a catch-all provision by giving seventh priority treatment not only to tax claims for taxable years that ended on or before filing, but also to any tax that was assessable after the commencement of the case — without regard to the taxable year.”²¹ Critically, here, the Court is looking at a taxable year that straddles the Petition Date (i.e. the tax year covered by the IRS Claim does not end on or before the Petition Date).²² As a result, the IRS Claim does not qualify for priority treatment under §507(a)(8)).

ii. The IRS Claim is Not Entitled to Administrative Expenses Status in Full Under Section 503(b)(1); and Should be Bifurcated Into Pre- and Post-Petition Periods.

The Court must then look to whether the tax debt was “incurred by the estate.” Section 503 states, in relevant part:

(a) an entity may timely file a request for payment of an administrative expense, or may tardily file such a request if permitted by the court for cause.

(b) After notice and a hearing, there shall be allowed administrative expenses, . . . including —

(1) (A) the actual, necessary costs and expenses of preserving the estate. . . .

(1)(B) any tax —

(i) Incurred by the estate, whether secured or unsecured including property taxes for which liability is in rem, in personam, or both, except a tax of a kind specified in section 507(a)(8) of this title; or

(ii) Attributable to an excessive allowance of a tentative carryback adjustment that the estate received, whether the taxable year to which such adjustment relates ended before or after the commencement of the case; . . . .²³

“[T]he elimination of eighth priority does not mandate administrative expense treatment. Even if the claim is deemed to arise post-petition — a question that was and will continue to be debatable — the courts will have to conclude that the tax liability was 'incurred by the estate' in order to grant administrative expense priority.”²⁴ Thus, pursuant to Section 503(b)(1)(B)(i), it must be determined whether the taxes were “incurred” by the estate, i.e., post-petition, within the meaning of Section 503(b)(1)(B)(i).²⁵ Here, the Trustee asserts that the taxes that underlie the IRS Claim were not incurred by the Debtors' estates (either in the Chapter 7 cases, or in the Chapter 11 cases).

The Bankruptcy Code does not define “incurred by the estate.” “However, most courts considering the issue have found that a tax is incurred when it accrues and becomes a fixed liability.”²⁶ State law determines the date that a tax is incurred.²⁷

Although pre-BAPCPA, the Third Circuit in In re Columbia Gas Transmission Corp. held that a tax liability is generally “incurred” on the date it accrues and not on the date of the assessment or the date on which it is payable.²⁸ The Third Circuit looked to In re Connecticut Motor Lines, Inc. for guidance:

Connecticut Motor Lines, a case decided under the Bankruptcy Act of 1898, § 64a, 11 U.S.C. § 104(a)(1) (1976 ed.), this Court found that taxes arising from wages relating to services rendered prior to the bankruptcy, but paid during the bankruptcy, were not entitled to priority as an administrative expense. This Court reasoned, among other things, that

the employer, in a case in which he was not involved in a bankruptcy proceeding, would have had to pay the wages as employer, under the Internal Revenue Code, even if he were no longer, in actuality, employer. And he would, at the time of payment, have had to pay the accrued taxes, despite his no longer being employer.²⁹

Interestingly, prior to BAPCPA there was a split of authority about whether to bifurcate a Straddle Tax Year; although the Third Circuit held that such Straddle Tax Years must be bifurcated into (at the time) priority and unsecured claims.³⁰ In In re Hillsborough Holdings Corp.,³¹ the bankruptcy court considered whether taxes generated from prepetition income could be claimed as an administrative expense of the estate as the associated tax return was filed post-petition. The Hillsborough Holdings court held:

a majority of courts have held that the date the taxes are accrued, rather than the date of assessment, is the date which controls. The mere fact that assessment of a tax does not occur until after the Bankruptcy petition is filed does not result in a tax relating to pre-petition activities being allowed as an administrative expense. To the extent that income was not earned by the estate during part of the tax year, but instead earned by the pre-petition debtor, the tax was not incurred by the estate and was not entitled to administrative expense.

The claim sought by the IRS to be allowed as an administrative expense relates to income received [before] . . . the date the Chapter 11 case was filed by these Debtors, this income is clearly attributable to pre-petition activities. To charge the estate with these taxes as cost administration is a proposition which this Court is unwilling to accept. Therefore, this Court is satisfied that the taxes incurred prepetition by the Debtor are not properly allowable as costs of administration pursuant to § 503.³²

In Matter of O.P.M. Leasing Services, Inc., the bankruptcy court was faced with the exact issue, albeit prior to BAPCPA, wherein the filed proof of claim for the pre-petition portion of a corporate income tax could not be precisely determined until the end of the debtor's fiscal year, terminating post-petition.³³ The Court held: “[n]onetheless, as the claim at issue consists of taxes allocable to business activities during the pre-petition period, that claim is not entitled to an administrative expense priority.”³⁴ The Court explained that the legislative history of then § 503(b)(1)(B) limited the administrative expense to “income earned by the estate during the case.”³⁵ The O.P.M. Leasing continued that to the extent “income is not earned by the estate during the case, but is instead earned by the pre-petition debtor, any tax liability on that income is not entitled to an administrative expense priority.”³⁶

Furthermore, the Supreme Court has held that when Congress “amends the bankruptcy laws, it does not write 'on a clean slate.'”³⁷ The Supreme Court has held:

this Court has been reluctant to accept arguments that would interpret the Code, however vague the particular language under consideration might be, to effect a major change in pre-Code practice that is not the subject of at least some discussion in the legislative history. Of course, where the language is unambiguous, silence in the legislative history cannot be controlling. But, given the ambiguity here, to attribute to Congress the intention to grant a debtor the broad new remedy . . .³⁸

The Third Circuit has held that absent “clear congressional intent,” we should not read the Bankruptcy Code provision to effect a major change in pre-Code practice.³⁹ “Incorporation by Congress of the former disallowance provision into the Code is significant and, unless it can be inferred that Congress intended clearly to change a provision of the existing law (such as through an explicit change in the language of the statute or a statement in legislative history), prior case law interpreting the provision is still valid law.”⁴⁰ “'[A] court's primary objective is to ascertain the intent of the legislature by looking at the language of the statute itself and giving it its plain, ordinary and commonly understood meaning.'”⁴¹

Where a statute's language is clear, the Court's obligation is to apply it according to its terms, unless such a literal application would produce an absurd result or one demonstrably at odds with the intent of the drafters. An interpretation is absurd if “it is so gross as to shock the general moral or common sense.” The fact that the statute might result in a harsh result when subjected to a plain meaning interpretation does not necessarily mean that it is absurd.⁴²

The IRS argues that “[w]hen Congress amends legislation, courts must presume it intends the change to have real and substantial effect.”⁴³ However, this canon of interpretation is inconsistent with the concept of not effecting a major change to pre-Code practice without explicit language. Here, BAPCPA had a real and substantial effect of creating a priority claim for tax years that ended on or before the petition date. In 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 BAPCPA regarding priority claims for tax years ending on or before the petition date.

As this matter hinges on the statutory language, interestingly there is a distinction between section 503(b)(1)(B)(i) and (ii). Section 503(b)(1)(B)(i) states “any tax . . . incurred by the estate.”⁴⁴ However, section 503(B)(1)(B)(ii) expressly gives administrative expense priority to “any tax. . . . attributable to an excessive allowance of a tentative carry back adjustment that the estate received, whether the taxable year to which such adjustment relates ended before or after the commencement of the case.”⁴⁵ Although not directly relevant substantively, it does indicate Congresses ability to be specific and to show intention. In other words, if Congresses desired to grant administrative expense priority to all straddle year taxes, it could have done so by using the language similar to that set forth in section 503(b)(1)(B)(ii).⁴⁶

Two cases decided after BAPCPA have found that the “intended effect” was to clarify that Straddle Tax Year liabilities are to be treated as post-petition claims. However, based on the plain meaning of §503(b)(1)(B) and the cannons of statutory interpretation, this Court disagrees as discussed infra.

In In re Earl Gaurdio & Sons, Inc., the Central District of Illinois Bankruptcy Court was faced with business income and liquor tax claim for the Straddle Tax Year. The Earl Gaurdio court held that the Straddle Tax Year was not a priority claim pursuant to section 507(a)(8) due to the amendments in BAPCPA (which this Court agrees with in this case as discussed supra). The Earl Gaudio court then examined whether the taxes at issue were “incurred by the estate.” The court held that income tax in Illinois is assessed on the date of the filing of the tax return and the than Illinois Income Tax Act provides that business income tax is incurred “no earlier than the end of the taxable year, when liability is accrued and fixes or inescapably imposed.”⁴⁷ The Earl Gaudio court stated that a “taxable event” was different than a “tax liability” — taxable events occur during the period whereas tax liability is not fixed until the end of the tax year. The Earl Gaudio court held:

The Debtor seems to conflate the concept of “taxable event” with “tax liability.” Most taxpayers have numerous taxable events occur during the course of any tax period. Every receipt of potentially taxable income, whether from wages, interest, dividends, rent, or asset sales, may be a taxable event. But a taxpayer's liability to pay a particular amount of taxes is generally calculated only at the end of a tax period, when all taxable events occurring during the period and when all deductions and credits that may be available to offset otherwise payable taxes are known. The occurrence of a taxable event is only one factor in calculating an entity's tax liability for a particular tax period and the date of such event is not the date when tax liability is fixed or inescapably imposed.⁴⁸

I disagree.The Court is not determining the amount of taxes due (or as the In re Earl Gaudio & Son, Inc. court refers to the “taxpayer liability”) — it is examining the priority based on whether the tax was incurred, administrative priority or general unsecured as the case may be. As the Eighth Circuit Court stated in In re L.J. O'Neill Shoe Co., “[s]imply stated, the tax is being imposed against the single corporate entity in keeping with [the Bankruptcy Code] . . ., but the payment of the tax imposed is being divided into separate components in accordance with the bankruptcy laws determining the priority of payment of those claims. Thus, there is nothing in either the bankruptcy or tax laws which prevents us from allowing different treatment during distribution for different portions of. . . . claims in this case.”⁴⁹

Similarly in In re FR & S Corp.,⁵⁰ against faced with a Straddle Tax Year, the court held: “the Debtor filed for bankruptcy prior to the close of its calendar year, thus the tax for taxable year 2008 accrued subsequent to the filing of the bankruptcy petition meaning that the first prong of the test is satisfied and the income tax liability for the year 2008 was 'incurred by the estate.' Therefore, the court concludes that the PR Treasury's right to payment or claim arises in the case of a corporate debtor, on the last day of its taxable year, that is, December 31, 2008.”⁵¹ The FR & S court noted that pre-BAPCPA jurisprudence allowed bifurcation of a tax year. The court continued that

The 2005 BAPCPA amendments to Section 507(a)(8)(A) provide that income taxes for the straddle year are entirely post-petition administrative expenses.⁵²

Again, I disagree. The Court could not find any legislative history or statutory language allowing for the Straddle Tax Year to be an administrative claim. In fact, although Congress could have expressly written such, it did not.

In Marion County Treasurer v. Blue Lustre Products, Inc.,⁵³ albeit before BAPCPA, the District Court for the Southern District of Indiana examined the date on which a tax was “incurred.” The Blue Lustre court stated: “[w]hile the assessment date and the date the tax is incurred are not necessarily the same date, Indiana law indicates that these dates are the same, in that Ind.Code § 6-1.1-2-4 imposes the annual tax liability on the person who is the owner of the property on the assessment date. Therefore, while the owner is not required to file a personal property tax return until May 15 of the same year, and is not required to pay the taxes until May 10 and November 10 of the following year, the liability of the owner is fixed as of March 1 [the date the Indiana assessment]. In fact, it appears that the owner's liability would not be affected even if the property were sold after this date.”⁵⁴ The Blue Lustre court reasoned that “[b]ecause the estate does not exist until after the bankruptcy petition is filed, taxes incurred by the debtor prior to the filing of the petition are not taxes incurred by the estate.”⁵⁵ The court continued that it is the date the taxes are incurred rather than on the date that the taxes are due that determines whether taxes qualify as administrative expenses.⁵⁶

Commentators have stated that “[t]he amendment to Section 507(a)(8) contained in the BAPCPA is clearly intended to follow the government's position on this issue and to overrule the bifurcation cases, although the technical draftsmanship of the amendment may have left something to be desired.”⁵⁷ It is argued that by “failing to amend §503(b)(1)(B) to make clear that pre-petition Straddle Year taxes are 'incurred by the estate' leaves open the bizarre and unintended possibility that such taxes are neither pre-petition priority claims nor administrative period claims.”⁵⁸

On the other hand, “[t]reating the entire straddle year as a post-petition tax period is also much simpler administratively. Debtors do not need to allocate their income and deductions between the pre-and post-petition tax portion of the filing year, or defend the decision to bifurcate when challenged on audit.”⁵⁹

The IRS points to Hall v. United States,⁶⁰ which the IRS acknowledges is distinguishable on its facts. Hall involved a Chapter 12 case where the individual farmer debtors ultimately were held to be responsible for certain tax liabilities, rather than the bankruptcy estate, as no separate taxable entity was created through the commencement of the bankruptcy cases.⁶¹ The Hall court reasons that the interplay between the bankruptcy code and tax law "reinforces the reasonableness of our view that whether an estate 'incurs' taxes under § 503(b) turns on such chapter-by-chapter distinctions . . ." in the bankruptcy code.⁶² The Supreme Court distinguished the case before them, a Chapter 12 debtor, from caselaw concerning corporate debtors.⁶³

Hall is readily distinguishable from the issue presented here; and is limited by the very language of the opinion; including two instances expressly noting that corporate debtors were treated differently and that the holding was limited to Chapter 12 cases as the bankruptcy code is applied on a chapter-by-chapter basis.

“Administrative expense priority should only be given to obligations that resulted in or arose out of a benefit received after the bankruptcy estate came into being . . .[,]”⁶⁴ unless Congress gives specific instructions otherwise. The Court appreciates that this result may cause an administrative burden on the debtors and the IRS to properly parse out pre- and post- petition events; however, the Court cannot read language into the Code or “guess” Congressional intent. The plain-meaning of the statute indicates that although the amount or liability may be decided at the conclusion of the tax year; the administrative priority of that liability must turn on whether the estate “incurred” the claim. As such, the Court holds that pre-petition events that incur tax liability during “Straddle Tax Years” are afforded general unsecured status whereas, post-petition events that incur tax liability during those same “Straddle Tax Years” are afforded administrative priority — in effect, bifurcating the straddle tax years into two distinct treatments under the Bankruptcy Code.

CONCLUSION

For the reasons discussed above, the Court will sustain the Objection and reclassify the IRS Claim, Claim No. 87-1, as a general unsecured claim, provided, however, that the Court will allow the government 90 days to file an amended claim specifying the tax liability, if any, that is allocable to the period after the Petition Date. An Order will be issued.