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Go Broke: State Tax Bankruptcy in the COVID-19 Era

Posted on Dec. 21, 2020
Jamie Szal
Jamie Szal
Martin I. Eisenstein
Martin I. Eisenstein

Martin I. Eisenstein is managing partner and Jamie Szal is an associate at Brann & Isaacson in Lewiston, Maine. Both are members of the firm’s group that represents its business clients — including a quarter of the 100 largest internet retailers and providers of artificial intelligence, information technology, and telecommunications services — in state and local tax and unclaimed property matters.

In this installment of Eyes on E-Commerce, Eisenstein and Szal ponder the advent of COVID-19 business bankruptcies in their discussion of key aspects of bankruptcy law as it relates to state and local tax claims. The two argue that these laws are important for SALT practitioners to understand to facilitate a smooth emergence by their clients from bankruptcy without the burden of state and local tax claims.

Copyright 2020 Martin I. Eisenstein and Jamie Szal.
All rights reserved.

The reader may misconstrue this column’s title as somehow indicating that insufficient tax revenue means states are in jeopardy of bankruptcy because of the global pandemic. While some are in budgetary crisis,1 states’ plight is not the subject of this article. Rather, it discusses the intersection of bankruptcy law and state and local tax agencies’ claims so as to permit a SALT practitioner to handle those tax claims in the context of a client’s chapter 11 petition for relief. To the extent that the health crisis is leading to more chapter 11 filings,2 we address state tax bankruptcies, but our insights relate to the special provisions of bankruptcy law as they apply to state tax claims.

We recently represented several companies through chapter 11 proceedings (debtors) and handled state tax claims in that context. Although we are (thankfully) not bankruptcy lawyers, we work closely with the bankruptcy attorneys representing debtors. Our state and local tax expertise permits the bankruptcy counsel to focus on the administration and management of the estate, including resolving other creditors’ claims. Our role as special state tax counsel has been to litigate and negotiate the state and local tax claims with the support of bankruptcy counsel.

While we hope that it will be unnecessary for any of our clients to resort to a chapter 11 filing, it is important that state and local tax attorneys are aware of bankruptcy law to effectively advocate to minimize their clients’ tax obligations. Indeed, chapter 11 filing gives counsel a distinct and unusual opportunity to limit tax liabilities.

Primer on Bankruptcy

Learning and understanding the nuts and bolts of bankruptcy law is like trying to study a foreign language. While to many it may seem like a fruitless exercise in grasping the pronunciation of the French language or understanding German grammar, a SALT lawyer need not be fluent in bankruptcy law. The attorney must, however, understand bankruptcy concepts in general to appreciate and use the advantages that the bankruptcy court and bankruptcy law provide to companies in resolving thorny state tax claims.

A company initiates the typical bankruptcy case by filing a chapter 11 petition in bankruptcy court in the state of its incorporation or where it has a place of business. Most bankruptcy cases in which we have been involved were filed either in Delaware or the Southern District of New York.

The company and its management usually remain in control of its day-to-day operations after filing a chapter 11 petition, and the company is deemed a debtor in possession. The Bankruptcy Code places the debtor in possession in the position of a fiduciary, with the rights and powers of a trustee.3 Just as the company has the authority to operate the business once it files a petition, it continues to do so after filing the bankruptcy plan.4

A chapter 11 petition basically calls a time out to the business’s creditors to permit it to reorganize its affairs during the course of the bankruptcy and to develop a reorganization plan to govern future operations and the treatment of its debt. The time out is the automatic stay, one of the hallmarks of bankruptcy. The automatic stay prohibits creditors — including state and local tax agencies — from taking enforcement actions such as imposing a lien for nonpayment, collecting on an assessment, and commencing or continuing an administrative proceeding.5 However, the automatic stay does not prohibit the government from commencing or continuing an audit, demanding tax returns, issuing a notice of tax deficiency, making an assessment, or issuing a notice and demand for payment of an assessment.6 In other words, with the exception of collection proceedings, state tax proceedings against a debtor can continue. But while the bankruptcy is pending, a debtor-taxpayer need not pursue remedies at the administrative or state court level regarding pre-petition claims. Rather, the debtor should defer to the bankruptcy court proceedings. Indeed, the addition of bankruptcy to the dynamics of a state tax claim presents an opportunity to resolve claims favorably for the taxpayer, as we discuss throughout this article.

In general, all pre-petition debts are discharged in bankruptcy unless the creditor files a proof of claim with the bankruptcy court.7 Discharge means a release, and the discharge provisions of the Bankruptcy Code apply to state and local tax obligations that arose before the filing of the petition, known as pre-petition claims. In chapter 11 proceedings all but certain state and local tax pre-petition claims arising before the petition’s filing are barred. That is, despite an audit or an assessment for pre-petition claims, the applicable provisions of the Bankruptcy Code provide an absolute defense to a company against a state or local attempt to pursue tax claims, again subject to some qualifications.8

A state or locality, of course, can present its claims to avoid the release of claims that the Bankruptcy Code provides to debtors. A state or local tax claim — like those of other creditors — is presented by way of a proof of claim.9 A proof of claim, which can be filed by the state or local tax jurisdiction or by the debtor itself listing the claims in its petition,10 invokes the jurisdiction of the bankruptcy court to resolve the tax claims of the state or locality. Once a proof of claim is filed, a business can finally litigate state tax claims outside the state administrative proceedings and state courts. Taxpayers have a remedy in federal court (albeit bankruptcy court) without the necessity of proving an exception to the Tax Injunction Act.11 Once a government agency files a proof of claim, it is deemed to waive sovereign immunity.12

State tax departments usually have a division devoted to filing and presenting bankruptcy claims. Massachusetts, for instance, has adopted this approach. And in California, Florida, and New York, the general counsel’s office of the state tax agency often handles tax claims. In other states, such as Texas, the attorney general’s office handles all bankruptcy claims.

A debtor in bankruptcy must object to the proof of claim, lest the claim automatically be deemed allowed.13 Once a debtor files an objection, the bankruptcy court will conduct a hearing to determine the amount to be allowed,14 unless the proof of claim is not timely filed.15 The bar date for filing the proof of claim for a state or local tax claim is generally 180 days after the bankruptcy petition was filed.16 A creditor may seek leave of the court to file a proof of claim at any point up to the bar date,17 and must seek leave to amend a previously filed proof of claim to add additional claims at any point after the bar date.18

Of course, the effectiveness of the bar date in releasing the taxpayer of a claim is based on notice to the creditor; adequate notice is a theme running through much of bankruptcy proceedings.19 Without proof of notice to the creditor, the state or locality’s claim is not barred.20 Companies normally use claims agents such as Duff & Phelps or Kurtzman Carson Consultants to provide notice to creditors and receive filed claims. In our experience, these claims agents blanket state and local tax and unclaimed property agencies, even if they are unaware of the agency’s specific claims.

Once a state or local agency files a proof of claim, and the claim amount is allowed either by negotiated resolution between the government and taxpayer representatives or by a bankruptcy court decision, the claim is paid in accordance with the provisions of the reorganization plan, subject to the Bankruptcy Code. The Bankruptcy Code requires the payment of priority unsecured claims before paying the remaining unsecured claims. Section 726 of the Bankruptcy Code provides for a waterfall of payment of allowed unsecured claims of the creditors. The creditors in the first tier — holders of priority claims — include holders of the following tax claims:21

  1. income or gross receipts taxes for a tax year ending on or before the date of the filing of the petition;22

  2. property taxes incurred before the commencement of the case and last payable within one year before the date of the petition’s filing;

  3. a tax — such as a sales tax — required to be withheld, regardless of whether the tax was actually withheld23;

  4. an employment tax;

  5. an excise tax, such as the Washington business and occupation tax or the Texas margin tax, on a transaction occurring before the date of the filing of a petition that requires the filing of a tax return within three years before the date of the filing of the petition; or

  6. a penalty for any of the foregoing taxes if it is “in compensation for actual pecuniary loss.”24

Taxes incurred post-filing of bankruptcy — together with penalties thereon — are considered administrative expenses,25 and entitled to be deemed priority claims under section 503(a)(2). A government agency is not required to file a proof of claim for those expenses, though in our experience state agencies typically file claims to ensure that they are paid.

Each priority claim must be paid in full before general unsecured creditors are paid. Thus, states have the obvious incentive to establish that their claims have priority status. In that regard, pre-petition interest is deemed a priority claim in the same manner as claims for taxes themselves.26 However, interest on the claim may not accrue during the pendency of the bankruptcy proceeding.27 In our experience, states commonly characterize their filed tax claims as priority claims, even though some of them may not fit within the section 507 definition of priority claims.

The Bankruptcy Code gives the debtor in possession the exclusive right to file a plan of reorganization within 120 days from the filing of the petition.28 After that date, other creditors can file a plan of reorganization, but it is usually the debtor who files the plan. A chapter 11 plan of reorganization must designate classes of claims and the amount to be paid to each creditor within the class.29 The plan must use the following groupings: claim holders as secured creditors, unsecured creditors entitled to priority, general unsecured creditors, and equity security holders. The plan also provides for the order of payment of each class of creditor. Plans typically provide that all claims for debt — including taxes — incurred before the filing of the bankruptcy petition are discharged, except for specified allowed claims.

After giving creditors the opportunity to object, the bankruptcy court is required to hold a hearing on the proposed plan of reorganization. The court will accept or modify the plan after the hearing, and the debtor can then emerge from bankruptcy. Section 1141 of the Bankruptcy Code generally provides that confirmation of the plan discharges the debtor from any debt that arose before the filing date of the petition. After emerging from bankruptcy, the debtor is required to make plan payments and is bound by the plan of reorganization.30

There are exceptions to the release of pre-petition debt regarding state taxes, including a tax in which the debtor “made a fraudulent return” or “willfully attempted in any manner to evade or defeat such tax.”31 Also, the discharge only applies to the company that filed the petition — not to any affiliates32 or officers or representatives of the debtor. Thus, for states that have responsible person statutes, it is important in settlement of claims to obtain a release for not only the company, but also any affiliate and all officers and representatives of the debtor.

The debtor is required to implement the plan as approved by the bankruptcy court.33 The court retains the authority after confirmation of the plan to verify that the debtor properly implemented the plan and to make determinations of objections to claims, which must be resolved before a plan can be fully consummated.

Negotiating a Settlement With A State Tax Agency

Bankruptcy provides an opportunity for a taxpayer to resolve state and local tax claims in a favorable way. We appreciate that in general state tax administrative agencies and courts attempt to be objective to resolve cases based on the law. But state tax departments pursuing tax claims within their own administrative agency or even an independent administrative tribunal clearly have home-court advantage. The federal bankruptcy court takes this advantage away. And in our experience, tax authorities are much more willing to negotiate favorable settlements of tax cases — to the benefit of the taxpayer community — in the bankruptcy context.

Points of leverage for settlement include the threat of litigation in court, where there may be an uncertain outcome. Even if the agency prevails on its claims, it may be a Pyrrhic victory, inasmuch as the payment under the plan may not be 100 cents on the dollar.

Also, prompt payment, which is possible in settlement of the proof of claim versus awaiting the results of litigation and the payment terms under the plan, can be a significant inducement to settlement. As we noted earlier, interest does not accrue during the pendency of the bankruptcy. Moreover, a reorganization plan often provides for payments of allowed claims over time at low interest rates. The opportunity to obtain settlement with a cash payment shortly after the settlement often provides a powerful incentive for the government to settle the tax claim.

What’s more, classifying the claim as a priority unsecured claim or a general unsecured claim can substantially affect the amount paid to the government agency, and thus the value of the claim for settlement purposes. Limiting interest and eliminating the penalty on tax claims is probable, because interest may not accrue after the filing of the petition and penalties are likely not to be deemed priority claims.

Moreover, the kind of taxes that constitute priority claims have defined rules under section 507 of the Bankruptcy Code. For example, sales taxes and vendor use taxes to be collected from customers are priority claims, while consumer use taxes are not. Income, gross receipts, and excise taxes are subject to priority only if the return for the taxes is last due within the three-year period before the filing of the petition. Stale claims generally are not entitled to priority. Income taxes and gross receipts taxes, however, may be subject to priority status if the liability has been assessed within the 240-day period before the filing of the bankruptcy petition.34 While priority for excise taxes does not have that condition, a necessary prerequisite for priority status is that the transaction on which the excise tax is assessed occurred before the date of the filing of the petition.35 The Washington Business and Occupation Tax, for example, is a tax on gross receipts, but it is also structured as an excise tax. Determining which rules for priority status under section 507 of the Bankruptcy Code apply gives a tax counsel an argument that the company may not have in the non-bankruptcy contexts.

As we discuss in later sections, taxpayers also often have strong arguments to limit assessments based on when the proof of claim is filed, and its substance. As a threshold matter, a state’s failure to timely file a proof of claim gives the taxpayer a strong argument to eliminate the claim. But while the state can seek leave to file a late claim, it has the burden of convincing the bankruptcy court that it has a basis to do so.

The practitioner should carefully analyze the proof of claim the agency filed. A taxpayer has good arguments that the proof of claim as filed can limit the state to the type of tax, the periods of time set forth in the proof of claim, and the amount of tax described in the proof of claim. And the agency’s failure to assert priority status can be fatal to payment of the claim.

Finally, a settlement — at least before the company emerges from bankruptcy — requires bankruptcy court approval. Strong support from the debtor, combined with the debtor’s selling it to the stakeholders, can facilitate bankruptcy court approval.36 The taxpayer’s arguments are given greater weight in the settlement context.

Settling a bankruptcy claim should be done through a closing agreement. While memorializing the agreement in this way is standard operating procedure, what is distinct in the bankruptcy context is that the settlement may require the bankruptcy court’s approval,37 if in particular the settlement occurs before the company emerges from bankruptcy. If the bankruptcy court’s approval is required, then other stakeholders — including the creditors’ committee — may need to be consulted to facilitate approval by the bankruptcy court judge.

An important clause in any settlement agreement is a release of directors, officers, employees, and representatives of the taxpayer. In the bankruptcy context, responsible party liability is not automatically discharged. It is therefore imperative to add this clause lest the state use its responsible party liability clause to proceed against the individual officers, managers, or other employees that could be deemed personally responsible.

The Bankruptcy Court’s Authority to Determine Claims

A bankruptcy court’s authority to determine state tax claims occurs in three instances. As noted, the first is to approve a settlement between the debtor and the government agency.

The second situation occurs after a hearing on objections by the debtor or another party in interest to any proof of claim. Section 502(b) of the Bankruptcy Code gives the bankruptcy court wide discretion to decide all claims, including state and local tax claims.

The third situation, which is related to the second, is based on Bankruptcy Code section 505(a)(1). The bankruptcy court “may determine the amount or legality of any tax,” except a tax that has been “contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the [bankruptcy] case.” The bankruptcy court may also adjudicate claims for tax refunds as long as its determination is made more than 120 days after the debtor requested that refund from the governmental entity.38

The limits on bankruptcy court authority are twofold. First, one must consider whether there has been an adjudication by a judicial or administrative tribunal of competent jurisdiction before the petition was filed. If so, then the court does not have authority to resolve the issue.

This in turn raises the question whether informal administrative reviews, as many state tax agencies provide, constitute the requisite adjudication within the meaning of Rule 505(a). We think that the better argument is that unless the agency provides for the common features of court adjudication — the ability to pursue discovery, issue subpoenas, or cross-examine witnesses — the administrative review should not be considered a judicial or quasi-judicial proceeding.39

Second, the state could argue that the bankruptcy court should abstain from exercising jurisdiction.40 States turn to an old decision41 in which the U.S. Supreme Court concluded that a bankruptcy “policy of revising and redetermining tax valuations” contradicts the long-standing policy of “federal non-interference with the taxing power of states.”42 This Court decision, however, should be of limited use outside the property tax arena, which was the tax at issue in the case. As one court contended, bankruptcy courts should abstain only “upon a showing that uniformity of assessment is of significant importance.”43

Obviously, state tax authorities prefer to retain the home-court advantage they have when adjudicating tax liabilities through state tax administrative procedures. But under what circumstances is the uniformity of assessment significant? We think it should be limited to property tax issues. The policy behind chapter 11 bankruptcy — providing businesses with a fresh start by relief from past liabilities — is of greater significance. It outweighs the state interest in retaining control over the determination of tax liability, except in the unusual circumstance in which uniformity is important.

Potential Objections to State Proofs of Claim

Timely filed proofs of claim by state and local tax authorities may be entitled to priority. All the same, debtors have a variety of arguments to challenge whether they are priority claims and are either timely or properly filed. Lawyers representing debtors should pay close attention to facts such as the date when the claim is filed, the type of tax identified in the claim, the tax periods covered by the claim, whether the state reserved any right to amend subject to a pending audit, and whether the claim is an amended one.

Is the Proof of Claim Entitled to Priority?

Bankruptcy Code section 507(a) details proofs of claim that are entitled to priority in the payout of claims under the plan. Subsection (a)(8) specifically addresses proofs of claim filed by government entities. Priority of proofs of claim for states or localities for tax liabilities turns on factors such as the tax type itself, as well as several key dates (the petition date being foremost among them).

Not every type of tax is entitled to priority status. In fact, priority status may apply only to taxes measured by income or gross receipts, property taxes, taxes the debtor is required to collect (such as sales taxes) or withhold (such as payroll taxes) and excise taxes, as well as pre-petition accrued interest and compensatory penalties on the taxes. 11 U.S.C. section 507(a)(8). While these types of taxes encompass the vast majority of potential tax liabilities of debtors, the list is not all inclusive. Notably, consumer use taxes that are not collected from customers, but instead are imposed on the purchaser, are not entitled to priority. Likewise, telecommunications or utility fees and charges that are not taxes, along with unclaimed property (escheat), are not entitled to priority under section 507(a)(8).

The type of tax also plays an important role in determining the tax years entitled to priority. “Old and cold” tax liabilities are not eligible for priority, but the definition of stale claims varies by type of tax.

Subsection (A) under section 507(a)(8) provides that income tax and gross receipts tax liabilities are granted priority status in one of three circumstances:

  1. the tax return was due (including extensions) within the three-year lookback period from the date the petition was filed;

  2. the liability was assessed within the 240-day lookback period before the filing of the petition; or

  3. the liability was not assessed by the date the petition was filed, but was still assessable under applicable state law.44

Under subsection (E), regarding excise tax liabilities, a proof of claim is entitled to priority in only one instance. The liability must relate to tax returns that were due (including extension) within three years of the filing of the petition. Similarly, property taxes and employment taxes are subject to the same three-year lookback period.45 Other taxes are not so limited.

Note that subsections (A), (D) and (E) turn on the date that a tax return is due. The due date (taking into account any applicable valid extensions), not the date the return is actually filed, is the operative date.46 Liabilities relating to returns that are filed late, but within that three-year lookback period, are not necessarily entitled to priority. Practitioners should also be aware of the COVID-19-related extended due dates for filing income tax returns adopted by virtually every state, and the impact those extended due dates have on claim priority.47 Unlike income and gross receipts taxes, excise and employment taxes are not given priority status even though the state retains the power to assess — or has assessed within the 240-day period before the petition filing.48

Can the Agency Amend Its Proof of Claim?

A state or local tax agency often finds itself seeking to change the substance of the proof of claim filed before the bar date — by adding a tax or changing the amount of the claim, for examples. To do so, the agency must amend the initial claim. This then begs the question: Under what circumstances can a state or local government amend a timely, properly filed proof of claim?

Neither the Bankruptcy Code nor the bankruptcy rules refer to amending a proof of claim. In practice, however, creditors are permitted to amend claims; after all, the official Bankruptcy Form 10 Proof of Claim inquires, in question 4, whether the claim amends one already filed.49 If a claim is properly amended, it supersedes the initial claim.

Whether a state or local tax creditor is entitled to amend its timely filed proof of claim depends on various factors. The bankruptcy court has discretion to determine whether to permit a late-filed claim, which is the rubric under which “amending” a claim occurs since most amended claims are filed after the bar date. Amendments should not be used as back-door bar date extensions, because doing so would allow a creditor to “effectively help itself to automatic extensions of the bar date without seeking leave of the court.”50 A government creditor that had an “unqualified right after the bar date to amend proofs of claim dramatically” would render the bar date “meaningless.”51

Bankruptcy Rule 9006(b)(1) gives the court discretion to enlarge the time to file claims “where the failure to act was the result of excusable neglect.” The Supreme Court articulated the standard for “excusable neglect” for the late filing of a proof of claim in Pioneer Investment Services Co.52 The Court made an equitable determination on the basis of four factors:

(1) the danger of prejudice to the debtor;

(2) the length of the delay and its potential impact on judicial proceedings;53

(3) the reason for the delay, including whether it was within the reasonable control of the movant; and

(4) whether the movant acted in good faith.54

In situations in which the government agency timely filed a proof of claim but seeks to amend the claim to add a tax or years in dispute, courts have reached different results depending on whether the initial claim “provided adequate notice of the existence, nature, and amount of the claim as well as the creditor’s intent to hold the estate liable.”55 Specifically, courts look at the degree to which the state provided notice, if at all, to the debtor of the possibility that the state may amend the claim. Notice is a critical factor in determining whether to allow amendment of the claim.

States will often provide notice in the initial proof of claim by reserving the right to amend pending an audit’s outcome. A state can attach an addendum to the proof of claim, stating in narrative form that the proof of claim is estimated and may be amended based on the results of a pending audit. A state may also use a letter identifier on the proof of claim schedule, incorporating a key code legend for each line on the tax liability schedule. Please see a sample proof of claim used by Texas below.

When representing a company through chapter 11 bankruptcy, practitioners need to be on the alert for these types of reservation of rights. A tax jurisdiction that fails to provide adequate notice may find itself holding the short straw, unable to amend its claim.

Did the Government Creditor Take the Proper Steps to Amend?

While amending a proof of claim is generally accepted in practice, it is not a foregone conclusion. If the government creditor otherwise meets the substantive threshold factors to establish its right to amend, the question then becomes whether the government creditor has in fact taken the proper steps to do so.

Amending a claim is not as simple as filing a new Form 10, “Proof of Claim,” and marking “yes” in response to inquiry 4. If a creditor seeks to amend the proof of claim before the bar date, the creditor may file a motion to do so, though it is not required.56 However, if a tax agency seeks to amend its proof of claim after the government bar date, it must file a motion seeking permission from the bankruptcy court.57 The savvy practitioner should be on the alert for whether the state sought permission from the bankruptcy court to file any attempts to amend a proof of claim, even if the tax authority otherwise signaled in the original proof of claim that an amendment was likely to follow.

Can a Government Creditor Amend Its Claim to Add Another Tax Type or Tax Year?

Arguably, a tax authority should be held to all the details of the original claim, such that each tax period (and tax type) is treated effectively as a separate claim. By that token, it should not be permitted to amend the claim by adding an additional tax period or a new tax type.

Separate treatment makes sense — and in that lies an opportunity. As discussed, a key principle in the Bankruptcy Code is adequate notice, which creditors must give. It is not enough for a state agency to claim that “you, business, owe me some tax.” A state revenue department that files a claim for income taxes puts the debtor-company on notice for that tax type. A debtor would have no notice at all should that state suddenly change from income to, say, payroll taxes.

There is no universal opinion among bankruptcy courts. Very few of these cases, however, explicitly found that each tax period and tax type stand on its own. Most courts consider whether you treat each tax period and tax type separately or in aggregate weigh in favor of separate treatment.58 The devil lies in the details. States should not be permitted to aggregate the value of their claims and apply the value, in aggregate, to the audited liability of a single tax year.

The Scope of the Limitations on the Dischargeability of Debt in Bankruptcy Under 11 U.S.C. Section 1141(D)(6)

The ultimate question in any bankruptcy proceeding is how much the debtor will be relieved from outstanding debts. While the chapter 11 proceedings generally provide broader discharge to corporate debtors than do chapters 7 or 13, for individual and other debtors, there are exceptions. Under 11 U.S.C. section 1141(d)(6)(B)(ii), the confirmed bankruptcy plan of a corporate debtor does not discharge tax debt in circumstances in which the corporation “willfully attempted in any manner to evade or defeat such tax.”

Subsection (d)(6)(B)(ii) was added to section 1141 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,59 which was a broad overhaul of the Bankruptcy Code. The legislative history and committee reports on the bill suggest that this subsection was adopted to narrow what historically was a very broad grant of bankruptcy relief to corporations.60

No reported decision addresses section 1141(d)(6)(B)(ii).61 The wording of section 1141(d)(6)(B)(ii), however, is almost identical to the language of 11 U.S.C. section 523(a)(1)(C): “A discharge under section . . . 1141 . . . does not discharge an individual debtor from any debt for a tax or a customs duty. . . with respect to which the debtor . . . willfully attempted in any manner to evade or defeat such tax.” Although litigation based on section 523 relates to individuals pursuing bankruptcy, the robust body of case law interpreting that section can shed light on the section 1141 counterpart for corporations.62

The courts have adopted a three-part test under section 523. A debtor willfully attempts to evade or defeat a tax in which the debtor:

  1. had a duty to pay the tax;

  2. knew of the duty; and

  3. voluntarily and intentionally violated the duty.63

From the cases cited in footnote 64, we find the following examples of conduct that suggest willful intent:

  1. implausible or inconsistent explanations of behavior;

  2. inadequate financial records;

  3. transfers of assets in the face of serious financial difficulties;

  4. failure to file returns while engaging in lavish expenditures or paying other creditors with the tax funds;

  5. affirmative acts to avoid payment; and

  6. failure to act in a timely fashion following notification of liability from the tax authority.

On the other hand, failure to file a return with nothing more — such as also creating a shell entity or resorting to a particularly high volume of cash transactions — is generally not considered “willful evasion.”64

In short, there is no bright-line test for willful attempt to evade or defeat the payment of the tax. The decision in turns on all facts and circumstances.

Two key principles, separately and in concert, shift the balance in favor of dischargeability. First, a tax agency — like any other creditor — bears the burden of proving nondischargeability.65 Second, exceptions to discharge are strictly construed in favor of the debtor.66 The philosophical design of bankruptcy to provide a “fresh start” supports a strict, narrow interpretation of the exceptions.67 Broadly interpreting section 1141(d)(6)(B)(ii) would dilute this policy.

Conclusion

As we appear to be entering the second, if not third, surge of the COVID-19 crisis, we foresee more businesses filing for chapter 11. The pandemic has already toppled several retail giants. The wave of bankruptcies for smaller businesses has started and will increase as the pandemic continues. It is important that SALT practitioners understand the implications of bankruptcy law on the state and local tax claims of their clients to facilitate a smooth emergence by their clients from bankruptcy without the potentially crushing burden of onerous state and local tax claims.

FOOTNOTES

1 Heather Gillers and Gunjan Banerji, “U.S. States Face Biggest Cash Crisis Since the Great Depression,” The Wall Street Journal, Oct. 28, 2020.

2 Mary Williams Walsh, “A Tidal Wave of Bankruptcies Is Coming,” The New York Times, updated Aug. 3, 2020.

3 11 U.S.C. section 1107.

4 11 U.S.C. section 1108.

5 11 U.S.C. section 362.

6  11 U.S.C. section 362(b)(9).

7 See 11 U.S.C. section 1141(d)(1)(A) (confirmation of plan discharges the debtor from debt that arose before the date of confirmation, except as provided in the plan or order confirming the plan).

8 11 U.S.C. section 362(b)(9)(D) (while bankruptcy does not stay an audit, “any tax lien that would otherwise attach to property of the estate by reason of such an assessment shall not take effect”). The federal law of bankruptcy preempts state law provisions regarding the remedies of a state against taxpayers for taxes. The supremacy clause provides that federal laws, such as the Bankruptcy Code, “shall be the supreme Law of the Land.” U.S. Const. Art. VI, cl. 2. Under the federal preemption doctrine, federal law preempts state law when a discernible conflict or inconsistency arises. See Arizona v. United States, 567 U.S. 387, 399, 132 S.Ct. 2492, 183 L.Ed.2d 351 (2012); and Gibbons v. Ogden, 9 Wheat. 1, 210-211, 6 L.Ed. 23 (1824). When preemption applies, states are deprived of the power to act under the applicable state law. See Hillsborough County, Florida v. Automated Medical Laboratories Inc., 471 U.S. 707, 712, 105 S.Ct. 2371, 85 L.Ed.2d 714 (1985). Bankruptcy courts have held that the Bankruptcy Code preempts state tax laws. In re Jadeco Construction Corp., 606 B.R. 169, 182 (Bankr. E.D.N.Y. 2019) (citing In re Murphy, 331 B.R. 107, 120 (Bankr. S.D.N.Y. 2005)). See also 11 U.S.C. section 106(a)(1) (sovereign immunity is abrogated generally); and section 106(b) (government creditor waives sovereign immunity regarding the claim filed, as well as against property of estate that arose out of the same transaction or occurrence that is the basis for the government’s claim). However, note that debtors must continue to file any tax returns that become due after the petition date or risk dismissal of their bankruptcy petition. 11 U.S.C. section 521(j).

9 See 11 U.S.C. section 501.

10 In the case of liability for the fuel use tax assessed in accordance with the International Fuel Tax Agreement, 49 U.S.C section 31705 et al., the claim may be filed by the virtual jurisdiction.

11 28 U.S.C. section 1341.

12 11 U.S.C. section 106(b).

13 11 U.S.C. section 502.

14 11 U.S.C. section 502(b).

15 11 U.S.C. section 502(b)(9).

16 Id. The bar date for claims other than state or local ones is usually earlier than the bar date for state and local tax claims. Fed. R. Bankr. P. 3002(c)(1).

17 Fed. R. Bankr. P. 9006(b)(1).

18 Id.

19 11 U.S.C. sections 342(b), 521(a)(1)(A).

20 The test for determining whether a claim is indeed subject to a bar date, such that the debt underlying the claim will be discharged through bankruptcy, is reviewed in light of due process considerations. In re New Century TRS Holdings Inc., 465 B.R. 38, 45 (Bankr. D. Del. 2012). The foremost consideration is whether sufficient notice of the claim’s bar date was provided to the creditor. In re New Century, 465 B.R. at 45. When notice is not proper, creditors are not bound by the bar date. On the other hand, when proper notice is provided, the bar date discharges all debts for which claims were not filed. Id. at 46 (citing In re Smidth & Co., 413 B.R. 161, 165 (Bankr. D. Del. 2009).

21 11 U.S.C. section 507(a)(8).

22 Section 507(a)(8)(A) should be reviewed in detail, because it adds limitations on the right to recover these income tax claims as a priority claim.

23 Use taxes due on the debtor’s purchases do not fit within section 507.

24 11 U.S.C. section 507(a)(8)(G). Most state and local tax penalties are not in compensation for actual pecuniary loss, so these jurisdictions would be hard-pressed to establish the priority status of their claims.

25 11 U.S.C. section 503(8)(b)(1)(B).

26 See In re Larson, 862 F.2d 112, 118-119 (7th Cir. 1988) (citing In re Brinegar, 76 B.R. 176, 178-79 (Bankr. Colo. 1987)); Young, 70 B.R. at 45; In re EEI Energy Inc., 75 B.R. 637, 638-39 (Bankr. N.D. Ill. 1987); In re Mikrut, 79 B.R. 404, 408-09 (W.D. Wisc. 1987); In re H.G.D. & J. Mining Co., 74 B.R. 122, 125 (Bankr. S.D. W.Va. 1986), aff’d by unpublished opinion, 836 F.2d 546 (4th Cir. 1987); Treister, 52 B.R. at 737; In re Keller & Katkowsky P.C., 55 B.R. 155, 157 (Bankr. E.D. Mich. 1985); Pharmadyne, 53 B.R. at 522; and In re Healis, 49 B.R. 939, 942 (Bankr. M.D. Pa. 1985)).

27 11 U.S.C. section 502(b)(2).

28 The period can be — and frequently is — extended by the bankruptcy court. 11 U.S.C. section 1121.

29 11 U.S.C. section 1123.

30 11 U.S.C. section 1142.

31 11 U.S.C. section 1141(d)(6)(B). Section 1141(d)(6)(A) provides a similar exception to discharge as subsection B, precluding discharge for a false representation or fraud.

32 Typically, a company filing a chapter 11 petition does so on its own behalf — as well as all subsidiaries and affiliates.

33 11 U.S.C. section 1142.

34 Bankruptcy Code section 507(a)(8)(A)(ii).

35 What constitutes a transaction for purposes of section 507(a)(8) is very broadly construed. In re National Steel Corp., 321 B.R. 901, 913 (N.D. Ill. 2005) (citing In re Pemberton Pub. Inc., 29 B.R. 519 (D. Mass 1983)). Bankruptcy courts look to a tax based on a series of transactions, rather than narrowly interpreting “transaction” as a tax posed on a single transaction. Id.

36 Bankruptcy Rule 9019(a) provides for court approval of settlements, in which the court determines whether the settlement is fair and equitable. Courts generally look at a number of factors — including the possibility of success, the interest of the creditors, whether other parties in interest affirmatively support the proposed settlement, the nature and breadth of releases to be obtained by officers and directors, and whether competent and experienced counsel support the settlement. In re Iridium Operating LLC, 478 F.3d 452, 462 (2d Cir. 2007).

37 Id.

38 11 U.S.C. section 505(a)(2).

39 In In re Onondaga Plaza Maintenance Co., 206 B.R. 653 (N.D.N.Y. 1997), the bankruptcy court held that it did not have the authority to determine a debtor’s property tax liability that had been challenged before the assessment board (which was considered “quasi-judicial,” could administer oaths, take testimony, and hear proofs).

40 See In re New Haven Projects Ltd. Liability Co., 225 F.3d 283 (2d Cir. 2000); and In re Fairchild Aircraft Corp., 124 B.R. 488 (W.D. Tex. 1991) (bankruptcy courts may abstain from determining state tax liability, particularly where “uniformity of assessment” concerns are implicated — e.g., where the valuation method used by the appraisal district is being attacked).

41 Arkansas Corp. Commission v. Thompson, 313 U.S. 132, 142-45 (1941) (relating to property taxes; “it is difficult to believe that it would not be seriously argued that Congress . . . intended to impose upon the bankruptcy court the unusual power and delicate duty of trying out afresh the facts found by the state” relating to tax assessments). See also Burford v. Sun Oil Co., 319 U.S. 315, 63 S.Ct. 1098, 87 L.Ed. 1424 (1943).

42 Id. at 145.

43 In re Fairchild Aircraft Corp., 124 B.R. at 491 (citing H.R. Rep. No. 595, at 356; and In re Diez, 45 B.R. 137, 139 (Bankr. S.D. Fla. 1984)); and In re Super Van, 161 B.R. 184, 190 (Bankr. W.D. Tex. 1993).

44 11 U.S.C. section 507(a)(8)(A). Subsection 507(a)(8)(A) does give a state two alternative bases to assert priority status for income tax claims regardless of the due date of the tax returns. Subsection (A)(ii) permits priority status if the state had assessed the income tax within the 240-day period before the filing of the petition. Subsection (A)(iii) gives priority to claims that were assessable by the state post-filing under its law — that is, those claims for which the state or local statute of limitations has not otherwise expired. See In re Hillsborough Holdings Corp., 116 F.3d 1391 (11th Cir. 1997); In re Proxim Corporations et al., 369 B.R. 812 (D. Del. 2007); and In re King, 961 F.2d 1423, 1426 (9th Cir. 1992). At least one case has concluded that subsection (a)(8)(A) refers to income tax liabilities that were not yet assessed, though were still assessable under state law because the returns were under audit. In re Fein, 22 F.3d 631, 632 (5th Cir. 1994).

45 Id. at section 507(a)(8)(B), (D), (E).

46 In re Pemberton Pub. Inc., 29 B.R. 519 (D. Mass 1983).

47 Katherine Loughead et al., “Tracking State Legislative Responses to COVID-19,” Tax Foundation (last updated Apr. 30, 2020).

48 11 U.S.C. section 507(a)(8)(D) and (E).

49 Bankruptcy Form 410, Proof of Claim.

50 In re Stavriotis, 977 F.2d 1202, 1206 (7th Cir. 1992).

51 Id. Accord United States v. Jones, 2000 WL 1175717 (W.D. Mich. June 28, 2000) (unreported) (chapter 13 debtor filed protective claim on behalf of IRS; after plan confirmed, IRS filed proof of claim, increasing amount of claim).

52 Pioneer Investment Services Co. v. Brunswick Associates Ltd. Partnership, 507 U.S. 380, 389 (1993).

53 The faster a tax authority moves to amend a timely filed initial claim, the more likely that a court will allow the amendment. See In re Bishop, 122 B.R. 96 (Bankr. E.D. Mo. 1990).

54 Pioneer, 507 U.S. at 395. See also In re Lehman Bros. Holdings Inc., 433 B.R. 113, 119 (Bankr. S.D.N.Y. 2010); In re Residential Capital LLC, 2020 WL 1228646 (Bankr. S.D.N.Y. Mar. 12, 2020); and In re Limited Gaming of America Inc., 213 B.R. 369, 373-74 (Bankr. N.D. Okla. 1997) (quoting In re Tanaka Brothers Farms Inc., 36 F.3d 996, 998 (10th Cir. 1994)).

55 In re Limited Gaming of America Inc., 213 B.R. at 372-73 (quoting In re Unioil Inc., 962 F.2d 988, 992 (10th Cir. 1992)). The court in that case rejected the request to amend the initial claim to increase it from $5,000 to $351,190.28. As the court stated, “where amendment to claim is sought after the claim deadline has passed, ‘the second claim should not only be of the same nature as the first but also reasonably within the amount to which the first claim provided notice.’” Id. at 375 (quoting In re AM International Inc., 67 B.R. 79, 82 (N.D. Ill. 1986)). See also In re Stavriotis, supra note 50, not permitting the IRS to amend its proof of claim to not only add a subsequent year, but also to increase the amount of the claim filed 220-fold. On the other hand, the court in In re Bishop allowed the IRS to amend a proof of claim to increase the amount of the claim because the amended proof of claim, filed within days of the initial claim, fell within the scope and nature of the original claim. Supra note 53.

56 Fed. R. Bank. P. 9006(b)(1).

57 Id. at (b)(1) and (3). Indeed, subsection (b)(3) reiterates that the bankruptcy court’s authority to allow an amendment after the bar date arises “only to the extent and under the conditions stated” in the applicable rule, which under (b)(1) requires a motion. Id. (Emphasis added.)

58 See, e.g., district courts in the Second Circuit, In re PT-1 Communications Inc., 292 B.R. 482, 487 (Bankr. E.D.N.Y. 2003); district courts in the Third Circuit, In re Continental Airlines Inc., 183 B.R. 698, 699 (D. Del. 1995); in the Fifth Circuit, United States v. Waindel, 65 F.3d 1307, 1311-12 (5th Cir. 1995); in the Sixth Circuit, In re Chavis, 160 B.R. 804, 806 (Bankr. S.D. Ohio 1993), aff’d, 47 F.3d 818 (6th Cir. 1995); in the Seventh Circuit, In re Stavriotis, supra note 50; In re Unroe, 937 F.2d 346, 349 (7th Cir. 1991); in the Eighth Circuit, United States v. Baker (In re Baker), 129 B.R. 607, 608 (E.D. Mo. 1991); in the Tenth Circuit, Sunwest Hotel Corp. v. Board of County Commissioners of Reno County, Kansas, Nos. 92-40079-11, et al., 1998 WL 982905, at *9 (D. Kan. Sept. 29, 1998); and in the Eleventh Circuit, In re Gilley, 288 B.R. 901, 905 (Bankr. M.D. Fla. 2002).

59 See P.L. 109-8 section 708, 119 Stat. 23.

60 Bankruptcy Code Manual section 1141:33.

61 There is, on the other hand, limited case law under section 1141(d)(6)(A) involving corporate debtors, including in the Southern District of New York.

62 11 U.S.C. section 523(a)(1)(C). We reiterate that, by its terms, section 523 applies only to “individual” debtors, not corporations. In re Hawker Beechcraft, 515 B.R. 416, 425-26 (S.D.N.Y. 2014) (stating in dicta, “On its face, therefore, section 1141(d)(6) is self-executing,” implying that there is no need to incorporate any analysis, interpretation, or other limitation from the case law interpreting section 523).

63 See, e.g., In re Bruner, 55 F.3d 195, 200 (5th Cir. 1995); In re Toti, 24 F.3d 806, 809 (6th Cir. 1994), cert. denied, 513 U.S. 987, 115 S.Ct. 482, 130 L.Ed.2d 395 (1994); Hochstein v. United States, 900 F.2d 543 (2d Cir. 1990); In re Wright, 191 B.R. 291, 292 (S.D.N.Y. 1995); In re Semo, 188 B.R. 359, 362 (Bankr. W.D. Pa. 1995); In re Freidus, 165 B.R. 537, 541-542 (Bankr. E.D.N.Y. 1994); In re Angel, No. 93-11683-BH, 1994 WL 69516, *3 (Bankr. W.D. Okla. 1994); In re Laurin, 161 B.R. 73, 75 (Bankr. D. Wyo. 1993); and Langlois v. United States, 155 B.R. 818, 821 (Bankr. N.D.N.Y. 1993).

64 See, e.g., In re Thorngren, 229 B.R. 170 (Bankr. N.D. Ill. 1998); and In re Haas, 48 F.3d 1153 (11th Cir. 1995) (Congress did not intend that failure to pay, without more, should result in nondischargeability). Cf. Klayman, 333 B.R. 695 (nonpayment coupled with affirmative acts to avoid payment is sufficient to be “willful evasion”); and In re Bruner, supra note 63.

65 See, e.g., United States v. Beninati, 438 B.R. 755 (N.D. Ohio 2010); Langlois supra note 63; In re Wright, supra note 63.

66 United States v. Storey, 640 F.3d 739, 742 (6th Cir. 2011) (interpreting section 523).

67 Hawkins v. Franchise Tax Board, 769 F.3d 662, 666-67 (9th Cir. 2014) (interpreting section 523(a)(1)(C)).

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