Assert of Transferee Liability Against Debtors Is 'Premature'

[2] This document may contain taxpayer information subject to section 6103. This document may also contain confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. Therefore, this document shall not be disclosed beyond the office of individual(s) to whom it is addressed and in no event shall it be disclosed to the taxpayers or their representatives.

[3] Specifically, if this memorandum is addressed to a District Counsel, then only office personnel working the specific case or subject matter may use this document. If this memorandum is addressed to a District Director, then only office personnel working the specific case or subject matter may use this document. This memorandum shall not be disclosed or circulated beyond such office personnel having the requisite "need to know."

[7] On * * * the * * * filed a joint voluntary Chapter 11 bankruptcy petition. Thereafter, the * * * operated their cattle feeding business as debtors-in-possession. The * * * never filed Forms 1041 for the income tax liabilities incurred by the bankruptcy estate. On * * * an order was filed confirming the bankruptcy plan. The plan did not specifically provide for the payment of the administrative taxes incurred by the estate. At the time of confirmation, the plan indicated no priority taxes were owed to the Service and that all post-petition taxes incurred by the debtors were paid as due and would continue to be paid as due. Upon confirmation of the plan, the property of the estate vested in the debtors. The examination division has determined that the estate should have filed fiduciary income tax returns for the periods * * * through * * * and * * * through * * *. ¹ The examination division has also determined that assets with an estimated net value of $* * * were turned back to the * * * upon confirmation of the plan. There are no longer any assets in the bankruptcy estate from which to collect its unassessed and unpaid income tax liabilities because of the return of the assets to the * * *.

[8] The Service did not file either a proof of claim or a request for payment for the bankruptcy estate's unpaid taxes. The Service has not attempted to reopen the bankruptcy case pursuant to Bankruptcy Code (B.C.) section 350. On * * * the * * * filed a Withdrawal of Request for Entry of the Final Decree in the connection with their bankruptcy proceeding. In this document, the * * * representative noted that the estate ". . . may not have filed separate tax returns. . ." and that the estate ". . . is currently in the process of resolving these issues with the Internal Revenue Service. . ." On * * * the Bankruptcy Court ordered that no final decree should be entered and that counsel for the debtors are ordered to file a status report on * * * We understand from * * * of District Counsel, * * * that this status report has never been filed.

[9] On * * * the Service issued a notice of deficiency to the * * * for their * * * and * * * income tax years. This case is under settlement consideration in Appeals, * * *. We understand from our telephone conversation with Appeals Officer * * * that the taxpayer's representative has informally indicated that he would be willing to include the unreported income that is the subject of the proposed transferee notices in the * * * income for their * * * and * * * tax years, if the Service does not issue the proposed transferee notices. Appeals, * * * has indicated that they are inclined to reject this settlement proposal because this income was not attributable to the * * *

[10] On August 18, 1993, the Assistant Chief Counsel (Income Tax & Accounting) responded to your request for assistance concerning the issue of whether the payments to a debtors-in-possession (DIPS) from the bankruptcy estate for their personal living expenses should be treated as income to the DIPS, which should be reported separately on the DIPS' Form 1040.

[12] Section 6901 provides a procedure by which the Service may collect unpaid taxes of the transferor from a transferee. The Service bears the burden of proving that a taxpayer's acts render it liable as a transferee. See I.R.C. section 6902 and Tax Court Rule 142(d).

[13] A transferee's liability may be established either at law or in equity. Estate of Stein v. Commissioner, 37 T.C. 945 (1962), subsequent proceedings, 40 T.C. 275 (1963). For the purpose of responding to your inquiry, we will first look to see whether the * * * qualify as transferees at law. Transferee liability at law arises when 1) the transferor transfers property; 2) at the time of the transfer and at the time the transferee liability is asserted, the transferor is liable for the tax; 3) a valid contract exists between the transferor and the transferee; and 4) under the contract, the transferee agree to assume the liability of the transferor. Bos Lines, Inc. v. Commissioner, 354 F.2d 830 (8th Cir. 1965).

[14] A review of the facts provided reveals that the * * * did not contractually agree to assume the unpaid income tax liabilities of the bankruptcy estate. Therefore, the * * * cannot be liable as transferees at law for the unpaid federal income tax liability of the bankruptcy estate.

[15] Since the * * * are not transferees at law, it is necessary to determine whether they are transferees in equity. To establish transferee liability in equity, the Service must prove the following: 1) the * * * received property from the bankruptcy estate; 2) the bankruptcy estate transferred property to the * * * without consideration or for less than adequate consideration; 3) this transfer was made during or after the period the income tax liability of the bankruptcy estate accrued; 4) the bankruptcy estate was insolvent prior to or because of the transfer of the property to the * * * 5) all reasonable efforts to collect from the bankruptcy estate were made and further collection efforts would be futile; and 6) the value of the property the bankruptcy estate transferred to the * * * Hagaman v. Commissioner, 100 T.C. 180 (1993).

[16] The existence and extent of transferee liability is determined by the applicable state law. Commissioner v. Stern, 357 U.S. 39 (1958). In this case the transfers of property were made in * * * therefore it is necessary to look to the law of * * * to determine whether the * * * are liable as transferees of the bankruptcy estate. Under * * * law, transferee liability at the time of the transaction is governed by * * * which provides

[17] In this case, the Service would initially be required to prove a transfer of the assets from the bankruptcy estate to the * * * occurred. The proposed notices of transferee liability attached to your memorandum dated August 30, 1993, indicated that the assets of the bankruptcy estate were transferred to the * * * as part of the bankruptcy proceeding.

[18] The second element of transferee liability in equity requires a showing that the transfers in issue were made for inadequate consideration. Under * * * law, if a transfer renders the transferor insolvent, it is presumed a fraudulent conveyance took place. * * *. The burden of dispelling the presumption of fraud is on the recipient of the transferred property. * * * * * *. The facts provided indicate that the * * * paid no consideration for the transfer of the assets from the bankruptcy estate, therefore this requirement has been satisfied.

[19] The third element of transferee liability concerns the accrual of the transferor's income tax liability at the time of or prior to the transfer. Here, the transferor would be the bankruptcy estate for the tax periods ending * * * and * * * See I.R.C. 1398(c). The Tax Court has held that tax liabilities though unassessed are obligations due and owing at the end of the taxable year. Hagaman v. Commissioner, 100 T.C. 180, 185 (1993).

[20] The fourth element necessary to establish transferee liability is to show insolvency of the transferor at the time of the transfer or insolvency resulting from the transfer itself. In this case, since all the assets of the bankruptcy estate were transferred to the * * * this element would be satisfied.

[21] The next element of transferee liability dictates that, before the Service can recover from the transferee, it must exhaust all remedies against the transferor for its unpaid income tax liability. This requirement is avoided where it is apparent that proceeding against the transferor would be futile. Generally, the courts have held the Service may proceed directly against a transferee in the case of an insolvent transferor. Davis v. Commissioner, T.C. Memo. 1964-244, 23 T.C.M. (CCH) 1449 (1964); Miller v. Commissioner, 42 T.C. 593, 599-600 (1964). However, in this case the Service still has the opportunity to move pursuant to B.C. section 350 to reopen the bankruptcy proceeding to have the issue of the unpaid administrative taxes addressed. In re Shondel, 950 F.2d 1301, 1304 (7th Cir. 1991) (decision to reopen bankruptcy case lies within discretion of the bankruptcy court). As such, until the Service is denied the opportunity to attempt to collect the unpaid taxes from the bankruptcy estate in the bankruptcy proceeding, we do not believe this part of the transferee liability test has been satisfied. ³

[22] Finally, the Service must establish the value of the transferred property. Bartmer v. Automatic Self-Service Laundry, Inc. v. Commissioner, 35 T.C. 317 (1960), Acq. 1961-2 C.B. 4. In this regard, the Service would have the burden of proving the items transferred and their value. Bartmer, at 325 and Millikin v. Commissioner, T.C. Memo. 1959-210, 18 T.C.M. (CCH) 995, 1019 (1959), aff'd, 298 F.2d 830 (4th Cir. 1962). ⁴

[23] Based upon the foregoing analysis, we believe that it would be premature to assert that the * * * are liable as transferees for the unassessed and unpaid income tax liabilities of the bankruptcy estate. As such, we suggest the Service move to reopen the bankruptcy proceeding pursuant to B.C. section 350 before issuing notices of transferee liability to the * * * If the bankruptcy court denies the Service's request to reopen the bankruptcy proceeding to address the issue of the unpaid administrative taxes, and if this issue is not resolved in Appeals, we recommend your office issue notices of transferee liability to the * * *

[24] If you require any further information with respect to this matter, please contact Nancy Romano at (202) 622-7940.

² It is not clear from your memorandum to us dated August 30, 1993, how this figure was determined by the examination division.

³ In responding to your request for assistance, we asked the Chief, Branch 3 (General Litigation) for advice on whether the Service had waived its claim for the unpaid administrative taxes by not filing a proof of claim in the bankruptcy proceeding. For your reference, we have attached a copy of their response to this memorandum.

⁴ Although we conclude that the assertion of transferee liability against the * * * at this time would be premature, if it became appropriate to issue transferee liability notices at a later time, it would be necessary for the Service to prove the items transferred and their respective value with as much specificity as possible.

[26] The Examination Division determined that the estate should have filed Forms 1041 for the * * * and * * * tax years, the tax years in which the estate was liable for the payment of taxes. The Examination Division has discovered that substantial assets with a net asset value of $* * * were transferred to the debtors upon confirmation of the plan. ² As a result of that transfer, there are no longer any assets in the estate from which to collect the tax liability of the estate, which we understand is in excess of $* * *.

[27] Currently, the * * * have a case pending in Tax Court. They are disputing the amounts set forth in Statutory Notices of Deficiency which were issued to them as individuals for the * * * and * * * tax years. ³ We were also informed that if the taxpayers had properly prepared their individual tax return for the * * * tax year that they would be entitled to a credit.

[28] In requesting our advice you specifically wanted to know whether the Service had "waived" its claim to proceed against the estate for the 1041 liabilities. In the case of individuals proceeding under chapter 11 of the Bankruptcy Code, a separate taxable entity is created upon the filing of the petition for relief in bankruptcy. I.R.C. section 1398. As debtors-in-possession, the * * * were liable for filing the estate tax returns. I.R.C. section 6012(b)(3). The taxes accrued by the bankruptcy estate constitute administrative expenses which are given first priority in payment as set forth in the Bankruptcy Code. 11 U.S.C. sections 503(b)(1)(B) and 507(a)(1). Under the provisions of chapter 11, administrative expenses, such as the taxes incurred by the estate, are to be paid in full upon confirmation of the plan of reorganization. 11 U.S.C. section 1129(a)(9)(A). The Service need not file a proof of claim for payment of these taxes but instead may file a request for payment. It is our understanding that in this case, no request for payment was ever filed by the Service. It could be that the Service was not aware of the bankruptcy proceeding.

[29] In a chapter 11 proceeding, the statutory penalty for failure to file a claim is the loss of the right to vote on and receive distribution under the plan. B.R. 3003(c)(2). No other loss or penalty is affixed to a creditor's failure to file a claim in a chapter 11. As the failure to file a proof of claim results in a loss of the right to payment under the plan, then the Service would have no right to payment in this case if it is determined that the administrative tax liability was discharged. If the claim is nondischargeable, however, the Service can collect outside the plan as well as under the plan. In re Kinney, 123 B.R. 889 (Bankr. D. Nev. 1991). Thus, the relevant issue is whether or not the Service's claim for administrative taxes owed by the estate was discharged upon confirmation of the plan of reorganization.

[30] Section 1141(d)(1) of the Bankruptcy Code generally provides that the confirmation of a plan discharges the debtor from any debt that arose before the date of such confirmation whether or not a proof of claim is filed, such claim is allowed or the holder of the claim has accepted the plan. Pursuant to section 1141(d)(2), confirmation does not discharge an individual debtor from any debt excepted from discharge under section 523. The taxes at issue do not fall into any of the exceptions listed in section 523. Thus, the discharge which the individual debtors received upon confirmation of the plan of reorganization, releases the debtors of any personal liability for the administrative taxes. See generally Dixon v. Bennett, 531 A.2d 1318 (Md. App. 1987), cert. denied, 536 A.2d 664 (1988). It does not, however, extinguish the underlying debt or affect the estate's liability for these taxes. In fact, section 524 of the Bankruptcy Code which specifically provides for the effect of the discharge clearly states that:

[31] If the estate wanted to be relieved of liability for these administrative taxes it should have brought a proceeding under section 505(b) of the Bankruptcy Code. Under section 505(b), the trustee may request a prompt audit of the estate's liability for taxes. If an audit is conducted and the trustee does not agree with the result of the audit, the trustee may ask the bankruptcy court to resolve the dispute. Once the liability is determined and paid, the trustee, the debtor, and any successor to the debtor are discharged from any liability for such tax.

[32] Although the discharge granted to the debtors upon confirmation of the plan does not affect the estate's liability, the debtors may assert that section 1141(c) of the Bankruptcy Code precludes collection from the estate's property which vested in them upon confirmation. Section 1141(c) provides that,

[34] Even though bankruptcy law does not extinguish the liability owed by the estate, state law will ultimately determine whether transferee liability can be asserted against the debtors. District counsel's memo concludes that under * * * law, the elements necessary to establish fraudulent conveyance can be proved. We understand that you will be researching this matter. You should note, however, that since the transfer at issue took place "as a matter of law", under state law the transfer may not constitute a fraudulent conveyance. The property from which the Service could collect the liabilities at issue was originally property of the debtors. At the time that the debtors filed for relief under chapter 11 of the Bankruptcy Code, a bankruptcy estate was created which consisted of all legal or equitable interests of the debtor in property as of the commencement of the case. 11 U.S.C. section 541(a)(1). Upon confirmation of the plan, the property was vested in the debtors. 11 U.S.C. section 1141(b). At the time the property vested in the debtors, the estate no longer had an interest in the property and except as otherwise provided in the plan or in the order confirming the plan, the property was no longer subject to claims of creditors. ⁵ Moreover, while, as district counsel maintains, there was no consideration given for the transfer, the Bankruptcy Code does not require any consideration for the transfer to occur since the transfer occurs as a matter of law upon confirmation of the plan of reorganization.

[35] Finally, even if * * * law supports the assertion of transferee liability, as a transferee in equity, the Service may first want to request that the bankruptcy court reopen this case pursuant to section 350 of the Bankruptcy Code. Granted, the fact that more than * * * years have elapsed since the plan was confirmed does not help the Service's case. Assuming that the Service never received notice of the bankruptcy proceeding, then the bankruptcy court may be more receptive to allowing the case to be reopened. ⁶ Once the Service has established that it has no alternative legal remedy against the estate, then it may assert a transferee in equity theory against the debtors.

[36] In conclusion, the Service's claim for administrative taxes was not discharged. We think that there is support for the equitable argument that the debtors should be liable as transferees assuming that state law supports the assertion of transferee liability. As noted, the fact that the transfer occurs as a "matter of law" may preclude the assertion of transferee liability. As there is no clear bankruptcy law on point and there is a significant amount of money at stake, we do not think that the litigating hazards preclude the Service from pursuit of this matter. We suggest, however, that an attempt be made to reopen the bankruptcy proceeding before pursuing the debtors on a transferee liability theory.

[37] We hope the information we have provided will help you in rendering advice to the field in this matter. If we can be of any further assistance, please contact Holly Wilson at 622-3630.

The administrative expenses of the debtors, to the extent claims for such have been allowed pursuant to Section 503(b) of the Code prior to the distribution date, shall be paid in full upon the distribution date or shall be paid upon such other terms as may be agreed upon by the holder of such allowed claim for expenses or as otherwise ordered by the Court. Administrative expenses in this case shall include fees due debtors' bankruptcy counsel, * * * of and on behalf of * * * debtors' accountant, and debtors' recordkeeping service, * * *

² We questioned whether in fact the debtors received assets with such a high net value since it appeared from our review of the plan of reorganization that all of the assets which vested in the debtors were encumbered by liens granted the bank.

³ It is our understanding that for these tax years, the * * * did report farm income and expenses on Schedule F but did not report income which they received from the estate.

⁴ At one point during the legislative process it was clearly provided that the debtors could be liable as transferees for taxes which were not paid by the estate. If the debtor wanted to be relieved of these liabilities, he or the trustee needed to request a prompt audit. S. 2266, 95th Cong., 2d Sess. (1977). These provisions, however, never became part of the Bankruptcy Code. At the time these provisions were being proposed, however, the debtor would not have received a discharge for all debts which arose prior to confirmation, as is the case under current law. Instead, the debtor only would have been discharged from those debts which arose prior to the filing of the petition. Nevertheless, while the Code no longer clearly provides that the debtor may be held liable as a transferee, section 505(b) does provide that the debtor does not receive a discharge of any liability for the administrative tax unless the prompt audit procedures are followed.

⁵ It appears that the debtors may not have been aware of the creation of the separate taxable entity upon the filing of the petition since it is our understanding that they included farming income on their personal tax returns for the years at issue. If in fact this is true, then establishing a fraudulent conveyance may be very difficult. Furthermore, the fact that the debtors included the estate's income on their personal tax returns, precludes us from recommending that district counsel attempt to hold the debtors personally liable as fiduciaries of the estate.

⁶ Alternatively, if the bankruptcy court erroneously takes the position that the debtor's received a discharge of this liability, the Service should maintain that its claim is not subject to the discharge since the Service never had an opportunity to notice and a hearing on its claim. Mullane v. Central Hanover Bank & Trust Co., 339 U.S. 306 (1950); see generally, In re Worthing, 24 B.R. 774 (Bankr. D. Conn. 1982).