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BBA Partnership Tax Provisions and Bankruptcy– A Recipe for Disaster, Part 1

Posted on May 26, 2020

We welcome back guest blogger, A. Lavar Taylor.  Lavar’s practice is based in Southern California though you can find him pursuing cases around the country.  He spent the early days of his career in the General Litigation Division of Chief Counsel’s office where he learned the intricacies of the intersection of tax and bankruptcy.  We enjoy his insights today on a new issue that could vex bankruptcy and tax attorneys in the coming years.  Keith

Some of us practitioners are old enough to have endured the transition to the TEFRA Partnership audit provisions from the unwieldy pre-TEFRA rules that required the IRS to audit the tax returns of all partners in a tax partnership in order to assess deficiencies resulting from adjustments to Forms 1065 filed by those partnerships. That transition required a considerable learning curve. Even 30+ years after the enactment of the TEFRA Partnership audit provisions, we have still been “learning through litigation” about the proper interpretation of some of the more poorly drafted TEFRA Partnership audit provisions. See, e.g., Petaluma FX Partners, LLC v. Comm’r, 792 F.3d 72 (D. C. Cir. 2015).

The intersection between the TEFRA Partnership audit provisions and the bankruptcy/insolvency world has also proven to be quite interesting, as illustrated by the Ninth Circuit’s opinion in Cent. Valley Ag Enters. v. United States, 531 F.3d 750 (9th Cir. 2008). In that case, the taxpayer/debtor was allowed to challenge a claim filed by the IRS based on a TEFRA Partnership audit even though the IRS had issued an FPAA and the deadline for filing a Tax Court petition with respect to the FPAA had expired without any petition having been filed.  Outside of bankruptcy, no judicial challenges to the audit assessment made against that partner as the result of the TEFRA Partnership audit would have been permissible as of the date on which the Chapter 11 bankruptcy case was filed. But once inside Chapter 11, per the Ninth Circuit, the taxpayer/debtor/partner was entitled to challenge the merits of the audit assessment under section 505(a)(2) of the Bankruptcy Code.  The filing of the Chapter 11 by the partner allowed the debtor/taxpayer/partner to escape the otherwise preclusive effect of the failure of any party in interest to file a Tax Court petition in response to the FPAA.

Now, thanks to Congress, we are faced with learning an entirely new set of partnership audit provisions: the BBA Partnership audit provisions. Learning how these new provisions will operate in the real world is likely to be no less painful than it was to learn how the TEFRA Partnership audit provisions operate in the real world.

This learning process will be even more painful where a bankruptcy is involved. How much more painful? That remains to be seen, but masochists and sadists will likely rejoice.

This post discusses one of the many problems that are going to arise when the BBA Partnership audit provisions collide with the Bankruptcy Code, namely, how to classify, for purposes of the Bankruptcy Code, claims for audit assessments of income taxes arising under the BBA Partnership Audit proceedings. I plan to follow up this post with additional posts which will further discuss the problems that are going to arise as the result of the intersection of these two statutory schemes. A discussion of these issues appears timely in light of the current economic climate.

Classifying income tax claims under the Bankruptcy Code is important. How income tax claims get classified under the Bankruptcy Code determines matters such as: a) the order in which such claims get paid in Chapter 7 relative to other types of claims, b) whether such claims must be paid in full in a Chapter 11 case or in a Chapter 13 case, c) the terms on which such claims can or must be paid in a Chapter 11 case or in a Chapter 13 case, and d) the extent to which such claims can be discharged in bankruptcy.

Without getting too technical, there is a big distinction under the Bankruptcy Code between income tax claims that are for tax periods that end prior to the date of the filing of the bankruptcy petition (“pre-petition tax claims”) and income tax claims for tax periods that end after the date of the filing of the bankruptcy petition (“post-petition tax claims”). Pre-petition income tax claims, if not secured by the proper filing of a tax lien notice, are either “general unsecured” claims or “priority” claims. See, e.g., Bankruptcy Code 507(a)(8)(A), which determines what pre-petition income tax claims are treated as “priority” tax claims.

Post-petition income tax claims are sometimes (but not always) entitled to be paid as an administrative expense in the bankruptcy case. In other cases, post-petition income tax claims are not treated as administrative expense and cannot be paid out of proceeds held by a Chapter 7 Trustee and cannot be paid at all under a Chapter 11 plan.

In any bankruptcy case, unsecured pre-petition tax claims, whether treated as “priority” tax claims or as “general unsecured” claims, do not get paid until all administrative expense claims have been paid in full. Also, “priority” tax claims get preferred treatment over general unsecured claims in all types of bankruptcy cases.  

Thus, determining whether an income tax claim is a pre-petition claim or is instead a post-petition claim is important. Also, if an income tax claim is a pre-petition claim, determining whether that claim is a “priority” tax claim or is instead a “general unsecured” tax claim is important. Similarly, if an income tax claim is a post-petition claim, determining whether or not that post-petition income tax claim is an administrative expense claim is important.  See, e.g., Towers for Pacific-Atlantic Trading Co. v. United States (In re Pacific-Atlantic Trading Co.), 64 F.3d 1292 (9th Cir. 1995), which dealt with all of these issues in the context of an IRS claim for taxes for the tax year during which a corporate debtor/taxpayer went into chapter 11 bankruptcy.

Those of you who have some familiarity with the BBA Partnership audit provisions should already have an idea of where this discussion is headed. Under the BBA Partnership provisions, an audit of a partnership return for the year 2019 which ends in the year 2023 and which generates a deficiency can result in any of the following: 1) deficiency assessments against the 2019 partners for the 2019 tax year, 2) a deficiency assessment against the partnership for the tax year 2023, or 3) deficiency assessments against the 2023 partners for the tax year 2023.

Suppose, then, that the tax partnership files for chapter 11 at the end of 2022 and that this Chapter 11 case remained pending as of the end of 2023 without a chapter 11 plan being confirmed.  If an IRS audit of the partnership’s 2019 tax return comes to an end in 2023 and the taxes are assessed against the partnership for the year 2023 in 2024, how should that claim be classified under the Bankruptcy Code? The claim is for the 2023 tax year, a post-petition year. That suggests that the claim is a post-petition claim. But the claim is clearly based on pre-petition activity. Thus, there is an argument that the claim against the partnership should be treated as a pre-petition claim, even though the claim is for a post-petition tax year.

If the claim is to be treated a pre-petition claim, is the claim entitled to priority treatment under section 507(a)(8) even though that section only applies to claims for tax years that ended before the date on which the bankruptcy was filed? If the claim is to be treated as a post-petition claim, is the claim an administrative expense claim allowed under section 507(a)(2) of the Bankruptcy Code? Resolution of these issues will be important not only to the IRS, which will want to be paid what it is owed, but also to the 2023 partners of the partnership, who can be held personally liable for the partnership’s 2023 income tax deficiency assessment if it is not paid by the partnership.

Sorting out these classification issues in this very simple fact pattern, based on the law as it presently stands, will take years of litigation. There will undoubtedly be variations of this fact pattern, and there will be bankruptcy cases involving the partners in a partnership subject to the BBA Partnership audit provisions in which claim classification issues arise. Such claim classification issues are but a small fraction of the issues that will arise in bankruptcy cases involving individuals and entities subject to the BBA Partnership audit provisions.

Conclusion of Part I

It will be far more efficient to solve these problems through legislative and administrative action, rather than through litigation. The first step in this process, however, is to identify the problems that need to be solved. I hope to identify additional problems in future posts, and I invite the PT Community to help identify the problems that are out there. (For those of you interested in reading a short article which identifies some of the due diligence that bankruptcy professionals must perform as the result of the enactment of the BBA Partnership audit provisions, I invite you to review the following article which appeared in Business Law News, published by the California Lawyer’s Association, which can be found here.

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