In direct response to the financial pressures caused by the coronavirus, many companies, including Gold’s Gym, Neiman Marcus, J.C. Penney, and Hertz, have filed voluntary Chapter 11 bankruptcy petitions in 2020.1 Others are contemplating doing the same. For entities saddled with debt, Chapter 11 of the Bankruptcy Code can offer a fresh start through a plan to restructure, pay off, and discharge debt.2
To achieve this fresh start, it is often critical to resolve issues concerning disputed tax liability—especially when significant amounts are involved—to ensure that a company retains sufficient resources for the business coming out of bankruptcy.
Tax issues can present strategic considerations that may arise before filing the bankruptcy petition or during the bankruptcy process. These considerations may include the preparation of tax liability schedules, objections to Internal Revenue Service claims, expedited audits, IRS Appeals, potential tax liens, and choosing a forum for potential litigation. Most taxpayers will be unfamiliar with the complex interactions among the highly technical rules governing the bankruptcy process and tax disputes.
This article will provide an overview of a Chapter 11 reorganization bankruptcy case and the treatment of federal tax claims in bankruptcy. It will then discuss specific issues posed in resolving tax disputes, including the handling of matters in IRS Exam, before IRS Appeals, and in litigation.3
How Does Voluntary Chapter 11 Bankruptcy Work?
Petition and Proofs of Claim
Bankruptcy proceedings begin with filing a petition in the bankruptcy court and disclosing assets, debt, and other financial information. A creditor whose claim is not included in the schedules of liabilities filed by the debtor, or whose claim is scheduled as disputed, contingent, or unliquidated, must file a “proof of claim” in order to receive a distribution. Such proofs of claim are deemed allowed unless the debtor or another party in interest objects. The failure to object to a proof of claim can estop the debtor from challenging the payment of the claim in a separate litigation later. The bankruptcy court typically resolves disputes regarding contested amounts. As a practical matter, parties commonly resolve claims disputes through negotiation and settlement as well.
Bankruptcy Plan, Confirmation, and Discharge
The debtor in possession4 (or in rare instances, another party in interest, such as a creditor) files a Chapter 11 plan that specifies the treatment creditors will receive with respect to their claims. Claims that are allowed generally are paid in the following order—secured debt first, priority unsecured debt second (in order of priority as outlined in the Bankruptcy Code), and finally non-priority unsecured debt (which frequently receives little or no recovery).
The debtor in possession must also file a disclosure statement describing items relevant to assessing the plan, including assets, liabilities, its business operations, a summary of the proposed plan, and treatment of creditors under the plan. If the court approves the disclosure statement, then the plan proponent may solicit the votes of creditors entitled to vote. Once creditors have voted on the plan, the court will hold a hearing to determine whether to “confirm,” that is, approve, the plan.
If the court finds the plan in compliance with the Bankruptcy Code, the court will confirm the plan by issuing a confirmation order. The confirmed plan covers the terms and conditions of the payment of debts and whether the debts are discharged. The debts that arose before the plan was confirmed typically are discharged and are substituted with the obligations set forth in the plan. When the plan becomes effective, the debtor is said to have “emerged” from bankruptcy.
Where the amount of debt is unresolved at the time the plan is confirmed, the plan may include an agreed-upon amount or the plan can specify that the amount will be determined later and provide for an escrow or other negotiated arrangement to accommodate the later-determined amount. The court retains jurisdiction until the plan is executed and the case can be closed.
How Is Tax Liability Treated in a Chapter 11 Bankruptcy—Must It All Be Paid?
A debtor taxpayer often has unpaid tax liability from periods prior to filing bankruptcy as well as the continuing obligation to file federal income tax returns and pay tax during the administration of the bankruptcy. As with other types of debt, the treatment of tax liability in bankruptcy depends on whether the IRS’ tax claims are secured or unsecured and, if unsecured, whether the claims have priority.
Secured, Priority Unsecured, and Non-priority Unsecured Claims
Secured Claims—Federal Tax Liens. Claims secured by federal tax liens imposed prior to bankruptcy are considered secured claims and normally must be fully paid to the extent they are allowed and secured, though payment may be deferred under the plan. An automatic stay prevents a secured creditor such as the IRS from foreclosing on collateral that is the property of the estate during the bankruptcy. The stay also prevents creditors from imposing new liens against the property of the estate after the bankruptcy petition is filed. Bankruptcy does not automatically extinguish a secured creditor’s property right in collateral, even if the secured claim is discharged, until the allowed amount of the secured debt has been paid.
Where a secured tax liability exceeds the value of the collateral, the excess is treated as an unsecured tax liability.
Unsecured Tax Claims. The IRS enjoys a high level of protection for most types of unsecured federal income tax liability under the Bankruptcy Code’s hierarchy of priorities for the payment of various types of debt. Each type of unsecured tax liability that constitutes a priority liability must be paid (to the extent allowed) ahead of other unsecured liabilities with a lesser priority or without priority. Tax debt falls under the second priority, the eighth priority, or no priority, depending in large part on when the tax arises or is assessed and whether it is “pre-petition” or “post-petition” liability. A debtor’s unsecured federal income tax liability for periods ending prior to filing the bankruptcy petition is pre-petition tax liability, and its tax liability for taxable periods during the administration of the bankruptcy (until confirmation of the plan) is post-petition tax liability.
Post-Petition Tax Liability—Second Priority. The Bankruptcy Code grants second priority to post-petition tax liability, treating it as an administrative expense. Administrative expenses must be paid ahead of all lesser priority debt, including pre-petition tax liability. Post-petition tax liability generally must be paid in full by the effective date of the reorganization plan.
Pre-Petition Tax Liability—Eighth Priority or Non-priority. Most unsecured pre-petition income tax liability that is allowed will be accorded eighth priority. To qualify for the priority, it must be a pre-petition tax liability a) for which a return was due (including extensions) after three years before the petition was filed, b) that was assessed within 240 days before the petition was filed, or c) that relates to taxes that were not assessed before but are assessable after the commencement of the case, such as where the statute of limitations had been extended or a taxpayer has filed (or could file) a petition in the Tax Court.
Eighth-priority tax liability generally must be paid in full, usually in regular installments, the total of which must be paid no later than five years after the filing of the bankruptcy petition. Secured tax liability that would otherwise meet the description of an eighth-priority claim is paid in the same manner as an eighth-priority claim.
The remainder of pre-petition tax liability—that which does not qualify as eighth-priority debt—is non-priority general debt that often is not fully paid but rather is paid pro rata. This would include unpaid amounts that were assessed more than 240 days before the bankruptcy petition was filed with respect to a tax for which a return was due more than three years before the petition was filed. Such amounts may be discharged unless they fall within the exceptions to discharge, such as for taxes related to a fraudulent return or an attempt to evade tax. The IRS cannot, after the bankruptcy, collect discharged amounts in excess of the portion due under the bankruptcy plan.
IRS Proofs of Claims and Taxpayer Objections to Protect Tax Positions
To protect its rights, the IRS files proofs of claim with the bankruptcy court to assert a right of payment from the bankruptcy estate. The IRS will generally file separate proofs of claim in the bankruptcy case of each member of the consolidated group; each proof of claim will list the entire group’s income tax liability. (Although the debtor members of the group will have filed separate petitions, the court may order joint administration of related debtors’ cases. Allocation of liability and refunds may be more complicated where some members of the group are not included in the bankruptcy.)
If an IRS proof of claim relates to a filed return with pending assessments, it will include pre-petition penalties and interest. Penalties that relate to post-petition taxes are, like the taxes, treated as administrative expenses with second priority. Penalties with respect to taxes that have eighth priority are also eighth priority only if they are nonpunitive or compensatory in nature. Penalties that are not compensatory are general non-priority unsecured claims (unless secured).
For taxes not yet assessed, the IRS can file estimated proofs of claim, but the proofs of claim will not include penalties or interest. The Internal Revenue Manual recommends that the IRS promptly file estimated proofs of claim to protect the government’s interests, including for unfiled returns or in any situation before the exact liability is determined, such as when the debtor is under audit.
To contest the IRS claims, the debtor or another party in interest must file with the bankruptcy court timely objections to the proofs of claim or make the objection with a complaint for an adversary proceeding in the bankruptcy court; without an objection, the claim generally is deemed allowed.
Tax Debt Discharge
In Chapter 11 corporate-debtor reorganization cases, the bankruptcy court’s confirmation of the plan discharges most pre-confirmation debts. Discharged pre-petition priority debts must be paid to the extent they are allowed under the plan. The IRS cannot assess or collect discharged pre-petition corporate income tax liabilities beyond what the court or plan determines is due.
How Is Tax Controversy Resolved in Chapter 11 Bankruptcy?
Tax debt is often contested or uncertain, so it may be necessary or desirable to resolve a tax controversy in bankruptcy. Bankruptcy can alter the ordinary options and procedures for the resolution of issues in Exam, Appeals, and litigation.
As part of the Significant Bankruptcy Case Program, the IRS will follow special procedures to ensure coordination among IRS functions for large or otherwise significant cases. In such instances, a case coordinator will be involved where technical issues require coordination with the Exam team and field counsel, the National Office, or others. Significant Bankruptcy Case Program cases will be handled on an expedited basis if the unassessed proposed tax liability for all open years including pre-petition interest will exceed $1 million, the outstanding assessed liability with pre-petition interest exceeds $10 million, or expedited treatment is otherwise warranted. The IRS team handling the audit will create an action plan to audit all open years.
Determination by the IRS of liability for tax that arises during the administration of the estate (that is, after the filing of the bankruptcy petition) can also be expedited. If the debtor in possession files a return and requests a final determination of those post-petition taxes, it may pay the amount reported on the return in full satisfaction of the liability (absent fraud or material misrepresentation) unless the IRS notifies the debtor within sixty days that the return has been selected for audit or completes the audit and notifies the debtor of additional tax due within 180 days of the request (or longer if permitted by the court).
One purpose of expediting audits is to ascertain, as accurately as possible, the amounts the IRS will claim in the bankruptcy proceedings prior to the deadline for filing proofs of claim. The Internal Revenue Manual instructions state that “Every effort should be made to ensure that the initial claims filed are as accurate and complete as possible even if estimates are necessary.” Any estimates “should be based on historical amounts or partial development of the [issues] under audit.” In a Chapter 11 case, the court sets the deadline by which claims are due. In some cases, the government may request an extension of time to file its proofs of claim based on the “complexities” of the audit and the time needed to file accurate claims. A taxpayer’s responsiveness may affect whether the government seeks or receives an extension.
A taxpayer may want to resolve any issues at the audit stage where possible in order to avoid the delay in bankruptcy proceedings that could result from tax litigation. Establishing a strong position in the audit could result in a more favorable settlement.
Another benefit of expedited audits is to expose any controversy that may require resolution in IRS Appeals or through litigation to facilitate the execution of the bankruptcy plan. At the end of the audit, if unagreed, the IRS will issue a thirty-day letter, allowing the taxpayer to file a protest and take any unagreed issues to IRS Appeals, or will issue a Notice of Deficiency if the taxpayer is not filing a protest with Appeals.
Alternatively, the debtor and the IRS can agree to include a provision in the bankruptcy plan providing that they will address all or a portion of the open tax issues after the bankruptcy, subject to the court’s confirming the plan. In confirming the plan, the court must take into account the requirements of the Bankruptcy Code regarding the treatment of other claims or interests potentially impacted by the future determination of tax liability. The terms of such an agreement are negotiated and can vary; they may include an escrow provision or a fixed pool for lower priority unsecured creditors, for example.
IRS Administrative Appeals
Generally, where field counsel has referred the bankruptcy case to the Department of Justice Tax Division, IRS Appeals can attempt to settle the issues before it within six months of the filing of the bankruptcy petition. If the case is resolved based on hazards of litigation, a closing agreement will be required. If the case is not resolved, Appeals will issue a Notice of Deficiency. In addition, if an objection to the proof of claim of the IRS is filed while the case is in Appeals, Appeals will immediately issue a Notice of Deficiency.
Determination of Disputed Tax Liability Through Litigation
A taxpayer will need to make strategic decisions about when and where to litigate any tax issues that have not been resolved in Exam or IRS Appeals. Generally, prior to bankruptcy, a taxpayer can file a petition in the Tax Court for a redetermination of the proposed deficiency without fully paying the tax, or can instead fully pay the tax (plus any penalty and interest), file an administrative claim for refund, and file suit in the district court or the Court of Federal Claims. If contemplating bankruptcy, a taxpayer may wish to consider the timing of its tax litigation relative to filing the bankruptcy petition.
Is Tax Court Litigation an Option for Debtors in Bankruptcy?
If a taxpayer would prefer to litigate in the Tax Court, it may want to file the Tax Court petition and, to the extent possible, get the case underway prior to filing the bankruptcy petition. Once the bankruptcy petition is filed, an automatic stay generally bars the commencement or continuation of a proceeding in the Tax Court. The debtor (or the government) can file a motion in the bankruptcy court to lift the stay so the case can continue in the Tax Court. Factors that may impact the court’s decision to lift the automatic stay include how far the Tax Court case has progressed, potential whipsaw or consolidation of the case with other cases in the Tax Court, and other judicial efficiencies. The Internal Revenue Manual instructs the government to file a motion to lift the stay for Tax Court cases that started before the automatic stay went into effect.
If the taxpayer files a bankruptcy petition first, the automatic stay prevents the filing of a petition in the Tax Court. The taxpayer can file a motion in the bankruptcy court to lift the stay, however, and if the bankruptcy court grants the motion, the taxpayer-debtor may commence a Tax Court case.
If the motion to lift the stay is not granted and the taxpayer cannot commence or continue a case in the Tax Court, the parties generally can seek to litigate the existence and amount of the proposed deficiency in the bankruptcy court. The government would file a proof of claim for the estimated deficiency, and the taxpayer-debtor could file an objection (or objection and motion), which would begin a contested matter (to be resolved in a bankruptcy court hearing) or an objection and complaint to begin an adversary proceeding in bankruptcy court, which is like a lawsuit within the bankruptcy. The bankruptcy court’s adjudication of the tax liability under 11 USC Section 505 would have the effect of res judicata on the Tax Court for those tax years, and that deficiency could be immediately assessed.
Can a Taxpayer in Chapter 11 Bankruptcy Litigate Tax Issues in the District Court or the Court of Federal Claims?
Before bankruptcy, a taxpayer may determine that it would be more advantageous to litigate in the Court of Federal Claims or the district court than in the Tax Court. In that case, the taxpayer would pay the full proposed liability, file an administrative refund claim, and (before or after filing a bankruptcy petition) file suit in the Court of Federal Claims or district court. Taxpayers paying the proposed liability within the ninety days before filing the bankruptcy petition should be aware of the rules permitting recovery from creditors of certain pre-petition transfers. Taxpayers paying the proposed liability after the filing of the bankruptcy petition would be subject to the rules applying to post-petition transactions and the use of property in the estate (including cash collateral). In some instances, the taxpayer may have initiated a refund suit long before contemplating bankruptcy.
The bankruptcy petition does not automatically prevent the taxpayer from continuing to pursue a refund in these courts. Importantly, the bankruptcy stay prevents the government from filing a counterclaim or applying a setoff, although pre-petition income tax refunds can be offset against pre-petition income tax liabilities. However, the government (or the taxpayer debtor, if it prefers the bankruptcy court) may file a motion to remove a refund action to the bankruptcy court. The Court of Federal Claims or district court will have concurrent jurisdiction with the bankruptcy court if either the motion for removal is denied or the motion is granted but the case is remanded. If the motion for removal is granted, the case can be litigated in the bankruptcy court through an adversary proceeding, which is initiated through a complaint.
Any settlement that results in a refund to a C corporation in excess of $5 million will require review by the Congressional Joint Committee on Taxation. A decision based on the opinion of the court does not require Joint Committee review.
Whereas ordinarily tax cases can be heard in the district court only if the tax has been paid and a refund claim filed, a tax dispute in bankruptcy may reach the district court without prior payment when a district court decides that a tax issue otherwise before the bankruptcy court should be heard by the district court instead. The jurisdiction of bankruptcy courts is derivative of the district courts, and the district courts can “withdraw” the automatic reference of a bankruptcy case to the bankruptcy court in whole or in part. Some courts have found withdrawal warranted when the bankruptcy case involved a tax dispute that touched upon unsettled or complex areas of federal tax law. Thus, even when a case is initiated in bankruptcy court, depending on the significance and complexity of the tax issues, it may be decided in the district court.
Litigating Tax Issues in Bankruptcy Court
Generally, the bankruptcy court has the authority to determine the existence and amount of the debtor’s tax liability (including related fines or penalties), whether or not assessed or paid. Thus, unlike in the district court and Court of Federal Claims where the “full payment” rule applies, the bankruptcy court has jurisdiction even when the asserted tax liability has not been paid. Tax issues may be decided by the bankruptcy court if the court does not lift the stay or grants a motion for removal to the bankruptcy court, or the taxpayer has not filed suit in another court and the bankruptcy court has authority to hear the dispute.
In the case of a federal income tax refund, before filing suit in a district court or the Court of Federal Claims, a taxpayer generally must wait until the IRS has disallowed its administrative claim or until six months have passed after it filed its claim for refund, whichever is earlier. In contrast, the bankruptcy court may determine the right of the estate to a tax refund just 120 days after the debtor-in-possession properly requests such a refund from the IRS (or before if the IRS makes a determination earlier).
Corporate debtors in Chapter 11 cases should list their tax refund claims relating to pre-petition years as assets. Those assets are property of the estate. A tax refund is part of the bankruptcy estate even when the tax refund is contingent or not determinable as of the petition date. Additionally, when the IRS files a proof of claim, the estate can counterclaim for a tax refund.
Debtors considering pursuing tax refund claims in bankruptcy court should carefully consider whether courts in their jurisdiction treat tax refund claims as core proceedings, over which the bankruptcy court has full jurisdiction, or non-core proceedings, which the bankruptcy court may need to refer to the district court in some jurisdictions. Limitations on the jurisdiction of the bankruptcy court are beyond the scope of this article.
Can a Taxpayer Appeal a Bankruptcy Court Determination?
Decisions of the bankruptcy court are appealable to the district court of the same district. They can also be appealed to Bankruptcy Appellate Panels (BAPs) instead of the district court in circuits where BAPs have been established,5 but only where districts within those circuits authorize appeals to a BAP. BAPs comprise three bankruptcy judges from the districts in the circuit. In rare circumstances, certain orders can be appealed directly to the Court of Appeals from the bankruptcy court. A decision of a district court or BAP can be appealed to the US Court of Appeals for the circuit where the bankruptcy court sits (and then potentially to the US Supreme Court).
Proper tax representation during the bankruptcy process, beginning prior to filing bankruptcy, can help debtors navigate unique Exam, Appeals, and litigation procedures to arrive at the correct tax liability and determine with greater certainty the resources available to them as they emerge from bankruptcy.
Joel Williamson is a co-practice leader and partner, Marjorie Margolies is a partner, and May Chow is an associate at Mayer Brown’s National Tax controversy and litigation practice.
Editor’s note: The authors acknowledge the assistance of Tom Kiriakos, practice leader and partner, and Tyler Ferguson, associate, both members of Mayer Brown’s restructuring practice.
- Hank Tucker, “Coronavirus Bankruptcy Tracker: These Major Companies Are Failing Amid the Shutdown,” Forbes, May 3, 2020, www.forbes.com/sites/hanktucker/2020/05/03/coronavirus-bankruptcy-tracker-these-major-companies-are-failing-amid-the-shutdown/#29346dad3425.
- This article focuses on procedural issues associated with determining the federal income tax liability (and related interest and penalties) of corporate debtors filing under Chapter 11 of the Bankruptcy Code (United States Code [USC] Title 11) who intend to continue business operations. (Separate rules may apply to individuals and other entities, liquidations, and to other types of bankruptcy.) The tax consequences of substantive issues arising in a bankruptcy (including cancellation of indebtedness income and certain tax attributes) are also beyond the scope of this article.
- The principal sources for this article are the Bankruptcy Code, the Tax Code (USC Title 26), USC Title 28 regarding the Judiciary and Judicial Procedure, the Internal Revenue Manual, Collier on Bankruptcy (16th ed., June 2020), and case law.
- A debtor in possession is a debtor that retains possession of its property and continues to operate its business where no trustee is appointed, as is often the case in a non-liquidation Chapter 11 bankruptcy. The terms debtor, debtor in possession, taxpayer, and trustee may be used interchangeably here with respect to the period during which the bankruptcy case is pending.
- The First, Sixth, Eighth, Ninth, and Tenth Circuits have established BAPs.