A Liquidating Trustee's Principal Tools for Resolving Tax Issues in Bankruptcies

As part of making distributions to allowed claimants of a bankrupt entity, a liquidating trustee must decide the best way to handle potential outstanding tax liabilities. Generally, this decision requires the trustee to decide between two available options; namely:

1. Make one or more “final” distributions to allowed claimants to wind-down the estate and leave the estate (and the trustee) open to tax liability should the Internal Revenue Service (“IRS”) successfully challenge any of the tax positions taken by the estate and/or the trustee during the time period of the applicable statute of limitations, which could be three years, six years or, in the case of fraud, never (the “Statute of Limitations”); or
2. Explain to allowed claimholders that distributions will be net of all potential tax liabilities for the duration of the Statute of Limitations.

No prudent trustee would assume any risk relating to alternative (a) above, as once the estate's assets are irretrievably disbursed, the IRS could hold the trustee personally liable. Fortunately, the Bankruptcy Code, in the form of ' 505, equips trustees with effective tools to resolve tax issues and avoid this dilemma.

It is also important to note that ' 505 is available to reorganized debtors, however the stakes are not as high for reorganized debtors as there is generally no trustee left “holding the bag,” but rather the ongoing business would satisfy any final determination of tax owed and concomitantly the returns to the allowed claimholders would rise and fall with the value of the reorganized equity interest. The exception may be the reorganized debtor that liquidates within a few years after the effective date of the bankruptcy. In this generally rare exception, the application of the rules herein apply with similar importance.

Section 505

1. Section 505 provides two methods for resolving tax issues and determining tax liabilities: Section 505(a) provides a grant of jurisdiction to bankruptcy courts to determine tax matters, and
2. Section 505(b) provides a mechanism that allows a trustee to request an expedited determination of any unpaid liability of the estate from the IRS. In the case of a state tax, this section also allows the trustee to request a determination of any unpaid liability of the estate from the appropriate state tax authority.

These two provisions are the primary tools at the disposal of a trustee seeking to resolve any outstanding tax matter. Although the two subsections serve a similar purpose, namely the resolution of potential tax liabilities, there are significant differences in their procedure and scope.

Procedure: The Efficiencies Of ' 505(b)

Section 505(b)(2) creates an efficient method of dealing with the question of potential tax liabilities. It allows for a prompt determination of tax liability, initiated simply by filing the return, paying the tax reflected on the return, and including a request for prompt determination. This relatively simple course of action produces a significant result.

The IRS must decide within 60 days whether it will examine the return. If the IRS chooses to examine the return, it has 180 days from the date of receipt to complete the audit. If the IRS chooses not to examine the return or fails to complete the audit in the 180-day window, the estate, trustee, debtor, and any successor to the debtor are discharged from any liability for such tax.

The usefulness of this section is immediately clear: A trustee can obtain a conclusive statement of tax liability in as little as 60 days and at most 180 days as opposed to enduring the Statue of Limitations. And if the IRS does audit the returns and asserts additional liability, the trustee has the ability to challenge the IRS's position in bankruptcy court.

On the other hand, Section 505(a)(1) requires the trustee to file a standard form motion before the bankruptcy court. This motion requires the trustee to pursue an adversary proceeding in the bankruptcy court to determine the tax liability, complete with motions, discovery, depositions, interrogatories, and requests for the production of documents.

The Limited Scope of ' 505(b)

It may be unclear, given the relative ease of ' 505(b), why a trustee would ever choose an adversarial proceeding under ' 505(a). Section 505(a) is indispensable because it grants bankruptcy courts with nearly unlimited jurisdiction to resolve tax matters, whereas a trustee may only employ the prompt audit procedure of ' 505(b) in a narrow set of circumstances. The plain language of ' 505(a)(1) allows the court to “determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.”

Section 505(a)(2) provides three exceptions to the broad grant of jurisdiction: (A) taxes already contested and adjudicated by a judicial or administrative tribunal; (B) tax refunds before the earlier of 120 days after a request for such refund or a determination of such request by the appropriate governmental unit; and (C) the amount or legality of any amount arising in connection with an ad valorem tax on real property of the estate, if the applicable period for contesting or redetermining that amount under any law has expired.

Thus, ' 505(a) encompasses all tax-related matters without regard to whether they occur pre-petition, during the administration of the case, or even post-confirmation. While a bankruptcy court's post-confirmation jurisdiction under ' 505(a) is problematic and unclear as to scope, suffice it to say that bankruptcy courts likely have the power to decide the income tax consequences of a confirmed plan of reorganization.

Furthermore, ' 505(a) provides for significantly greater flexibility than ' 505(b) in terms of resolving legal conclusions. For example, ' 505(a) appears to allow taxpayers to definitively determine legal theories supporting tax positions, such as the existence and availability of tax attributes (e.g., net operating losses) or the application of the tax rules requiring the reduction of such attributes, areas of tax law that often affect taxpayers emerging from bankruptcy. In contrast,
' 505(b) is technically limited to resolving the amount of tax owed during a given tax period or periods.

The practical implication of this difference is illustrated when a determination of the amount of a tax refund is sought. Section 505(a)(2) governs the authority of bankruptcy courts to determine any right of the estate to a tax refund and so determination of a tax refund is explicitly within the scope granted by ' 505(a). On the contrary, ' 505(b) has been held inapplicable to tax refunds by some courts that strictly interpret the section's language.

Section 505(b) provides that its scope is limited to the determination “of any unpaid liability of the estate for any tax incurred during the administration of the case.” This language suggests that unlike ' 505(a), ' 505(b) may not be utilized to determine pre-petition or post confirmation tax liabilities. Accordingly, ' 505(b)'s usefulness is likely limited to liabilities incurred in the window of time from the filing of the petition for bankruptcy to the confirmation of the plan (the “Administration Period”), thus creating an important need for ' 505(a) relief to resolve other potential liabilities.

Practical Application

Here is a simplified road map on how a trustee should use ' 505(a) and ' 505(b) to resolve a tax matter during different stages of a bankruptcy case. First, pre-Administration Period tax issues should be resolved under ' 505(a), since the scope of ' 505(b) is limited to tax liabilities arising during the Administration Period. Second, tax issues arising during the Administration Period require a more a nuanced approach.

If a trustee seeks determination of an unpaid liability, then the most efficient solution is to employ ' 505(b)'s expedited audit procedure. If, on the other hand, the tax issue relating to the Administration Period does not pertain to an unpaid liability of the estate (e.g., relates to a tax refund), then the trustee's remedy is likely going to be ' 505(a).

However, because seeking relief under ' 505(b) does not foreclose the trustee's ability to subsequently utilize ' 505(a), the trustee should strongly consider first attempting to utilize the simple and cost-efficient procedures of ' 505(b). This is because the IRS or applicable state authority may acquiesce on the issue and even if such taxing authority does successfully reject the use of ' 505(b), the trustee will not be prevented from subsequently exercising the bankruptcy court's ' 505(a) jurisdiction to litigate the same issues.

Finally, if a tax question arises with respect to a post Administration Period, it is beyond the scope of ' 505(b) and moreover it is even likely beyond the reach of the bankruptcy court. However, if the matter relates to deciding the income tax consequences of a confirmed plan or to the funding of a bankruptcy plan, the trustee may have a compelling argument that ' 505(a) should apply.

For example, the bankruptcy plan may call for a reorganization or sale of assets and the trustee may want to establish with certainty the tax consequences of such transaction in order to make distributions to allowed claimants.

Categorizing tax matters based on whether they arise before, during or after the Administration Period is an oversimplification and many times it is not clear to which time period a tax matter pertains. A trustee should make use of the ' 505(b) procedure whenever doing so is arguably appropriate, as ' 505(a) will still be available if the IRS or applicable state taxing authority successfully contends that the use of ' 505(b) is inappropriate.

Conclusion

Between ' 505(a)'s near unlimited scope and ' 505(b)'s efficient procedure, ' 505 provides a trustee with the necessary tools for resolving most any tax matter and, as such, trustees should give strong consideration to these provisions to definitively determine tax liabilities as part of an estate's plan of reorganization or liquidation.

Patrick M. Cox is a partner in the Corporate & Securities Department of Brown Rudnick LLP in New York. He focuses his practice on taxation law and has extensive experience in general tax planning including issues of partnership, real estate, international and corporate taxation. He can be reached at 212-209-4949 or [email protected]. Robert J. Stark is also a partner in Brown Rudnick's New York office and focuses his practice on complex corporate restructuring, including in-court Chapter 11 cases and out-of-court workouts. He can be reached at 212-209-4862 or [email protected].

As part of making distributions to allowed claimants of a bankrupt entity, a liquidating trustee must decide the best way to handle potential outstanding tax liabilities. Generally, this decision requires the trustee to decide between two available options; namely:

1. Make one or more “final” distributions to allowed claimants to wind-down the estate and leave the estate (and the trustee) open to tax liability should the Internal Revenue Service (“IRS”) successfully challenge any of the tax positions taken by the estate and/or the trustee during the time period of the applicable statute of limitations, which could be three years, six years or, in the case of fraud, never (the “Statute of Limitations”); or
2. Explain to allowed claimholders that distributions will be net of all potential tax liabilities for the duration of the Statute of Limitations.

No prudent trustee would assume any risk relating to alternative (a) above, as once the estate's assets are irretrievably disbursed, the IRS could hold the trustee personally liable. Fortunately, the Bankruptcy Code, in the form of ' 505, equips trustees with effective tools to resolve tax issues and avoid this dilemma.

It is also important to note that ' 505 is available to reorganized debtors, however the stakes are not as high for reorganized debtors as there is generally no trustee left “holding the bag,” but rather the ongoing business would satisfy any final determination of tax owed and concomitantly the returns to the allowed claimholders would rise and fall with the value of the reorganized equity interest. The exception may be the reorganized debtor that liquidates within a few years after the effective date of the bankruptcy. In this generally rare exception, the application of the rules herein apply with similar importance.

Section 505

1. Section 505 provides two methods for resolving tax issues and determining tax liabilities: Section 505(a) provides a grant of jurisdiction to bankruptcy courts to determine tax matters, and
2. Section 505(b) provides a mechanism that allows a trustee to request an expedited determination of any unpaid liability of the estate from the IRS. In the case of a state tax, this section also allows the trustee to request a determination of any unpaid liability of the estate from the appropriate state tax authority.

These two provisions are the primary tools at the disposal of a trustee seeking to resolve any outstanding tax matter. Although the two subsections serve a similar purpose, namely the resolution of potential tax liabilities, there are significant differences in their procedure and scope.

Procedure: The Efficiencies Of ' 505(b)

Section 505(b)(2) creates an efficient method of dealing with the question of potential tax liabilities. It allows for a prompt determination of tax liability, initiated simply by filing the return, paying the tax reflected on the return, and including a request for prompt determination. This relatively simple course of action produces a significant result.

The IRS must decide within 60 days whether it will examine the return. If the IRS chooses to examine the return, it has 180 days from the date of receipt to complete the audit. If the IRS chooses not to examine the return or fails to complete the audit in the 180-day window, the estate, trustee, debtor, and any successor to the debtor are discharged from any liability for such tax.

The usefulness of this section is immediately clear: A trustee can obtain a conclusive statement of tax liability in as little as 60 days and at most 180 days as opposed to enduring the Statue of Limitations. And if the IRS does audit the returns and asserts additional liability, the trustee has the ability to challenge the IRS's position in bankruptcy court.

On the other hand, Section 505(a)(1) requires the trustee to file a standard form motion before the bankruptcy court. This motion requires the trustee to pursue an adversary proceeding in the bankruptcy court to determine the tax liability, complete with motions, discovery, depositions, interrogatories, and requests for the production of documents.

The Limited Scope of ' 505(b)

It may be unclear, given the relative ease of ' 505(b), why a trustee would ever choose an adversarial proceeding under ' 505(a). Section 505(a) is indispensable because it grants bankruptcy courts with nearly unlimited jurisdiction to resolve tax matters, whereas a trustee may only employ the prompt audit procedure of ' 505(b) in a narrow set of circumstances. The plain language of ' 505(a)(1) allows the court to “determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.”

Section 505(a)(2) provides three exceptions to the broad grant of jurisdiction: (A) taxes already contested and adjudicated by a judicial or administrative tribunal; (B) tax refunds before the earlier of 120 days after a request for such refund or a determination of such request by the appropriate governmental unit; and (C) the amount or legality of any amount arising in connection with an ad valorem tax on real property of the estate, if the applicable period for contesting or redetermining that amount under any law has expired.

Thus, ' 505(a) encompasses all tax-related matters without regard to whether they occur pre-petition, during the administration of the case, or even post-confirmation. While a bankruptcy court's post-confirmation jurisdiction under ' 505(a) is problematic and unclear as to scope, suffice it to say that bankruptcy courts likely have the power to decide the income tax consequences of a confirmed plan of reorganization.

Furthermore, ' 505(a) provides for significantly greater flexibility than ' 505(b) in terms of resolving legal conclusions. For example, ' 505(a) appears to allow taxpayers to definitively determine legal theories supporting tax positions, such as the existence and availability of tax attributes (e.g., net operating losses) or the application of the tax rules requiring the reduction of such attributes, areas of tax law that often affect taxpayers emerging from bankruptcy. In contrast,
' 505(b) is technically limited to resolving the amount of tax owed during a given tax period or periods.

The practical implication of this difference is illustrated when a determination of the amount of a tax refund is sought. Section 505(a)(2) governs the authority of bankruptcy courts to determine any right of the estate to a tax refund and so determination of a tax refund is explicitly within the scope granted by ' 505(a). On the contrary, ' 505(b) has been held inapplicable to tax refunds by some courts that strictly interpret the section's language.

Section 505(b) provides that its scope is limited to the determination “of any unpaid liability of the estate for any tax incurred during the administration of the case.” This language suggests that unlike ' 505(a), ' 505(b) may not be utilized to determine pre-petition or post confirmation tax liabilities. Accordingly, ' 505(b)'s usefulness is likely limited to liabilities incurred in the window of time from the filing of the petition for bankruptcy to the confirmation of the plan (the “Administration Period”), thus creating an important need for ' 505(a) relief to resolve other potential liabilities.

Practical Application

Here is a simplified road map on how a trustee should use ' 505(a) and ' 505(b) to resolve a tax matter during different stages of a bankruptcy case. First, pre-Administration Period tax issues should be resolved under ' 505(a), since the scope of ' 505(b) is limited to tax liabilities arising during the Administration Period. Second, tax issues arising during the Administration Period require a more a nuanced approach.

If a trustee seeks determination of an unpaid liability, then the most efficient solution is to employ ' 505(b)'s expedited audit procedure. If, on the other hand, the tax issue relating to the Administration Period does not pertain to an unpaid liability of the estate (e.g., relates to a tax refund), then the trustee's remedy is likely going to be ' 505(a).

However, because seeking relief under ' 505(b) does not foreclose the trustee's ability to subsequently utilize ' 505(a), the trustee should strongly consider first attempting to utilize the simple and cost-efficient procedures of ' 505(b). This is because the IRS or applicable state authority may acquiesce on the issue and even if such taxing authority does successfully reject the use of ' 505(b), the trustee will not be prevented from subsequently exercising the bankruptcy court's ' 505(a) jurisdiction to litigate the same issues.

Finally, if a tax question arises with respect to a post Administration Period, it is beyond the scope of ' 505(b) and moreover it is even likely beyond the reach of the bankruptcy court. However, if the matter relates to deciding the income tax consequences of a confirmed plan or to the funding of a bankruptcy plan, the trustee may have a compelling argument that ' 505(a) should apply.

For example, the bankruptcy plan may call for a reorganization or sale of assets and the trustee may want to establish with certainty the tax consequences of such transaction in order to make distributions to allowed claimants.

Categorizing tax matters based on whether they arise before, during or after the Administration Period is an oversimplification and many times it is not clear to which time period a tax matter pertains. A trustee should make use of the ' 505(b) procedure whenever doing so is arguably appropriate, as ' 505(a) will still be available if the IRS or applicable state taxing authority successfully contends that the use of ' 505(b) is inappropriate.

Conclusion

Between ' 505(a)'s near unlimited scope and ' 505(b)'s efficient procedure, ' 505 provides a trustee with the necessary tools for resolving most any tax matter and, as such, trustees should give strong consideration to these provisions to definitively determine tax liabilities as part of an estate's plan of reorganization or liquidation.

Patrick M. Cox is a partner in the Corporate & Securities Department of Brown Rudnick LLP in New York. He focuses his practice on taxation law and has extensive experience in general tax planning including issues of partnership, real estate, international and corporate taxation. He can be reached at 212-209-4949 or [email protected]. Robert J. Stark is also a partner in Brown Rudnick's New York office and focuses his practice on complex corporate restructuring, including in-court Chapter 11 cases and out-of-court workouts. He can be reached at 212-209-4862 or [email protected].