Witt, Co-author, Sheinfeld, Witt & Hyman, Collier on Bankruptcy Taxation
David Elrod, Shareholder, Elrod, PLLC, Dallas, Texas
views expressed are those of the authors alone.
In addition to possible disputes over federal taxes owed
to the IRS, debtors in a title 11 case must also consider disputes with state
and local jurisdictions over state and local taxes. The Bankruptcy Code vests
bankruptcy courts with broad jurisdiction to determine the amount or legality
of any tax.
However, two recent cases have declined jurisdiction in actions brought
post-confirmation involving disputes over the state tax effects of confirmed
plans of reorganization. Chapter 11 debtors now face additional complexity and
uncertainty because of these decisions.
Jurisdiction Over Taxes
For debtors in a title 11 case, the bankruptcy court has
broad jurisdiction to determine the tax liability of a debtor to any taxing
authority whether incurred before or after the filing of the petition.
Thus, any tax controversy - whether involving disputes over state and local
taxes alleged due for periods prior to the filing of the petition or over any
taxes incurred by the estate -- is subject to the jurisdiction of the
This would include disputes over the debtor's state and local tax liability for
the tax periods affected during the pendency of the case (such as the amount of
taxable income, the amount and carryover of tax attributes), as well as the
exclusion of income from the discharge of indebtedness, the tax treatment of
asset transfers and the tax treatment of transactions provided under a chapter
11 plan of reorganization.
To insure consistency among the fifty states and account
for the unique issues faced by debtors, Bankruptcy Code sections 346 and 1146
provide special federal rules for the treatment of state and local taxes.
Bankruptcy Code section 346 provides preemptive federal law governing, among
others, the tax treatment of the estate, taxation of partnerships, special
rules for tax attributes and exclusion of discharge income.
Bankruptcy Code section 1146 authorizes a proponent of the plan to request a
prompt determination, limited to questions of law, of the tax effects of the
plan under Bankruptcy Code section 346.
Since the reorganized debtor reports income, associated
tax attributes and the tax effects of plan transactions on tax returns filed post-confirmation,
any controversy with state and local taxing authorities over the debtor's
treatment of tax items occurs years later. This has resulted in some
interesting bankruptcy jurisdictional issues.
Two recent cases dealing with the state tax treatment of
cancelled debt realized under a confirmed plan - Kmart Corp. v. Ill. Dep't of
and In re Wilshire Courtyard
- held that the bankruptcy court did not retain jurisdiction to adjudicate
state tax issues. In the former, the bankruptcy court determined that
Bankruptcy Code section 1146(b) only applied to pre-confirmation requests and
there was no other source for post-confirmation jurisdiction. In the latter, a
Ninth Circuit Bankruptcy Appellate Panel held, without citing Bankruptcy Code
sections 346 or 1146, that it had no post-confirmation jurisdiction over a
state tax dispute involving the State of California. Chapter 11 debtors should
consider the potential impact the loss of post-confirmation jurisdiction may
have on the treatment of plan transactions for state and local tax purposes.
the question whether, for State of Illinois income tax purposes, canceled debt
realized under a 2003 confirmed plan must be applied to reduce tax attributes,
specifically its net operating losses ("NOLs"). The company argued that, under
Bankruptcy Code section 346, the amount of canceled debt should not be applied
to reduce its NOLs for Illinois income tax purposes, thus resulting in a lower
tax liability. The State disagreed and seven years later - in 2010 - Kmart
filed an adversary proceeding asking the Bankruptcy Court to provide
declaratory relief regarding the state tax effects of the confirmed plan. The
court raised jurisdictional concerns and asked the parties to brief the issue.
Finding an actual controversy regarding the effect of
Bankruptcy Code section 346 on the plan and on the income taxes owing by Kmart
to the State of Illinois, the court then turned to whether it had subject
matter jurisdiction. Essentially, the court concluded that the only
jurisdictional source was "arising under" jurisdiction provided by Bankruptcy
Code section 1146(b), but the proponent of the plan must make the request
before the plan is confirmed. Thus, "arising under" jurisdiction existed only
under Bankruptcy Code section 1146(b) - and then only if a proponent of the
plan makes a pre-confirmation request regarding the state tax effects of the
proposed plan. Since the request was made years later - after confirmation -
the court had no jurisdiction.
Courtyard involved a1998 commercial real estate partnership chapter 11
reorganization. The plan provided for the continuation of the debtor's
ownership of the property and a substantial reduction in outstanding
indebtedness. The debtor partnership excluded the debt cancellation income
("CODI") for federal and state tax purposes. Subsequently, the California
Franchise Tax Board ("FTB") determined the plan amounted to a sale producing
taxable gain. In 2009, the debtor moved to reopen the case on the basis the FTB
was collaterally attacking the confirmed chapter 11 plan. The bankruptcy court
concluded it had subject matter jurisdiction to
determine the applicability of Bankruptcy Code section 346 and the plan
effected a debt reduction generating excludable CODI and held for the debtor
finding no additional taxes were due by reason of the plan transactions.
On appeal, the Ninth Circuit Bankruptcy Appellate Panel
reversed, finding the bankruptcy court had no alternative "arising under title
11" or "related to" 28 U.S.C. section
1334(b) jurisdiction because there was no right to relief created under title
11 and no "close nexus" to the bankruptcy case. The
BAP acknowledged there would be "arising under" subject matter jurisdiction if
there was a provision of the Bankruptcy Code dealing with state income tax
consequences, but inexplicably did not reference Bankruptcy Code section 346.
In deciding whether jurisdiction existed to challenge state
tax disputes years after the plan of reorganization is confirmed, two courts
have concluded they lacked jurisdiction to hear the debtor's case. Chapter 11
debtors are now faced with additional complexities and obstacles concerning
state and local tax determinations arising post-confirmation. To avoid the
result reached in these two cases, chapter 11 debtors should consider the
additional complexity and uncertainty of jurisdiction over post-confirmation
state and local tax controversies when preparing their plans.
 11 U.S.C. § 505. For a complete
discussion, see Sheinfeld, Witt &
Hyman, Collier on Bankruptcy Taxation (Matthew Bender 2012).
 11 U.S.C. § 505(a)(1). Generally,
state and local taxes assessed and due prepetition are claims against the
estate subject to the rules of priority under 11 U.S.C. § 507 and
dischargeability under 11 U.S.C. § 523.
 There are limitations on (a) the
ability to re-litigate cases contested and adjudicated, (b) obtain refunds
and (c) with respect to ad valorem taxes
on real or personal property. 11 U.S.C. § 505(a)(2).
 11 U.S.C. §§ 346, 1146(b).
 11 U.S.C. § 346.
 11 U.S.C. §1146(b).
 2012 Bankr. LEXIS 2185 (Bankr. N.D.
Ill. May 15, 2012) [an enhanced version of this opinion is available to lexis.com
 459 B.R. 416, 2011 Bankr. LEXIS 3925
(B.A.P. 9th Cir. Sept. 19, 2011) [enhanced version].
 Kmart Corp. v. Ill. Dep't of Revenue,
2012 Bankr. LEXIS 2185. Interestingly, both the debtor and the State of
Illinois argued that the bankruptcy court had jurisdiction.
 28 U.S.C. § 1334(b).
re Wilshire Courtyard, 437 B.R. 380 (Bankr. C.D. Cal. 2010) [enhanced version].
re Wilshire Courtyard, 2011 Bankr. LEXIS 3925 (B.A.P. 9th Cir.
Sept. 19, 2011).
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