State Taxes and Bankruptcy – Does the Court Have Jurisdiction?

by Fred Witt, Co-author, Sheinfeld, Witt & Hyman, Collier on Bankruptcy Taxation (LexisNexis).   

and David Elrod, Shareholder, Elrod, PLLC, Dallas, Texas

The views expressed are those of the authors alone.

Introduction

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.[1] 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.

Pre-Confirmation 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.[2] 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 bankruptcy court.[3] 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.[4] 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.[5] 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.[6]

Post-Confirmation Jurisdiction

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 Revenue[7] and In re Wilshire Courtyard[8] - 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.

In re Kmart Corp.

Kmart involved 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.[9]

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.[10]

In re Wilshire Courtyard

In re Wilshire 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[11] 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.[12]

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.[13] 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.[14]

Conclusion

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.


[1] 11 U.S.C. § 505. For a complete discussion, see Sheinfeld, Witt & Hyman, Collier on Bankruptcy Taxation (Matthew Bender 2012).

[2] 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.

[3] 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).

[4] 11 U.S.C. §§ 346, 1146(b).

[5] 11 U.S.C. § 346.

[6] 11 U.S.C. §1146(b).

[7] 2012 Bankr. LEXIS 2185 (Bankr. N.D. Ill. May 15, 2012) [an enhanced version of this opinion is available to lexis.com subscribers] .

[8] 459 B.R. 416, 2011 Bankr. LEXIS 3925 (B.A.P. 9th Cir. Sept. 19, 2011) [enhanced version].

[9] 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.

[10] Id.

[11] 28 U.S.C. § 1334(b).

[12] In re Wilshire Courtyard, 437 B.R. 380 (Bankr. C.D. Cal. 2010) [enhanced version].

[13] In re Wilshire Courtyard, 2011 Bankr. LEXIS 3925 (B.A.P. 9th Cir. Sept. 19, 2011).

[14] Id.

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