Absent definitive decisions in the applicable Circuit, bankruptcy chapter 12 debtors should consider pursuing a strategy of partial liquidation, paying available proceeds to secured lenders, and then utilizing the bankruptcy to deal with the taxes that typically accompany liquidation. But they should continue to conduct their business to avoid jeopardizing their qualification for favorable tax treatment.
The income tax treatment of gains triggered in Chapter 12 bankruptcy has been a serious problem (and shortcoming) since enactment of the provision in 1986. The Bankruptcy Tax Act of 1980 did not extend the same treatment to Chapter 12 filers that had been available to filers under Chapter 7 and Chapter 11. The [Bankruptcy Abuse Prevention and Consumer Protection Act] of 2005 [Pub. L. No. 109-8, § 1003, 119 Stat. 23 (2005), (BAPCPA)]included a provision to address the problem but several ambiguities resulted from the way the provision was redrafted. Accordingly, litigation has occurred. After Bankruptcy Court decisions in five states and several District Court decisions, the Eighth Circuit Court came down on all issues in favor of the debtors in September of 2009. The Ninth and Tenth Circuits have cases pending.
[BAPCPA] included a provision allowing a Chapter 12 debtor to treat claims arising out of "claims owed to a governmental unit" such as tax on the gain or recapture income, as a result of "sale, transfer, exchange, or other disposition of any farm asset used in the debtor's farming operation" to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge. [11 U.S.C. § 1222(a)(2), added by the BAPCPA.] By treating government claims (including taxes) as unsecured claims, the amounts would be in line for discharge.The 2005 Act produced several ambiguities or unclear meanings...
... [O]n September 16, 2009, the Eighth Circuit Court of Appeal affirmed the... In re Knudsen... and In re Schilke [district court decisions]. [Knudsen v. Internal Revenue Service, 581 F.3d 696 (8th Cir. 2009).] The decision favored the debtors on four important issues :1. Congress waived sovereign immunity in the enactment of 11 U.S.C. Sec. 1222(a)(2)(A);2. a Chapter 12 debtor may treat post-petition taxes imposed on the debtor's income earned during the Chapter 12 proceeding as an administrative expense;3. pre-petition and post-petition sales of slaughter hogs (and other ordinary income property) are eligible for discharge under the special treatment provided by the 2005 Act; [11 U.S.C. § 1222(a)(2)(A)] and4. the "marginal" method of allocation is the correct way to allocate the taxes between the priority and non-priority claims under Chapter 12.
... [A]s to the "marginal" or "pro rata" approaches, the Eighth Circuit found the language in the statute to be ambiguous and invoked a long-standing rule of construction that ambiguous provisions should be construed in favor of the debtor. That meant the marginal approach could be used by the taxpayer as opposed to the pro rata approach favored by the IRS...On May 7, 2010, the Bankruptcy Appellate Panel for the Tenth Circuit Court of Appeal affirmed the District Court of Colorado in...In re Ficken, 2010 Bankr. LEXIS 1325.
...[I]t seems prudent to continue to conduct a farming or ranching operation when Chapter 12 is filed. Failure to do so could jeopardize qualification for the favorable tax treatment afforded by the 2005 Act [11 U.S.C. § 1222(a)(2)(A)] and could possibly subject the farmer or rancher to liability for all of the taxes.
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RELATED LINKS: For further information, see:
15-TX1 Collier on Bankruptcy Taxation P TX1.08
5-39 Agricultural Law 39.04
13-120 Agricultural Law 120.08