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What Does Avoidance of Taxes Mean in 1129(d)

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Section 1129(d) of the Bankruptcy Code is one component of the confirmation inquiry that is rarely cited, less understood and not the subject of much court interpretation. It may factor into the confirmation equation both at the time of confirmation and prospectively as taxable events inure to the reorganized debtor. A recent opinion by the bankruptcy court for the District of Connecticut2 underscores its value to governmental creditors and the pitfalls to plan proponents,3 should it not be considered in the chapter 11 confirmation process.

Section 1129(d) provides, in relevant part, that "on request of a party in interest that is a governmental unit, the court may not confirm a plan if the principal purpose of the plan is the avoidance of taxes...." "The government unit has the burden of proof on the issue of avoidance." Courts have been uniform in finding that for §1129(d) to apply, it must be raised by a governmental unit and not the debtor. In re McLean Indus. Inc., 132 B.R. 267, 270 (Bankr. S.D.N.Y. 1991). Further, some courts believe that the court may, under its equitable powers in §105(a), raise the issue as part of the court's §1129 analysis in confirming a plan. See In re Hartman Material Handling Systems Inc., 141 B.R. 802, 808-09 (Bankr. S.D.N.Y. 1992); In re Rath Packing Co., 55 B.R. 528 (Bankr. N.D. Iowa 1985). Also, the burden of proof is clearly on the government. Bankruptcy courts have finally recognized that for §1129(d) to apply, the principal purpose of the plan must be the avoidance of taxes.4

In answering what the "avoidance of taxes" means, or at least what its intent is, the legislative history of §1129(d) is instructive. Section 1129(d)'s predecessor, §269 of the Bankruptcy Act, provided that "where it appears that a plan has for one of its principal purposes the avoidance of taxes, objection to its confirmation may be made...by the Secretary of the Treasury, or,...State..." Section 1129(d) was enacted to codify the Supreme Court's ruling in Gregory v. Helvering, 293 U.S. 465 (1935),5 which in turn had been codified in the Internal Revenue Code.6


Section 1129(d) can apply where the debtor manifests an intent to avoid the payment and treatment of pre-petition taxes and control the disposition of tax consequences not yet realized at the time of confirmation.

As enacted, §1129(d) tracked the language of its predecessor (§269 of the Act) but provided that the court had to make a finding that the principal purpose of the plan was the avoidance of taxes before a plan could be denied confirmation under §1129(d). Little was written on §1129(d) until 1992, when the Internal Revenue Service (IRS) issued new regulations that provided that the IRS could review the tax consequences of a confirmed plan, such as the allowance of a net operating loss (NOL), even after a bankruptcy court had approved the plan. Therefore, even though the court could have made a finding under §1129(d) that the principal purpose of the plan was not the avoidance of taxes, the IRS, through its regulations, believed that it had the final discretion to determine the tax consequences of a confirmed plan even after the court had previously approved the plan. Treas. Reg. 1.269-3(e) (1992).

The reaction from at least one court (which is probably representative of many courts) was swift and clear: the authority to adjudge the tax avoidance of any chapter 11 plan was within the sole provenance of the bankruptcy court, and the IRS' regulations, while helpful in explaining the IRS' rationale and position on tax matters, were not binding on the court. Hartman Material, 141 B.R. at 808-09.7 As such, the court reviewed the prospective effect a finding that a plan was not confirmed with the principal purpose of tax avoidance (under the paradigm of collateral estoppel and res judicata) would have on the IRS' ability to review and determine tax events post-petition. The court examined the "factual frames of reference" in determining whether the NOLs that were being claimed at confirmation could be subject to IRS review post-petition. The court concluded that the IRS could not be estopped from making a §269 determination regarding the debtor's future use of NOLs for transactions not specifically contemplated at the time of confirmation. Hartman Material, 141 B.R. at 812. As such, a NOL not used as a deduction at the time of confirmation is subject to IRS review at the time it is claimed on a tax return. Id.

The Hartman Material court's holding comports with the intent of §1129(d), which is to review the use of tax credits as they relate to plan confirmation, and determine whether their misuse is the sole purpose of reorganization. Further, it seems that the bankruptcy courts have concluded that, absent a government request, a court should determine the tax consequences of a proposed plan if the plan contemplates the use of tax benefits as a condition of confirmation.8 However, the curious application of §1129(d) is in how courts have utilized it to determine if the tax avoidance through the reorganization process, absent tax consequences, is a basis for the denial of confirmation.

Both the courts in Hartman Material and Rath Packing Co. recognized that in order to reach a determination of whether the plan was proposed in good faith, they needed the implicit finding that the plan had not been proposed with the sole purpose of tax avoidance. Hartman Materials, 141 B.R. at 809. Further, the court in In re Cohen, 173 B.R. 950, 957-58 (Bankr. S.D. Fla. 1994), found that where the debtor did not provide for the retention of the IRS' lien and to use her post-petition earnings to pay the IRS' claim, that the debtor's sole purpose in proposing her plan was for tax avoidance under §1129(d). As a result, the case was dismissed on the motion of the IRS for the debtor's failure to account for the IRS' lien and to provide for payment of the IRS' claim through her plan (the debtor had also converted non-exempt assets into exempt assets and made fraudulent transfers to family members). The opinion was vacated on appeal. The district court noted that the IRS had not raised §1129(d) as a basis of dismissal. The district court held that §1129(d) could only be used as a basis for denial of confirmation, and not an independent ground for dismissal other than in support for dismissal under §1112(b)(2). Cohen v. United States (In re Cohen), 191 B.R. 482, 487 (S.D. Fla. 1995).9

The bankruptcy court in In re Scott Communications related the plan confirmation process to tax avoidance both as a matter of good faith and as a review of post-confirmation tax events. The debtor filed a pre-packaged liquidating chapter 11 plan that provided that the capital gains attributable to the sale of the debtor's assets were not to be provided for in the plan of reorganization because they would arise post-confirmation. Further, the plan provided an injunction against collection from the third parties, and precluded the taxing authorities from pursuing tax claims incident to the sale. Scott Communications, 227 B.R. at 599.

The debtor argued that because the purchase price for the debtor's assets was less than the amount of its secured debt, the requirement to pay the capital gains on the sale was unnecessary. The debtor also maintained that because the capital gains on the sale would not occur until after confirmation of the plan, the debtor did not have to provide for the tax as an administrative expense because it fell outside the administrative claim period. The court found the debtor's arguments baseless, noting that the elevated priority of paying administrative claims, including tax claims, could not be circumvented by a sale that would pay less than all secured claims. Id. at 600. Further, the fact that the capital gains would not occur until after the plan was confirmed does not excuse the debtor from providing for it in the plan. The court reasoned that the administrative period for the payment of administrative claims extends beyond the date of confirmation. Id.; citing Holywell Corp. v. Smith, 503 U.S. 47 (1992).

The debtor also sought protection for third parties from tax collection for the capital gains. Apparently, no basis was offered for the purpose of the injunction other than that the court could issue an injunction pursuant to §105(a). The court declined to issue an injunction, finding that the debtor had not shown that the injunction was necessary for the implementation or viability of the plan or that the collection action against the third parties would have a detrimental effect on the plan. The court also held that the debtor's attempt to violate the Anti-Injunction Act10 through the use of §105(a) does not override the specific intent of the Anti-Injunction Act, which is the preservation of the government's ability to assess and collect taxes. Id. at 602.

The Scott Communications court concluded that an analysis as to whether the principal purpose of a plan is the avoidance of taxes includes the context of surrounding circumstances. The court stated that if the sale were outside the scope of bankruptcy that the capital gains would have to be paid. The court also found that if the sale occurred prior to confirmation that the capital gains would have to be paid as an administrative claim. Further, the third parties that would be protected under the proposed plan would not be protected outside the bankruptcy. As such, the court held that the avoidance of the payment of the capital gains and the protection of third parties from tax collection was the principal purpose of the plan. Consequently, the plan failed under §1129(d).

Scott Communications illustrates that the §1129(d) inquiry is not limited simply to the considerations of tax consequences. Section 1129(d) can apply where the debtor manifests an intent to avoid the payment and treatment of pre-petition taxes and control the disposition of tax consequences not yet realized at the time of confirmation. As such, plan proponents should be mindful of addressing tax consequences in their plans to ensure that the bankruptcy court will conduct a §1129(d) inquiry and make the appropriate finding. Also, taxing authorities should use §1129(d) not only as a basis for objecting to a plan as to the issue of tax consequences of a plan, but also where the thrust of any plan is to avoid the required payment and treatment of taxes.


Footnotes

1 The views expressed in this article are Mr. Gargotta's and do not necessarily reflect the views of the Department of Justice or the Internal Revenue Service (IRS). Return to article

2 In re Scott Cable Communications Inc., 227 B.R. 596 (Bankr. D. Conn. 1998). Return to article

3 The term "plan proponent" is used because, in at least one reported decision, the bankruptcy court found that a plan offered by a competing creditor must consider the tax consequences. Smith v. Bank of New York, 161 B.R. 302, 307 (Bankr. S.D. Fla. 1993). Return to article

4 The Rath court found that the inclusion of the word "the" before "principal purpose" denoted "the most important." Rath, 55 B.R. at 536. Return to article

5 A taxpayer has the right to decrease or altogether avoid taxes owed by means permitted by law. Return to article

6 26 U.S.C. §269 (1954). Return to article

7 The debtor's plan involved a change in ownership by giving the debtor's unsecured creditors stock in exchange for their debt. As a result of the stock offering, unsecured creditors would receive more than 50 percent of the debtor's reorganized stock. Further, most of the debtor's assets would be sold, including NOLs that exceeded $298 million. Section 269 of the I.R.C. prohibits the use of NOLs where there is a change in ownership of a company and the principal purpose of the acquisition is the purchase of a tax deduction. The thrust of §269 is to prevent the trafficking of tax deductions to third parties who would otherwise not enjoy the benefit of the deduction except for the acquisition of the business entity that is entitled to the deduction. Hartman Materials, 141 B.R. at 806. Return to article

8 Cf. In re Eagle-Picher Indus. Inc., 203 B.R. 256, 277 (Bankr. S.D. Ohio 1996) (the court noted that no §1129(d) objection was raised, but nonetheless concluded §1129(d) was not violated); In re Trans World Airlines Inc., 185 B.R. 302, 318 (Bankr. E.D. Mo. 1995) (because no request had been made under §1129, it was not applicable); In re Drexel Burnham Lambert Group Inc., 138 B.R. 723, 772 (Bankr. S.D.N.Y. 1992) (no pleading was filed as to §1129(d), but the court held that the principal purpose of the plan was not the avoidance of taxes). Return to article

9 In fact, on remand, the IRS' claim was disallowed for certain periods. Cohen v. United States (In re Cohen), 198 B.R. 382 (Bankr. S.D. Fla. 1996). Return to article

10 26 U.S.C. §7421 provides, in relevant part, that no suit may be maintained if its purpose is the restraint of the assessment or collection of taxes against any person. Return to article

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Monday, March 1, 1999

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