Who would have thought it was possible? If a debtor does not like its tax obligations, it can ask the bankruptcy court to go back and retroactively change those tax bills. There is only one requirement for the debtor to take advantage of this extraordinary remedy provided under the Code: It must have done nothing to contest the tax bills. Section 505 is very powerful, and practitioners would be wise to include it in their arsenal when handling a bankruptcy case with significant tax claims.

Section 505(a)

Section 505(a)¹ provides a broad grant of jurisdiction to the bankruptcy court to determine the amount of any tax due from the debtor in the same forum addressing the debtor's overall financial condition, allowing the prompt resolution of a debtor's tax liability where that liability has not yet been adjudicated prior to the bankruptcy proceeding. Section 505(a) is available to all debtors under the Code,² including chapter 13.

In short, a debtor, as representative of the bankruptcy estate, is allowed to contest tax debts in the bankruptcy court even though its prior inaction would bar it from contesting them elsewhere. This remedy is permitted on the ground that taxes, with their special priority in a bankruptcy case, pose a special problem for creditors, and creditors should not be prejudiced by a debtor's inaction. In re Ledgemere Land Corp., 135 B.R. 193 (Bankr. D. Mass. 1991). See City Vending of Muskogee Inc. v. Oklahoma Tax Commission, 898 F.2d 122 (10th Cir. 1990).³

The broad jurisdictional grant under §505 does have some limitations, however. The bankruptcy court may not liquidate a tax liability that has already been adjudicated by a tribunal of competent jurisdiction before the bankruptcy petition is filed. 11 U.S.C. §505(a)(2)(A).⁴ If litigation relating to a tax obligation is pending in another tribunal when the bankruptcy petition is filed and no decision has yet been rendered, that proceeding would be stayed, and the bankruptcy court could technically hear the matter. (Generally, a more practical resolution is to modify the automatic say so that the prior case can be completed).

Further, §505 provides that a bankruptcy court may (not must) determine a debtor's tax liability. In some situations, bankruptcy courts have declined to adjudicate a debtor's tax liabilities in spite of their unquestioned jurisdiction to do so. The most frequently cited reasons for abstention are: (i) situations where uniformity of assessment is of significant importance, and (ii) circumstances where judicial economies come into play.

There are a number of factors that may be considered by a court when deciding whether to undertake a §505 review. These factors include the complexity of the tax issues to be decided, the need to administer the bankruptcy case in an orderly and efficient manner, the burden on the bankruptcy court's docket, the length of time required for trial and decision, the asset and liability structure of the debtor, and the prejudice to the debtor and potential prejudice to the taxing authority.⁵

Cases that have dealt with the assessment of real estate taxes have raised interesting issues resulting in decisions that reinforce the power of §505. In In re Ledgemere Land Corp., 135 B.R. 193 (Bankr. D. Mass. 1991), the court was confronted with the issues of whether, under §505, a bankruptcy court may adjudicate local real estate taxes assessed against a debtor where: (1) no abatement application has been filed with the town and the time for filing the application has lapsed; (2) an abatement application has been either granted or denied without a hearing, and the debtor has taken no appeal; or (3) refunds are sought for real estate taxes paid but no request for a refund has first been made to the town. Hon. James Queenan determined that since the taxes were never contested, and therefore not adjudicated, the bankruptcy court could determine the appropriateness of the tax assessments under §505. Judge Queenan noted that the reason for the broad treatment under §505 was to prevent creditors from being prejudiced by a debtor's failure, for whatever reason, to contest assessed taxes. 135 B.R. at 196.

In In re Fairchild Aircraft Corp., 124 B.R. 488, 492 (Bankr. W.D. Tex. 1991), the taxing authorities contended that the bankruptcy court could not adjust property values under §505(a) because the valuation process had been handled by an appraisal district that did not itself set, assess or levy property taxes. The court stated:

Simple logic demonstrates that property tax valuation is in fact a two-part process, consisting of both valuation and tax rate adjustment. That the state authorities have delegated these functions to two different agencies does not alter the fact that both functions make up the single task of determining the amount and legality of a given tax. In fact, only rarely do taxpayers individually contest the rates of taxation. More frequently, they attack the valuation of their property. The use of §505 to, in effect, remove only that valuation adjudication stage to the bankruptcy court is entirely consistent with the intended function of that section and does not undermine the state property taxation process.

Id. at 492.⁶

Procedure

A proceeding under §505 is considered a proceeding to obtain a declaratory judgment⁷ and is an adversary proceeding governed by the rules within Part VII of the Bankruptcy Rules. See 9 Am. Jur. 2d Bankruptcy §579 (1991); F.R.B.P. 7001(9). Generally, a debtor or trustee should file a complaint under §505. However, there is authority to suggest that other creditors in a bankruptcy proceeding can bring such an action. See, e.g., In re Major Dynamics, 14 B.R. 969 (Bankr. S.D. Cal. 1981) (creditors' committee filed adversary proceeding for determination of tax liability); see, also, Annotation, "Jurisdiction of Bankruptcy Court to Determine Tax Liability of Individuals or Entities Other than the Debtor Under 11 U.S.C. Section 505(a)," 97 A.L.R. FED. 160 (1990); In re Ledgemere Land Corp., 135 B.R. 193 (Bankr. D. Mass. 1991).

Conclusion

Although a bankruptcy court is not required to determine the amount of a debtor's tax liability, it has the power to do so under certain circumstances. Accordingly, if a debtor has significant federal, state or municipal tax obligations and has not fully objected to or adjudicated the propriety of those obligations, it would be wise to file a complaint under §505 in the debtor's bankruptcy case. The §505 complaint could result in a substantial reduction in the tax obligations, benefiting the debtor and its creditors.

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Footnotes

¹ Section 505. Determination of Tax Liability:

(a)(1) Except as provided in Paragraph (2) of this subsection, the court may 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.

(2) The court may not so determine—
(A) The amount or legality of tax, fine, penalty, or addition to tax if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the case under this title or
(B) Any right of the estate to a tax refund, before the earlier of—(i) 120 days after the trustee properly requests such refund from the governmental unit from which such refund is claimed; or (ii) a determination by such governmental unit of such request.

11 U.S.C. §505(a) (1988), as amended. Return to article

² See In re Poiroux, 167 B. R. 980 (Bankr. S.D. Ala. 1994) (chapter 13 debtors are not precluded from attempting to litigate their tax liability in bankruptcy court, despite their having executed an IRS form that waived their right to contest amount assessed until they had paid the amount the IRS claimed, where 11 U.S.C. §505(a) allows debtors to treat bankruptcy court as a pre-payment forum and to litigate taxes that have been assessed but remain unpaid without first paying the amount of tax due in full and seeking refund). Return to article

³ See, also, H.R. Rep. No. 595, 95th Cong. 1st Sess. 356 (1977). Return to article

⁴ See In re Teal, 16 F.3d 619 (5th Cir. 1994) (bankruptcy court lacked jurisdiction to entertain claims regarding chapter 7 debtors' 1979 tax year liabilities, where the debtor had full and fair opportunity to contest assessed penalties in tax court litigation). Return to article

⁵ See, e.g., In re Galvano, 116 B.R. 367, 372 (E.D.N.Y. 1990) (citations omitted) (court referred the matter disputing sales and use taxes for adjudication in tax court because the debtor was not inactive or disinterested and had few creditors other than federal and state taxing authorities. The court determined that the impetus for bankruptcy filing was the dissatisfaction with the decision of the tax bureau rather than the preservation of the estate). See, also, In re Fairchild Aircraft Corp., 124 B.R. 488 (Bankr. W.D. Tex. 1991); In re Diez, 45 B.R. 137 (Bankr. S.D. Fla. 1984); In re Hunt, 95 B.R. 442 (Bankr. N.D. Tex. 1989) (the possibility that related taxpayers would take different positions in the tax court from those asserted in the bankruptcy court caused the court to refer adjudication to the tax court); In re Huddleston, 107 B.R. 102 (Bankr. E.D. La. 1989) (court determined that referring adjudication of a bankrupt taxpayer to tax court, where case was already pending, was in the interest of judicial economy and did not prejudice the course of bankruptcy proceedings). Return to article

⁶ See, also, City of Amarillo v. Eakens, 399 F.2d 541, 544 (5th Cir. 1968), cert. denied, 393 U.S. 1051, 89 S.Ct. 688, 21 L.Ed.2d 692 (1969) (affirming bankruptcy referee's determination of tax liability via reconsideration of the valuation of the property taxed). Return to article

⁷ Proceedings under §505 of the Code, relating to tax determinations, and under 11 U.S.C. §1146, setting forth special state and local tax provisions for chapter 11 cases, are, along with actions brought under Internal Revenue Code §7428, excluded from the statutory provision that in a case of actual controversy within its jurisdiction, any court of the United States, upon the filing of an appropriate pleading, may declare the rights and other legal relations of any interested party seeing such declaration, whether or not further relief is or could be sought. 28 U.S.C.A. §2201(a). This exclusion was added to §2201(a) by the Bankruptcy Reform Act of 1978 (P.L. 95-598, Title II §249, 92 Stat. 2672). See, generally, 9 Am. Jur. 2d Bankruptcy §579 (1991). Return to article