The Incredible Expanding 1146(c)
Section 1146(c), in its own way, is a modest example of the "unfunded mandates" that were a topic of such concern in the 1980s. It states that the "making or delivery of an instrument of transfer under a plan confirmed under §1129" may not be taxed under any law imposing a "stamp tax or similar tax." The section is not, of course, confined on its face to state and local taxes, but since the federal government does not impose such taxes, it only affects non-federal entities. Thus, in its wisdom, the federal government chooses to give debtors with a confirmed plan a small benefit from the coffers of state and local governments.
While perhaps mildly annoying, the section has not been thought to be a major problem. The amount at stake in a given case is usually relatively small, both because stamp taxes are generally only in the range of 1 percent of the transaction amount and because the language appears to deal with only that limited number of transfers that are actually made at the time of plan confirmation. Since the vast majority of cases do not confirm a plan, most bankruptcy transfers would not be affected. That assumption, though, has been challenged in a number of recent cases that seek to take a far greater bite from state taxpayers by expanding the exception, both as to the character of the taxes and the number of transactions covered.
This would be objectionable enough if the issues were clearly presented, but that doesn't always happen. Such motions are often made without a listing of the property being transferred, so tax authorities do not know if they are affected. Even more problematic is a growing practice by which the motion refers to §1146, but the debtor's proposed order includes a broader exemption. For instance, in Kmart's sale motion concerning its "e-commerce assets," the motion referred to "stamp taxes and similar taxes," but the proposed order also referenced "sales and transfer taxes." Section 1146, of course, does not even refer to "transfer" taxes, much less "sales" taxes, so a party that merely read the motion would have no notice that an order might be entered that would bar collection of such taxes. Similarly, in GST Telecom, the motion sought to avoid taxes "under any law imposing a stamp or similar tax," but the proposed order stated that the transfer "shall not be taxed under any...law imposing or claiming to impose a stamp tax or a sale, transfer or other similar tax on any of the debtor's transfers or sales...." (emphasis added.) The number of cases in which these stealth orders have been appearing argues against this being merely an inadvertent drafting issue.
Those vastly expanded exemptions, which include sales, capital gains or use taxes, could exempt not only 1 percent of the sales prices, but 5, 10, 20 percent or more, which are amounts states cannot afford to forego in these difficult budget times. After these orders began to appear, a number of states became increasingly vigilant in challenging them. Just as they have put debtors on notice that they will contest orders broadly exempting going-out-of-business sales from state law regulation, so too they have been working together to make a concerted effort to catch these §1146 stealth orders. In addition, they are also filing substantive oppositions to the more straightforward attempts to expand §1146.
On the merits, the states believe there is a strong case to be made against both ways of expanding §1146. The easier attack is on the attempts to expand the scope of the tax that is covered, and courts have generally agreed with the states when they have raised timely objections. In In re 995 Fifth Avenue Associates L.P., 963 F.2d 503, 511 (2nd Cir. 1992), for instance, the court held that a sale was not exempt from a 10 percent tax imposed under New York state law on gains derived from real property transfer. An essential element of §1146(c) taxes, the court held, is that they used a low tax rate—typically one percent or less. Two recent cases from Delaware took the same position. In In re GST Telecom Inc., 2002 WL 442233, slip op. p. 3 (D. Del. 2002), the court held that Washington's 6.5 percent sales, or use, tax was not a stamp tax since such taxes rarely exceed about 1 percent, and later used the same reasoning in In re GST Telecom Inc., 2002 WL 1737445 (D. Del. 2002), to hold that California's 4.75 percent sales tax also was not a "stamp" tax. The same view has been expressed in CCA Partnership v. Director Revenue, 70 B.R. 696, 697-698 (Bankr. D. Del. 1987), and In re CCA Partnership, 72 B.R. 765, 767 (D.Del. 1987), aff'd., 833 F.2d 303 (3rd Cir. 1987).
In short, this issue is one that states are not likely to lose—so long as they are willing to come into bankruptcy court to litigate the issue. Debtors have not been loath to write these overly broad orders in the apparent hope that the states will not wish to lose their immunity and will not object to them. It has not been uncommon for courts to hold that a state can be placed in a "Catch 22" position without any violation of the Eleventh Amendment. The state can remain out of the case and have the federal court enter an overly broad default order that will nevertheless have binding, res judicata consequences; or it can come into the federal court and thereby waive its immunity. (Just how broadly such a waiver extends, no one quite knows.) The Fourth Circuit endorsed the view that states could be forced into this Hobson's choice in State of Maryland v. Antonelli Creditors' Liquidating Trust, 123 F.3d 777, 786-787 (4th Cir. 1997), itself a §1146 case, in the course of which it held that the state could be bound by an order that violated the Code, and must waive its immunity in order to raise that issue.2
However, the Supreme Court recently held in the case of South Carolina State Ports Authority, 122 S. Ct. 1864, 1876 (2002), that states cannot be forced into making such a choice. Where the state's only options are to refuse to appear and be bound by the order, or to appear and waive its immunity so a binding order can be entered against it, the court held that the state had been coerced to appear. The states submit that the same analysis applies here. One cannot obtain a binding order and then explain it away as merely "declaring" something about the meaning of the Code. Declaratory judgments are as much subject to the Eleventh Amendment as any other judgment,3 and the entry of binding judgments is precisely what the judicial power is for. U.S. v. Shaw, 309 U.S. 495, (1940) ("The suggestion that the order...is in reality not a judgment but only a 'judicial ascertainment' of credits does not affect our conclusion. No judgment...is more than that."). If their judgment is not meant to have a binding effect, then it is merely an advisory opinion, which no federal court has the power to issue. See, e.g., In re Pattullo, 271 F.3d 898, 901-902 (9th Cir. 2001); Rhone-Poulenc Surfactants and Specialties L.P. v. C.I.R., 249 F.3d 175, 181 (3rd Cir. 2001) (court could not "declare" meaning of statutes that might never be dispositive; until a decision would have a binding effect, any views expressed on the meaning of the law would be advisory opinion).
Nevertheless, the states still must confront decisions such as In re Linc Capitol Inc., 280 B.R. 640 (Bankr. N.D. Ill. 2002), in which the court held that it could simultaneously opine about whether §1146 applied to pre-confirmation transfers, but that the state could not argue about whether its taxes were covered by the section without filing an adversary action and submitting itself to the court's jurisdiction.4 On the other hand, the court in In re Automation Solutions International LLC, 274 B.R. 527 (Bankr. N.D. Cal. 2002), took a markedly different approach in red-penciling the debtor's proposed sales order, which included a provision declaring that the tax did not apply to preconfirmation transactions. The court noted that it was not in the business of entering comfort orders and that to do so would be futile in any event, since the failure to properly serve the motion, as for an adversary proceeding, would preclude it from being binding on the taxing authorities in any event.
The states face a greater problem with respect to the other branch of cases—whether transfers that do not occur in connection with a plan confirmation should also be covered by this section. The quintessential case in this regard was Clerk of Circuit Court for Anne Arundel County v. NVR Homes Inc., 222 B.R. 514 (E.D. Va. 1998), reversed, 189 F.3d 442 (4th Cir 1999). The debtor, a home builder, was in bankruptcy for some 18 months, during which time it sold houses in the ordinary course of business and paid recording taxes. When it proposed its plan, it asserted that all of those sales were made "under a plan confirmed" because it wouldn't have been able to get to a plan unless it had stayed in business and sold homes. Thus, since it needed to stay in business to confirm a plan, any sales that assisted in that goal were under a "plan confirmed."5 The district court found that argument to be persuasive, and the same reasoning has been used in other cases, such as In re Permar Provisions Inc., 79 B.R. 530 (Bankr. E.D.N.Y. 1987), In re Hechinger Investment Co. of Delaware Inc., 276 B.R. 43, 47 (D. Del., March 18, 2002) ("appropriate reading of §1146(c) would require only that a plan be ultimately confirmed. Thus, it is the fact of plan confirmation, rather than its timing, that is critical"), and GST Telecom, supra.
In some of those cases, the argument was made that the sale needed to be made quickly to preserve the maximum value for the estate, and that waiting until confirmation would take too long. This was the court's rationale in GST, where it treated the assets of a failed telecom as a wasting asset. And there is little doubt that the early sale allowed creditors to receive more for largely worthless assets than they would have received if the sale were delayed. The problem with this reasoning, though, is that it suggests that multi-million dollar deals would founder if the debtor is required to pay a 1 percent recording tax to complete them. By the very nature of the §1146 taxes, it is obvious that the exemption can only have the most trivial effect on the viability of a transaction. While there are many vociferous debates over the effect of a 20 or 25 percent capital gains tax, can anyone seriously suggest that a deal will rise or fall based on whether a stamp tax has to be paid? The fact is that this is a trivial benefit for debtors, and, precisely because it has only a minimal effect, there is no need to engage in legal gymnastics to try to expand the scope of the exception. Quick sales may be necessary to facilitate confirmation, but if so, they will take place with or without this modest tax windfall.
To be sure, a debtor and its creditors would always prefer not to pay tax—but if Congress had meant to exempt all sales during the case, or even all sales that helped to reach confirmation, there surely were more straightforward ways of saying so. Even the courts that rely on the "necessity" of the transfers to justify exempting pre-confirmation sales are sensitive to an obvious counter: What if the plan doesn't confirm? Even if an eventual confirmation can retroactively bless transfers that were made before the plan was even a gleam in the debtor's eye, what if the case later crashes and burns (as most do)? Surely the debtor is not entitled to the exemption then, but what are the alternatives?
The government could try to collect the tax from the debtor after the case converts to chapter 7 or is dismissed, but this is hardly practical. A debtor that cannot confirm a plan is often administratively insolvent. If so, will the court let the government collect in full while other creditors can clearly see that they will get little or nothing? (Even assuming there is enough to pay the tax in full?) Possibly, but taxing authorities are understandably wary of relying on that route. To their credit, the Delaware courts have begun requiring the debtor to escrow funds sufficient to pay the taxes as a condition of allowing such sales to be treated as exempt. But this "solution" raises as many questions as it answers. Who should hold such an escrow? Is the government entitled to interest on the taxes withheld? Can the debtor treat the escrow as cash collateral and use it if it provides adequate protection? The Code, of course, has no answers or insights on these issues.
In addition, courts taking this view often try to limit their holding to transfers that are "essential" or "necessary" to reach confirmation. Yet, as the Hechinger court noted, §1146 has no such limitations as to transfers made pursuant to a confirmed plan. Thus, to justify excepting transactions that do not take place under a plan, the court must invent a new limitation that is not contained in §1146. Moreover, in imposing this extra-statutory limitation, courts again face many new issues: Should the standard be whether the transfer is necessary for confirmation? Or merely helpful? (Will a court ever concede that it is approving a §363 sale that is not helpful, indeed not essential, to the case?) What level of proof is needed? Who bears the burden of proof? And what evidence is relevant? Again, there is no easy answer to such questions, since the courts must answer them without guidance from any language in the Code.
The Fourth Circuit recently analyzed the issue in In re NVR L.P., 189 F.3d 442 (4th Cir. 1999), and emphatically rejected the broad interpretation espoused above:
We must conclude that Congress, by its plain language, intended to provide exemptions only to those transfers reviewed and confirmed by the court. Congress struck a most reasonable balance. If a debtor is able to develop a chapter 11 reorganization and obtain confirmation, then the debtor is to be afforded relief from certain taxation to facilitate the implementation of the reorganization plan. Before a debtor reaches this point, however, the state and local tax systems may not be subjected to federal interference. Id. at 458.
Its decision contains a detailed analysis of prior case law, particularly from the Second Circuit, that is often relied on as supporting the broad view, and explains why those cases are not inconsistent with the plain language reading of the statute. Tax exemptions are, in general, to be narrowly construed—a principle that applies even in bankruptcy. See California State Board of Equalization v. Sierra Summit Inc., 490 U.S. 844, 851-52 (1989) ("Although Congress can confer an immunity from state taxation...a court must proceed carefully when asked to recognize an exemption from state taxation that Congress has not clearly expressed"). Yet here, the courts have adopted an ever-more elaborate structure to justify a broad tax exemption. Such structures often collapse under their own weight when they cannot find a clear base in the language of the Code. The states respectfully suggest that there is no need to read §1146 as giving anything more than what it says on its face—a moderate reward for those who cross the finish line and confirm a plan. Like a box of Cracker Jacks, there's only one prize per box!
2 The opinion purports not to decide the statutory issue, although the court made clear that it doubted there was a violation. However, it made equally clear that it would allow the state to be bound even if it were convinced that the state's view of §1146 was correct. Return to article
4 The conclusion that §1146 applied "was not made pursuant to an exercise of jurisdiction over the state; rather, it was entered pursuant to jurisdiction over the debtor and sale of its property," but in raising issues about its taxes, "the state has not identified a concrete controversy between it and Linc Capitol with regard to the exemption possible under §1146(c) and has not presented a particular tax issue for determination. Moreover, a declaratory ruling must be sought by adversary complaint." Why declaration of the meaning of the law did not equally require a "concrete controversy" by the debtor and the existence of an adversary party are interesting questions that the opinion does not answer. Return to article
5 "The business conducted during this...period is essential to the success of both the plan of reorganization and the debtor's emergence from bankruptcy.... These transfers...enabled NVR to remain a viable operation and avoid liquidation." 222 B.R. at 518-519. Return to article