Priority of Taxes in a “Straddle Year”

Recent decisions have cast light on the dispute over the proper treatment of claims of taxing authorities arising in a “straddle” tax year, which begins before the bankruptcy filing date and ends after it.  Because of the ambiguities of the drafting in revised § 507(a)(8) of the Bankruptcy Code, a tax claim arising in a straddle year could be interpreted as an administrative claim, a priority unsecured claim or even a nonpriority, unsecured claim.  Depending on the size of the claim, this determination could have a critical impact on a reorganizing debtor or the ability of unsecured creditors to receive a distribution in a liquidation.  Prior to the Code revisions in 2005, § 507(a)(7) provided that a tax claim would be accorded priority unsecured treatment if the claim was:

(A) A tax on or measured by income or gross receipts-

(i) for a taxable year ending on or before the date of the filing of a petition for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;

(ii) assessed within 240 days…before the date of the filing of the petition; [and]

(iii)…not assessed before, but assessable, under applicable law or by agreement, after the commencement of the case

Under this prior provision, several courts had concluded that a tax arising during a straddle tax year could be accorded priority unsecured status under § 507(a)(7)(A)(iii) as a tax not assessed before the commencement of the case, but capable of assessment after the case commenced.[1]  The holdings were not uniform, however.  Some courts bifurcated the straddle year and accorded administrative expense priority to the tax liability found to have arisen during the post-petition portion of the straddle tax year.[2]  Congress made an attempt to clarify the rights of taxing authorities in 2005 in revised and renumbered § 507(a)(8), which provides for eighth priority for unsecured claims of a governmental unit to the extent such claims are for:

(A) a tax on or measured by income or gross receipts for a taxable year ending on or before the date of the filing of the petition –

(i) for which a return, if required, is last due, including extensions, after three years before the date of the filing of the petition;

(ii) assessed within 240 days before the date of the filing of the petition…

By moving the phrase “for a taxable year ending on or before the date of the filing of the petition” from (A)(i) to the preamble in subsection (A) of § 507(a)(8) (and thereby making such language applicable to (A)(i), (A)(ii), and (A)(iii)), Congress precluded priority unsecured treatment of any portion of a straddle-tax-year claim.  Effectively, this statutory change limited the treatment of a straddle-tax-year claim to either an administrative claim or a nonpriority unsecured claim – a harsh result in either instance.

One of the first reported decisions interpreting new § 507(a)(8) found the taxing authorities to have an administrative claim for all taxes incurred in a straddle tax year.[3]   In Gaudio, the dispute involved the debtor and the Illinois Department of Revenue.  Relying upon Illinois law, the Gaudio court determined that a tax was incurred no earlier than the end of the taxable year, when liability is accrued and fixed.  Because the end of the tax year occurred post-petition, the entire claim was accorded administrative status.  However, decisions in two recent cases have questioned Gaudio’s interpretation of the revised § 507(a)(8).

In 2019, the U.S. Bankruptcy Court for the District of Delaware found that a tax claim arising during a straddle tax year needed to be bifurcated such that pre-petition events creating tax liability would be accorded general unsecured status, and post-petition events creating tax liability would be accorded administrative-expense status.[4]   The Affirmative I court made several observations in reaching this conclusion.  Even if a claim was deemed to arise post-petition, the tax liability must be incurred by the bankruptcy estate in order to acquire administrative-priority status, as an administrative claim should be based on an obligation that results in, or arose out of, a benefit received after the estate came into existence.  There was no evidence presented of a legislative intent to change prior practice in this regard when amending § 507(a)(8).   The court further noted that in seeking allowance of an administrative expense under § 503(b)(1), the movant bears the burden of establishing that its claim is an actual and necessary expense of preserving the debtor’s estate.  The court further found legislative support for partially denying administrative-priority status in the wording of § 503(b)(1)(B), which specifically addresses administrative tax claims.

Section 503(b)(1)(B)(ii) grants administrative-expense status to any tax for excessive allowance of a tax carryback.  That provision specifically states that the administrative-expense status applies whether the tax year to which the adjustment relates ended before or after the commencement of the case.  Congress thereby demonstrated in § 503(b)(1)(B)(ii) its ability to be specific and to show intent as to the particular tax year affected by a Bankruptcy Code provision.  If Congress had intended § 503(b)(1)(i) to apply to straddle tax years, it could have provided a similar level of specificity, but it did not.  Bifurcation of the straddle-year tax claim was therefore supported by statutory analysis and the absence of legislative intent to change prior practice.

Affirmative I was followed by a similar holding in the TelexFree case.[5]  TelexFree filed its chapter 11 petition in April 2014.  Virtually all of its income in 2014 was earned pre-petition, as it was almost immediately shut down post-petition because it was engaging in a Ponzi scheme.  The Internal Revenue Service (IRS) alleged that any tax liability for 2014 constituted an administrative claim.  The TelexFree court concluded that the 2014 income generated arose prepetition, therefore the tax relating to year 2014 was not incurred by the estate as required by § 503(b)(1)(B)(i).  In coming to this conclusion, the court focused on when an event occurred which caused the tax liability, not when the amount due is computed at the conclusion of the tax year.  The court went on to find that the debtor’s 2014 tax liability constituted a nonpriority unsecured claim because the tax liability did not satisfy the administrative-tax-claim requirements of § 503(b)(1)(B), nor did it satisfy the priority-unsecured-claim requirements of § 507(a)(8).

After TelexFree was decided, the Affirmative I was decision was overruled on appeal to the district court.[6]  The district court in Affirmative II concluded that the IRS imposes a tax for the entire year, not based upon individual events occurring during the tax year.  The court observed that there was no legislative history to support the IRS’s argument that by eliminating the priority status of a straddle-year tax claim in 2005, Congress intended to make taxes arising during a straddle year entirely administrative claims.  However, following Third Circuit case law, the court looked at the underlying substantive tax law to determine whether and when a tax is “incurred,” concluding that tax liability accrues and becomes fixed on the last day of the tax period, and therefore that is when the tax is “incurred.”

Conclusion

The potential anomalies arising from both TelexFree and Affirmative II are self-evident.  It would seem incongruous that a tax arising two or three years before the petition date is accorded priority unsecured status, while a tax claim arising on the eve of the bankruptcy and during a straddle tax year would receive a lower, nonpriority status.  Conversely, the holding in Affirmative II creates a situation where events giving rise to a tax liability clearly arise pre-petition, yet the tax claim is given elevated administrative-expense status.  This legal result could cause the timing of filing of a petition to be unnecessarily driven by tax consequences.

Congress should clearly set forth the appropriate treatment of tax claims arising during a straddle tax year.  The most logical result would be an apportionment of liability between priority unsecured status for the pre-petition portion of the tax year, and administrative-claim status for the post-petition portion of the tax year, with possible adjustment for the equities of the case depending on when the debtor’s income is actually earned and expenses are actually incurred.  The current circumstance is one of ambiguity and inconsistent results, thus creating unnecessary uncertainty when planning a bankruptcy filing.

[1] See Towers for Pacific-Atlantic Trading Co. v. United States, 64 F.3d 1292 (9th Cir. 1995); In re O.P.M. Leasing Serv’s., Inc., 68 B.R. 979, 983 (Bankr. S.D.N.Y. 1987).

[2] See, e.g., Missouri Dep’t of Rev, v. L.J. O’Neill Shoe Co., 64 F.3d 1146 (8th Cir. 1995).

[3] See Earl Gaudio & Son, Inc., Case No. 13-90942, 2017 Bankr. LEXIS 207 (Bankr. C.D. Ill. 2017).

[4] See In re Affirmative Ins. Holdings, 607 B.R. 175 (Bankr. D. Del. 2019)(“Affirmative I”).

[5] Darr v. U.S. (In re TelexFree), 615 B.R. 362 (Bankr. D. Mass. 2020)

[6] See In re Affirmative Ins. Holdings, 620 B.R. 73 (D. Del. 2020)(“Affirmative II”).

 

Originally published  in American Bankruptcy Institute Journal August 2022.

Lizotte. (2022). Priority of Taxes in a “Straddle Year.” American Bankruptcy Institute Journal, XLI(8), 14-15, 38.