Chapter 12 Bankruptcy Taxation – IRS Loses Again

Part of the 2005 overhaul of bankruptcy law involved a significant change in the tax rules applicable in a Chapter 12 bankruptcy.  That’s the chapter of the bankruptcy code that provides for reorganization for farmers.  The new law contains a provision that changes “governmental claims” arising from the “sale, transfer, exchange or other disposition of any farm asset used in the debtor’s farming operation” from a priority claim in the bankruptcy estate to a general unsecured claim, provided the debtor receives a discharge.  11 U.S.C. §1222(a)(2)(A).  IRS has argued in an Iowa case that the provision only applied to capital assets that the debtor used in farming, but lost.  In re Knudsen, 389 B.R. 643 (N.D. Iowa 2008).  The court, in that case, determined that it wasn’t appropriate to define a debt relief provision by using the Internal Revenue Code, and that the Congressional intent behind the provision did not support the IRS interpretation.  IRS also argued in that case that the provision didn’t apply to taxes triggered by the post-petition sale of assets because Chapter 12 does not create a separate taxable entity from the debtor.  But, the court disagreed, holding that such taxes can be paid as an administrative expense in the bankruptcy estate.  The court also ruled against the IRS on their position that the amount of the non-priority taxes is to be determined by using a proportional approach, instead adopting the debtors’ marginal approach.

In the most recent judicial opinion involving the Chapter 12 tax provision, the court followed the Iowa court’s approach.  Here, the debtors sold their 320-acre farm post-petition for $960,000.  The sale generated $29,000 of capital gains tax that the debtors proposed to include in their reorganization plan as an unsecured claim.  That meant they would pay the tax liability in full if funds were available, but would only make pro-rata payments on it along with other unsecured claims if funds were not available to pay it in full with the unpaid balance discharged.  The bankruptcy court ruled for IRS, holding that the new tax provision did not apply to taxes arising post-petition.  The debtors appealed.

On appeal, the court reversed.   The court was convinced that the legislative history of the provision demonstrated that it was intended to offer relief to farmers from the problem of not being able to put together a feasible reorganization plan due to taxes being priority claims that had to be paid in full before any unsecured claims could be paid.  The court noted that it’s holding was consistent with bankruptcy court opinions in In re Schilke, 379 B.R. 899 (Bankr. D. Neb. 2007) and In re Dawes, 382 B.R. 509 (Bankr. D. Kan. 2008), and the Federal District Court’s opinion in Knudsen.  In re Hall, No. CV-07-679-TUC-DCB (D. Ariz. Aug. 6, 2008). 

Note:  On the same day the Federal District Court decided Hall, the IRS filed a notice of appeal with the U.S. Circuit Court of Appeals for the Eighth Circuit in the Knudsen case.