Bankruptcy Court Rules on Chapter 12 Tax Provision

November 20, 2006 | Roger McEowen

The Bankruptcy Court for the Northern District of Iowa has become the first court in the nation to rule on the meaning and scope of language contained in the 2005 Bankruptcy Act designed to provide tax relief to farmers that file Chapter 12 (reorganization) bankruptcy. Historically, taxes triggered upon sale of farm assets were a priority claim in the bankruptcy estate and had to be paid in full ahead of the claims of general unsecured creditors. The 2005 Act changed that by stating:

"[claims]...owed to a governmental unit that arises as a result of sale, transfer, exchange, or other disposition of any farm asset used in the debtor's farming operation...shall be treated as an unsecured claim that is not entitled to priority...if the debtor receives a discharge."

The questions in the case involved the scope and breadth of that language. The court ruled for the IRS on some of the issues involved in the case, and for the debtors on other issues. Here's a summary of how the court ruled:

  1. The provision does not apply to the debtors' prepetition sale of fat hogs because the fat hogs were not "farm assets used in the debtors' farming operation.
  2. The allocation of income taxes between priority tax debt and "unsecured" tax debt (under the new provision) is to be calculated by prorating the actual tax for the period according to the proportions of income arising from the sale of farm assets used in the operation and income arising from all other sources.
  3. In applying the "best interest" test to the portion of the IRS tax claim treated as unsecured, a debtor satisfies the best interest test by showing that the distribution to the IRS under the plan is the same as it would be under a Chapter 7 liquidation for the same treatment status - that of an unsecured claim.     
  4. The provision permits the discharge of all debts permissibly provided for by the debtors' reorganization plan.     
  5. The tax generated by post-petition sale of farm assets which were used in the farming operation (i.e., land, machinery and equipment) is eligible for the favorable tax treatment under the new provision as an administrative expense that can be discharge without being paid in full. In re Knudsen, No. 05-03136M (Bankr. N.D. Iowa Nov. 20, 2006).

Knudsenopinion.pdf