What Does Avoidance of Taxes Mean in 1129(d)

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Mar 1999

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Section 1129(d) of the Bankruptcy Code is one component of the confirmation inquiry that is rarely cited, less

understood and not the subject of much court interpretation. It may factor into the confirmation equation both at the

time of confirmation and prospectively as taxable events inure to the reorganized debtor. A recent opinion by the

bankruptcy court for the District of Connecticut<a href="#2" name="2a">2</a> underscores its value to governmental creditors and the pitfalls to

plan proponents,<a href="#3" name="3a">3</a> should it not be considered in the chapter 11 confirmation process.

Section 1129(d) provides, in relevant part, that "on request of a party in interest that is a governmental unit, the

court may not confirm a plan if the principal purpose of the plan is the avoidance of taxes...." "The government unit has the burden of proof on the issue of avoidance." Courts have been uniform in finding that for §1129(d) to apply, it

must be raised by a governmental unit and not the debtor. In re McLean Indus. Inc., 132 B.R. 267, 270 (Bankr.

S.D.N.Y. 1991). Further, some courts believe that the court may, under its equitable powers in §105(a), raise the

issue as part of the court's §1129 analysis in confirming a plan. See In re Hartman Material Handling Systems Inc.,

141 B.R. 802, 808-09 (Bankr. S.D.N.Y. 1992); In re Rath Packing Co., 55 B.R. 528 (Bankr. N.D. Iowa 1985).

Also, the burden of proof is clearly on the government. Bankruptcy courts have finally recognized that for §1129(d)

to apply, the principal purpose of the plan must be the avoidance of taxes.<a href="#4" name="4a">4</a>

In answering what the "avoidance of taxes" means, or at least what its intent is, the legislative history of §1129(d)

is instructive. Section 1129(d)'s predecessor, §269 of the Bankruptcy Act, provided that "where it appears that a

plan has for one of its principal purposes the avoidance of taxes, objection to its confirmation may be made...by the

Secretary of the Treasury, or,...State..." Section 1129(d) was enacted to codify the Supreme Court's ruling in

Gregory v. Helvering, 293 U.S. 465 (1935),<a href="#5" name="5a">5</a> which in turn had been codified in the Internal Revenue Code.<a href="#6" name="6a">6</a>

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Section 1129(d) can apply where the debtor manifests an intent to avoid

the payment and treatment of pre-petition taxes and control the

disposition of tax consequences not yet realized at the time of

confirmation.

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As enacted, §1129(d) tracked the language of its predecessor (§269 of the Act) but provided that the court had to

make a finding that the principal purpose of the plan was the avoidance of taxes before a plan could be denied

confirmation under §1129(d). Little was written on §1129(d) until 1992, when the Internal Revenue Service (IRS)

issued new regulations that provided that the IRS could review the tax consequences of a confirmed plan, such as the

allowance of a net operating loss (NOL), even after a bankruptcy court had approved the plan. Therefore, even though

the court could have made a finding under §1129(d) that the principal purpose of the plan was not the avoidance of

taxes, the IRS, through its regulations, believed that it had the final discretion to determine the tax consequences of

a confirmed plan even after the court had previously approved the plan. Treas. Reg. 1.269-3(e) (1992).

The reaction from at least one court (which is probably representative of many courts) was swift and clear: the

authority to adjudge the tax avoidance of any chapter 11 plan was within the sole provenance of the bankruptcy

court, and the IRS' regulations, while helpful in explaining the IRS' rationale and position on tax matters, were not

binding on the court. Hartman Material, 141 B.R. at 808-09.<a href="#7" name="7a">7</a> As such, the court reviewed the prospective effect a

finding that a plan was not confirmed with the principal purpose of tax avoidance (under the paradigm of collateral

estoppel and res judicata) would have on the IRS' ability to review and determine tax events post-petition. The

court examined the "factual frames of reference" in determining whether the NOLs that were being claimed at

confirmation could be subject to IRS review post-petition. The court concluded that the IRS could not be estopped

from making a §269 determination regarding the debtor's future use of NOLs for transactions not specifically

contemplated at the time of confirmation. Hartman Material, 141 B.R. at 812. As such, a NOL not used as a

deduction at the time of confirmation is subject to IRS review at the time it is claimed on a tax return. Id.

The Hartman Material court's holding comports with the intent of §1129(d), which is to review the use of tax

credits as they relate to plan confirmation, and determine whether their misuse is the sole purpose of reorganization.

Further, it seems that the bankruptcy courts have concluded that, absent a government request, a court should

determine the tax consequences of a proposed plan if the plan contemplates the use of tax benefits as a condition of

confirmation.<a href="#8" name="8a">8</a> However, the curious application of §1129(d) is in how courts have utilized it to determine if the tax

avoidance through the reorganization process, absent tax consequences, is a basis for the denial of confirmation.

Both the courts in Hartman Material and Rath Packing Co. recognized that in order to reach a determination of

whether the plan was proposed in good faith, they needed the implicit finding that the plan had not been proposed

with the sole purpose of tax avoidance. Hartman Materials, 141 B.R. at 809. Further, the court in In re Cohen, 173

B.R. 950, 957-58 (Bankr. S.D. Fla. 1994), found that where the debtor did not provide for the retention of the IRS'

lien and to use her post-petition earnings to pay the IRS' claim, that the debtor's sole purpose in proposing her

plan was for tax avoidance under §1129(d). As a result, the case was dismissed on the motion of the IRS for the

debtor's failure to account for the IRS' lien and to provide for payment of the IRS' claim through her plan (the

debtor had also converted non-exempt assets into exempt assets and made fraudulent transfers to family members).

The opinion was vacated on appeal. The district court noted that the IRS had not raised §1129(d) as a basis of

dismissal. The district court held that §1129(d) could only be used as a basis for denial of confirmation, and not an

independent ground for dismissal other than in support for dismissal under §1112(b)(2). Cohen v. United States (In

re Cohen), 191 B.R. 482, 487 (S.D. Fla. 1995).<a href="#9" name="9a">9</a>

The bankruptcy court in In re Scott Communications related the plan confirmation process to tax avoidance both as

a matter of good faith and as a review of post-confirmation tax events. The debtor filed a pre-packaged liquidating

chapter 11 plan that provided that the capital gains attributable to the sale of the debtor's assets were not to be

provided for in the plan of reorganization because they would arise post-confirmation. Further, the plan provided an

injunction against collection from the third parties, and precluded the taxing authorities from pursuing tax claims

incident to the sale. Scott Communications, 227 B.R. at 599.

The debtor argued that because the purchase price for the debtor's assets was less than the amount of its secured

debt, the requirement to pay the capital gains on the sale was unnecessary. The debtor also maintained that because

the capital gains on the sale would not occur until after confirmation of the plan, the debtor did not have to provide

for the tax as an administrative expense because it fell outside the administrative claim period. The court found the

debtor's arguments baseless, noting that the elevated priority of paying administrative claims, including tax claims,

could not be circumvented by a sale that would pay less than all secured claims. Id. at 600. Further, the fact that the

capital gains would not occur until after the plan was confirmed does not excuse the debtor from providing for it in

the plan. The court reasoned that the administrative period for the payment of administrative claims extends beyond

the date of confirmation. Id.; citing Holywell Corp. v. Smith, 503 U.S. 47 (1992).

The debtor also sought protection for third parties from tax collection for the capital gains. Apparently, no basis was

offered for the purpose of the injunction other than that the court could issue an injunction pursuant to §105(a). The

court declined to issue an injunction, finding that the debtor had not shown that the injunction was necessary for the

implementation or viability of the plan or that the collection action against the third parties would have a

detrimental effect on the plan. The court also held that the debtor's attempt to violate the Anti-Injunction Act<a href="#10" name="10a">10</a>

through the use of §105(a) does not override the specific intent of the Anti-Injunction Act, which is the preservation

of the government's ability to assess and collect taxes. Id. at 602.

The Scott Communications court concluded that an analysis as to whether the principal purpose of a plan is the

avoidance of taxes includes the context of surrounding circumstances. The court stated that if the sale were outside

the scope of bankruptcy that the capital gains would have to be paid. The court also found that if the sale occurred

prior to confirmation that the capital gains would have to be paid as an administrative claim. Further, the third

parties that would be protected under the proposed plan would not be protected outside the bankruptcy. As such, the

court held that the avoidance of the payment of the capital gains and the protection of third parties from tax

collection was the principal purpose of the plan. Consequently, the plan failed under §1129(d).

Scott Communications illustrates that the §1129(d) inquiry is not limited simply to the considerations of tax

consequences. Section 1129(d) can apply where the debtor manifests an intent to avoid the payment and treatment of

pre-petition taxes and control the disposition of tax consequences not yet realized at the time of confirmation. As

such, plan proponents should be mindful of addressing tax consequences in their plans to ensure that the bankruptcy

court will conduct a §1129(d) inquiry and make the appropriate finding. Also, taxing authorities should use

§1129(d) not only as a basis for objecting to a plan as to the issue of tax consequences of a plan, but also where the

thrust of any plan is to avoid the required payment and treatment of taxes.

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<h3>Footnotes</h3>

<a name="1">1</a> The views expressed in this article are Mr. Gargotta's and do not necessarily reflect the views of the Department of Justice or the Internal Revenue Service (IRS). <a href="#1a">Return to article</a>

<a name="2">2</a> In re Scott Cable Communications Inc., 227 B.R. 596 (Bankr. D. Conn. 1998). <a href="#2a">Return to article</a>

<a name="3">3</a> The term "plan proponent" is used because, in at least one reported decision, the bankruptcy court found that a plan offered by a competing creditor must consider the tax

consequences. Smith v. Bank of New York, 161 B.R. 302, 307 (Bankr. S.D. Fla. 1993). <a href="#3a">Return to article</a>

<a name="4">4</a> The Rath court found that the inclusion of the word "the" before "principal purpose" denoted "the most important." Rath, 55 B.R. at 536. <a href="#4a">Return to article</a>

<a name="5">5</a> A taxpayer has the right to decrease or altogether avoid taxes owed by means permitted by law. <a href="#5a">Return to article</a>

<a name="6">6</a> 26 U.S.C. §269 (1954). <a href="#6a">Return to article</a>

<a name="7">7</a> The debtor's plan involved a change in ownership by giving the debtor's unsecured creditors stock in exchange for their debt. As a result of the stock offering, unsecured creditors

would receive more than 50 percent of the debtor's reorganized stock. Further, most of the debtor's assets would be sold, including NOLs that exceeded $298 million. Section 269

of the I.R.C. prohibits the use of NOLs where there is a change in ownership of a company and the principal purpose of the acquisition is the purchase of a tax deduction. The

thrust of §269 is to prevent the trafficking of tax deductions to third parties who would otherwise not enjoy the benefit of the deduction except for the acquisition of the business

entity that is entitled to the deduction. Hartman Materials, 141 B.R. at 806. <a href="#7a">Return to article</a>

<a name="8">8</a> Cf. In re Eagle-Picher Indus. Inc., 203 B.R. 256, 277 (Bankr. S.D. Ohio 1996) (the court noted that no §1129(d) objection was raised, but nonetheless concluded §1129(d) was not

violated); In re Trans World Airlines Inc., 185 B.R. 302, 318 (Bankr. E.D. Mo. 1995) (because no request had been made under §1129, it was not applicable); In re Drexel

Burnham Lambert Group Inc., 138 B.R. 723, 772 (Bankr. S.D.N.Y. 1992) (no pleading was filed as to §1129(d), but the court held that the principal purpose of the plan was not

the avoidance of taxes). <a href="#8a">Return to article</a>

<a name="9">9</a> In fact, on remand, the IRS' claim was disallowed for certain periods. Cohen v. United States (In re Cohen), 198 B.R. 382 (Bankr. S.D. Fla. 1996). <a href="#9a">Return to article</a>

<a name="10">10</a> 26 U.S.C. §7421 provides, in relevant part, that no suit may be maintained if its purpose is the restraint of the assessment or collection of taxes against any person. <a href="#10a">Return to article</a>

Journal Authors

Craig A. Gargotta

Journal Date

Monday, March 1, 1999 - 12:00