Back to Basics Exempting Real Estate Transfers from Taxation Post-Hechinger

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Jul/Aug 2004

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The practice of seeking bankruptcy court approval of an exemption from applicable state and local transfer tax under
§1146(c) in conjunction with the pre-confirmation sale of real property was commonplace, even routine, prior to the
decision of the Third Circuit Court of Appeals in Baltimore County v. Hechinger Liquidation Trust (In re Hechinger Inv. Co. of Del.), 335 F.3d 243 (3d Cir. 2003). In chapter 11 cases in which a reorganization plan had
yet to be formulated or filed, bankruptcy courts frequently incorporated transfer tax exemption provisions in sale
orders on a number of grounds.

<h4>Rationale</h4>

One justification for the inclusion of the §1146(c) exemption in a pre-confirmation sale order was that the sale
proceeds would be segregated and reserved for distribution under a plan to be filed in the future. Another, as in
Hechinger, involved the approval of a conditional exemption pending future confirmation of a plan. A third relied
on the notion that, absent the debtor's realization of the economic benefits of the proposed sale, it would not be in a
position to formulate a plan and that the sale was accordingly integral to the plan process.<a href="#2" name="2a">2</a> In essence, the liberal
availability of the transfer tax exemption in the pre-confirmation context was analogous to baseball's "neighborhood
play," in which some logical proximity of the sale to a plan was deemed sufficient to support the exemption.

<h4>Hechinger Holding</h4>

At least in the Third Circuit, Hechinger changed all that. A majority of the appeals court held that §1146(c)
of the Bankruptcy Code does not apply to pre-confirmation real estate sales under any circumstances.<a href="#3" name="3a">3</a>
Section 1146(c) provides as follows:

<blockquote>
The issuance, transfer or exchange of a security, or the making or delivery of an instrument of transfer under a plan
confirmed under §1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax. (emphasis added)
</blockquote>

The majority's holding was premised on what it characterized as the "natural" reading of the "under a plan
confirmed" language to mean "made pursuant to a confirmed plan." 335 F.3d at 254. Secondarily, the majority
relied on Supreme Court authority holding that statutory provisions relating to the exemption or deferral of taxes are
to be construed narrowly, citing United States v. Centennial Savings Bank FSB, 499 U.S. 573 (1991); United
States v. Wells Fargo Bank, 485 U.S. 351 (1988); and United States Trust Co. v. Helvering, 307 U.S. 57 (1939).

As one who practices in a high transfer tax jurisdiction (in which real estate transfers are taxed at a combined state
and county rate of 4 percent of the purchase price) and in which Hechinger is conclusive on the issue of the
availability of the exemption in the context of a pre-confirmation sale, it was important to rethink certain
fundamental procedural issues regarding the approval and consummation of the sale of real estate assets in chapter
11 cases. With Hechinger as background and with the filing of a single-asset real estate chapter 11 case imminent,
the ability to achieve the transfer tax exemption became critical in order for the case to make economic sense.

<blockquote><blockquote>
<hr>
<big><center>
[T]he bargain-hunting real estate marketplace loves two things above all else: bankruptcies and auctions.
</center></big>
<hr>
</blockquote></blockquote>

<h4>Facts of the Case</h4>

The debtor was a limited partnership that owned vacant commercial real estate in central Philadelphia. As with
most entities of its kind, the debtor was indebted to its real estate lender in an amount approximating the market
value of its property. The debtor had only a handful of unsecured creditors, consisting of accrued priority real
property taxes and relatively minor general unsecured claims for utility charges. Pre-petition, the debtor had
engaged in promising negotiations with a prospective purchaser to acquire the property for the sum of $3.425
million, subject to higher and better offers in the context of an auction to be conducted in the debtor's subsequent
chapter 11 case. Based on the initial offer, the transfer tax payable in either a non-bankruptcy sale transaction or
in a pre-confirmation sale would amount to $137,000, a sum that, if payable, would have rendered impossible
payment in full of the lender's secured claim, as well as payments on account of the priority tax, administrative
and trade claims against the debtor. Stated otherwise, in order for the transaction to make economic sense for any
party other than the lender, the state and local taxing authorities had to subsidize, through the application of the
§1146(c) exemption, the other creditors of the estate.

The first step in orchestrating a sale "under a plan confirmed" was entering into an agreement with the
prospective buyer in which the parties acknowledged that the transaction was conditioned on the entry of a
confirmation order and the applicability of the §1146(c) exemption. Another critical contractual provision involved
the buyer's acknowledgement that the transaction would be subject to higher and better offers in the context of an
auction that would take place if a qualified overbid was submitted in accordance with bidding procedures to be
approved by the bankruptcy court.

The optimal procedural mechanism for accomplishing the debtor's objective was thus to enter into the agreement
of sale and to file a liquidating plan and disclosure statement, together with a motion that sought the dual relief
of approving the disclosure statement and the debtor's proposed bidding and sale procedures contemporaneously.
In tandem with the motion to approve the disclosure statement and the bidding procedures, the debtor also issued
a notice to potential overbidders and auction participants advising those parties of the auction and the
opportunity to submit a qualified overbid. This notice also indicated that potential overbidders could obtain a
copy of the debtor's liquidating plan and disclosure statement upon request and contained a conspicuous
disclaimer concerning the debtor's non-solicitation of votes with respect to the plan prior to the bankruptcy court's
approval of the disclosure statement. See Century Glove Inc. v. First Am. Bank of N.Y., 860 F.2d 94 (3rd Cir.
1988).

Experience teaches that, even in relation to a previously stigmatized property, the bargain-hunting real estate
marketplace loves two things above all else: bankruptcies and auctions. The filing of a liquidating plan, the
centerpiece of which was a stalking-horse offer and the prospect of a substantial transfer tax savings, generated the
level of interest that the debtor had sought.

After the bankruptcy court approved the disclosure statement and the proposed bidding procedures, the debtor issued
a second notice advising prospective bidders of the deadline established by the court for the submission of
competing offers. As requested by the debtor, the order approving the disclosure statement also established a date
for the auction seven days prior to the confirmation hearing in the event that one or more qualified overbids was
received by the specified deadline.

This procedure enabled the debtor to solicit competing bids and to enhance the purchase price payable under the
stalking-horse agreement through the auction process. It also permitted the debtor to confirm both the sale and the
plan shortly after the auction. A total of 80 days had elapsed between the debtor's execution of the stalking-horse
agreement of sale and the confirmation hearing, about the same amount of time as the debtor would have required to
obtain separate orders approving proposed sale procedures and a sale of the real estate itself under §363 of the
Bankruptcy Code.

Because the debtor had sought approval of the real estate transaction exclusively pursuant to the proposed plan, the
state and local taxing authorities did not challenge the propriety of the transfer tax exemption. This fact resulted in
the availability of $137,000 for distribution to creditors and equity security-holders under the plan that otherwise
would have been allocated to transfer tax obligations. These dollars were critical in facilitating the full payment of
allowed creditor claims under the plan.

Against this result was the potential argument, not adopted by the respective state and local taxing authorities, that
the principal purpose of the debtor's plan was the avoidance of taxes in violation of §1129(d) of the Bankruptcy
Code.<a href="#4" name="4a">4</a>

Despite the statutory allocation of the burden of proof to the taxing authorities, the debtor was relieved that no
confirmation objection predicated on §1129(d) was filed, since it would have candidly admitted that an important, if
not principal, economic justification of the plan in relation to a §363 sale approach was indeed the avoidance of
transfer taxes.5 While I have found no case construing §1129(d) as prohibiting confirmation of a plan incorporating
a §1146(c) exemption, I was not anxious to test the interplay of those two Bankruptcy Code provisions in the
context of a single-asset real estate case.

Until §1129(d) is determined to have primacy in relation to §1146(c), however, the practice of orchestrating a
conveyance of real property under a plan in order to fund creditor distributions with tax savings is a sound one.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The author was counsel to the debtor in In re Feld Chestnut L.P., Bankruptcy No. 04-11658(KJC), filed in the Eastern District of Pennsylvania on Feb. 3, 2004. <a href="#1a">Return to article</a>

<a name="2">2</a> See, e.g., In re Smoss Enterprises Corp., 54 B.R. 950, 951 (E.D.N.Y. 1985) (holding that the transfer of realty was "under" the plan because it "was essential to the confirmation of the plan" and applying the rule of In re Jacoby-Bender, 758 F.2d 840 (2d Cir. 1985), to a pre-confirmation sale). <a href="#2a">Return to article</a>

<a name="3">3</a> The only other appeals court to have addressed the issue, NVR Homes Inc. v. Clerks of the Circuit Courts (In re NVR L.P.), 189 F.3d 442 (4th Cir. 1999), cert. denied, 528 U.S. 1117 (2000), is in accord. <a href="#3a">Return to article</a>

<a name="4">4</a> Section 1129(d) states: "Notwithstanding any other provision of this section, 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 or the avoidance of the application of §5 of the Securities Act of 1933. In any hearing under this subsection, the governmental unit has the burden of proof on the issue of avoidance." <a href="#4a">Return to article</a>

<a name="5">5</a> See In re Rath Packing Co., 55 B.R. 528 (Bankr. N.D. Iowa 1985) (holding that §1129(d) should be strictly construed to impose on the governmental unit an obligation to prove that the most important purpose of the plan is tax avoidance). <a href="#5a">Return to article</a>

Journal Authors

Jeffrey Kurtzman

Journal Date

Thursday, July 1, 2004 - 12:00

Bankruptcy Rule

2004