The Incredible Expanding 1146(c)

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Dec/Jan 2002

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Section 1146(c), in its own way, is a modest example of the "unfunded mandates"
that were a topic of such concern in the 1980s. It states that the "making or
delivery of an instrument of transfer under a plan confirmed under §1129" may not
be taxed under any law imposing a "stamp tax or similar tax." The section is not,
of course, confined on its face to state and local taxes, but since the federal
government does not impose such taxes, it only affects non-federal entities. Thus,
in its wisdom, the federal government chooses to give debtors with a confirmed plan
a small benefit from the coffers of state and local governments.

While perhaps mildly annoying, the section has not been thought to be a major
problem. The amount at stake in a given case is usually relatively small, both
because stamp taxes are generally only in the range of 1 percent of the transaction
amount and because the language appears to deal with only that limited number of
transfers that are actually made at the time of plan confirmation. Since the vast
majority of cases do not confirm a plan, most bankruptcy transfers would not be
affected. That assumption, though, has been challenged in a number of recent cases
that seek to take a far greater bite from state taxpayers by expanding the exception,
both as to the character of the taxes and the number of transactions covered.

This would be objectionable enough if the issues were clearly presented, but that
doesn't always happen. Such motions are often made without a listing of the property
being transferred, so tax authorities do not know if they are affected. Even more
problematic is a growing practice by which the motion refers to §1146, but the
debtor's proposed order includes a broader exemption. For instance, in Kmart's sale
motion concerning its "e-commerce assets," the motion referred to "stamp taxes and
similar taxes," but the proposed order also referenced "sales and transfer taxes."
Section 1146, of course, does not even refer to "transfer" taxes, much less
"sales" taxes, so a party that merely read the motion would have no notice that an
order might be entered that would bar collection of such taxes. Similarly, in GST
Telecom, the motion sought to avoid taxes "under any law imposing a stamp or similar
tax," but the proposed order stated that the transfer "shall not be taxed under
any...law imposing or claiming to impose a stamp tax or a sale, transfer or other
similar tax on any of the debtor's transfers or sales...." (emphasis added.) The
number of cases in which these stealth orders have been appearing argues against this
being merely an inadvertent drafting issue.

Those vastly expanded exemptions, which include sales, capital gains or use taxes,
could exempt not only 1 percent of the sales prices, but 5, 10, 20 percent
or more, which are amounts states cannot afford to forego in these difficult budget
times. After these orders began to appear, a number of states became increasingly
vigilant in challenging them. Just as they have put debtors on notice that they will
contest orders broadly exempting going-out-of-business sales from state law regulation,
so too they have been working together to make a concerted effort to catch these
§1146 stealth orders. In addition, they are also filing substantive oppositions
to the more straightforward attempts to expand §1146.

On the merits, the states believe there is a strong case to be made against both
ways of expanding §1146. The easier attack is on the attempts to expand the scope
of the tax that is covered, and courts have generally agreed with the states when
they have raised timely objections. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re 995 Fifth Avenue Associates
L.P., 963 F.2d 503, 511 (2nd Cir. 1992)</a>, for instance, the
court held that a sale was not exempt from a 10 percent tax imposed under New York
state law on gains derived from real property transfer. An essential element of
§1146(c) taxes, the court held, is that they used a low tax rate—typically one
percent or less. Two recent cases from Delaware took the same position. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
GST Telecom Inc., 2002 WL 442233</a>, slip op. p. 3 (D. Del.
2002), the court held that Washington's 6.5 percent sales, or use, tax was
not a stamp tax since such taxes rarely exceed about 1 percent, and later used the
same reasoning in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re GST Telecom Inc., 2002 WL 1737445 (D. Del.
2002)</a>, to hold that California's 4.75 percent sales tax also was not a
"stamp" tax. The same view has been expressed in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Partnership v. Director
Revenue, 70 B.R. 696, 697-698 (Bankr. D. Del. 1987)</a>, and

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re CCA Partnership, 72 B.R. 765, 767 (D.Del. 1987)</a>,
aff'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 303 (3rd Cir. 1987)</a>.

In short, this issue is one that states are not likely to lose—so long as they
are willing to come into bankruptcy court to litigate the issue. Debtors have not
been loath to write these overly broad orders in the apparent hope that the states
will not wish to lose their immunity and will not object to them. It has not been
uncommon for courts to hold that a state can be placed in a "Catch 22" position
without any violation of the Eleventh Amendment. The state can remain out of the
case and have the federal court enter an overly broad default order that will
nevertheless have binding, res judicata consequences; or it can come into the federal
court and thereby waive its immunity. (Just how broadly such a waiver extends, no
one quite knows.) The Fourth Circuit endorsed the view that states could be forced
into this Hobson's choice in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Maryland v. Antonelli Creditors' Liquidating
Trust, 123 F.3d 777, 786-787 (4th Cir. 1997)</a>, itself a
§1146 case, in the course of which it held that the state could be bound by an
order that violated the Code, and must waive its immunity in order to raise that
issue.<a href="#2" name="2a">2</a>

However, the Supreme Court recently held in the case of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Carolina State
Ports Authority, 122 S. Ct. 1864, 1876 (2002)</a>, that states cannot
be forced into making such a choice. Where the state's only options are to refuse
to appear and be bound by the order, or to appear and waive its immunity so a
binding order can be entered against it, the court held that the state had been
coerced to appear. The states submit that the same analysis applies here. One cannot
obtain a binding order and then explain it away as merely "declaring" something about
the meaning of the Code. Declaratory judgments are as much subject to the Eleventh
Amendment as any other judgment,<a href="#3" name="3a">3</a> and the entry of binding judgments is precisely
what the judicial power is for. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. v. Shaw, 309 U.S. 495, (1940)</a>
("The suggestion that the order...is in reality not a judgment but only a 'judicial
ascertainment' of credits does not affect our conclusion. No judgment...is more than
that."). If their judgment is not meant to have a binding effect, then it is
merely an advisory opinion, which no federal court has the power to issue. See,
e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Pattullo, 271 F.3d 898, 901-902 (9th Cir.
2001)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Surfactants and Specialties L.P. v. C.I.R., 249
F.3d 175, 181 (3rd Cir. 2001)</a> (court could not "declare" meaning of
statutes that might never be dispositive; until a decision would have a binding
effect, any views expressed on the meaning of the law would be advisory opinion).

Nevertheless, the states still must confront decisions such as <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Linc Capitol
Inc., 280 B.R. 640 (Bankr. N.D. Ill. 2002)</a>, in which the court
held that it could simultaneously opine about whether §1146 applied to
pre-confirmation transfers, but that the state could not argue about whether its taxes
were covered by the section without filing an adversary action and submitting itself to
the court's jurisdiction.<a href="#4" name="4a">4</a> On the other hand, the court in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Automation
Solutions International LLC, 274 B.R. 527 (Bankr. N.D. Cal.
2002)</a>, took a markedly different approach in red-penciling the debtor's proposed
sales order, which included a provision declaring that the tax did not apply to
preconfirmation transactions. The court noted that it was not in the business of
entering comfort orders and that to do so would be futile in any event, since the
failure to properly serve the motion, as for an adversary proceeding, would preclude
it from being binding on the taxing authorities in any event.

The states face a greater problem with respect to the other branch of cases—whether
transfers that do not occur in connection with a plan confirmation should also be
covered by this section. The quintessential case in this regard was <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Circuit
Court for Anne Arundel County v. NVR Homes Inc., 222 B.R. 514
(E.D. Va. 1998), reversed, 189 F.3d 442 (4th Cir 1999)</a>.
The debtor, a home builder, was in bankruptcy for some 18 months, during which
time it sold houses in the ordinary course of business and paid recording taxes. When
it proposed its plan, it asserted that all of those sales were made "under a plan
confirmed" because it wouldn't have been able to get to a plan unless it had stayed
in business and sold homes. Thus, since it needed to stay in business to confirm
a plan, any sales that assisted in that goal were under a "plan confirmed."<a href="#5" name="5a">5</a> The
district court found that argument to be persuasive, and the same reasoning has been
used in other cases, such as <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Permar Provisions Inc., 79 B.R. 530
(Bankr. E.D.N.Y. 1987)</a>, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hechinger Investment Co. of Delaware
Inc., 276 B.R. 43, 47 (D. Del., March 18, 2002)</a> ("appropriate
reading of §1146(c) would require only that a plan be ultimately confirmed. Thus,
it is the fact of plan confirmation, rather than its timing, that is critical"),
and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Telecom, supra.</a>

In some of those cases, the argument was made that the sale needed to be made
quickly to preserve the maximum value for the estate, and that waiting until
confirmation would take too long. This was the court's rationale in GST, where it
treated the assets of a failed telecom as a wasting asset. And there is little doubt
that the early sale allowed creditors to receive more for largely worthless assets than
they would have received if the sale were delayed. The problem with this reasoning,
though, is that it suggests that multi-million dollar deals would founder if the
debtor is required to pay a 1 percent recording tax to complete them. By the very
nature of the §1146 taxes, it is obvious that the exemption can only have the
most trivial effect on the viability of a transaction. While there are many vociferous
debates over the effect of a 20 or 25 percent capital gains tax, can anyone
seriously suggest that a deal will rise or fall based on whether a stamp tax has to
be paid? The fact is that this is a trivial benefit for debtors, and, precisely
because it has only a minimal effect, there is no need to engage in legal gymnastics
to try to expand the scope of the exception. Quick sales may be necessary to
facilitate confirmation, but if so, they will take place with or without this modest
tax windfall.

To be sure, a debtor and its creditors would always prefer not to pay tax—but if
Congress had meant to exempt all sales during the case, or even all sales that
helped to reach confirmation, there surely were more straightforward ways of saying so.
Even the courts that rely on the "necessity" of the transfers to justify exempting
pre-confirmation sales are sensitive to an obvious counter: What if the plan doesn't
confirm? Even if an eventual confirmation can retroactively bless transfers that were
made before the plan was even a gleam in the debtor's eye, what if the case later
crashes and burns (as most do)? Surely the debtor is not entitled to the exemption
then, but what are the alternatives?

The government could try to collect the tax from the debtor after the case converts
to chapter 7 or is dismissed, but this is hardly practical. A debtor that cannot
confirm a plan is often administratively insolvent. If so, will the court let the
government collect in full while other creditors can clearly see that they will get
little or nothing? (Even assuming there is enough to pay the tax in full?)
Possibly, but taxing authorities are understandably wary of relying on that route. To
their credit, the Delaware courts have begun requiring the debtor to escrow funds
sufficient to pay the taxes as a condition of allowing such sales to be treated as
exempt. But this "solution" raises as many questions as it answers. Who should hold
such an escrow? Is the government entitled to interest on the taxes withheld? Can
the debtor treat the escrow as cash collateral and use it if it provides adequate
protection? The Code, of course, has no answers or insights on these issues.

In addition, courts taking this view often try to limit their holding to transfers
that are "essential" or "necessary" to reach confirmation. Yet, as the Hechinger court
noted, §1146 has no such limitations as to transfers made pursuant to a confirmed
plan. Thus, to justify excepting transactions that do not take place under a plan,
the court must invent a new limitation that is not contained in §1146. Moreover,
in imposing this extra-statutory limitation, courts again face many new issues: Should
the standard be whether the transfer is necessary for confirmation? Or merely helpful?
(Will a court ever concede that it is approving a §363 sale that is not helpful,
indeed not essential, to the case?) What level of proof is needed? Who bears the
burden of proof? And what evidence is relevant? Again, there is no easy answer
to such questions, since the courts must answer them without guidance from any language
in the Code.

The Fourth Circuit recently analyzed the issue in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re NVR L.P., 189
F.3d 442 (4th Cir. 1999)</a>, and emphatically rejected the broad
interpretation espoused above:

<blockquote>
We must conclude that Congress, by its plain language, intended to provide
exemptions only to those transfers reviewed and confirmed by the court. Congress
struck a most reasonable balance. If a debtor is able to develop a chapter
11 reorganization and obtain confirmation, then the debtor is to be afforded
relief from certain taxation to facilitate the implementation of the reorganization
plan. Before a debtor reaches this point, however, the state and local tax
systems may not be subjected to federal interference. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 458</a>.
</blockquote>

Its decision contains a detailed analysis of prior case law, particularly from the
Second Circuit, that is often relied on as supporting the broad view, and explains
why those cases are not inconsistent with the plain language reading of the statute.
Tax exemptions are, in general, to be narrowly construed—a principle that applies even
in bankruptcy. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… State Board of Equalization v. Sierra Summit Inc.,

490 U.S. 844, 851-52 (1989)</a> ("Although Congress can confer an
immunity from state taxation...a court must proceed carefully when asked to recognize
an exemption from state taxation that Congress has not clearly expressed"). Yet
here, the courts have adopted an ever-more elaborate structure to justify a broad
tax exemption. Such structures often collapse under their own weight when they cannot
find a clear base in the language of the Code. The states respectfully suggest that
there is no need to read §1146 as giving anything more than what it says on
its face—a moderate reward for those who cross the finish line and confirm a plan.
Like a box of Cracker Jacks, there's only one prize per box!

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The views expressed herein are solely those of the author and should not be attributed to any Attorney General or member of their staff. <a href="#1a">Return to article</a>

<a name="2">2</a> The opinion purports not to decide the statutory issue, although the court made clear that it doubted there was a violation. However,
it made equally clear that it would allow the state to be bound even if it were convinced that the state's view of §1146 was correct. <a href="#2a">Return to article</a>

<a name="3">3</a> "[S]overeign immunity applies regardless of whether a...suit is for monetary damages or some other type of relief." Ibid. <a href="#3a">Return to article</a>

<a name="4">4</a> The conclusion that §1146 applied "was not made pursuant to an exercise of jurisdiction over the state; rather, it was entered pursuant
to jurisdiction over the debtor and sale of its property," but in raising issues about its taxes, "the state has not identified a concrete
controversy between it and Linc Capitol with regard to the exemption possible under §1146(c) and has not presented a particular tax issue
for determination. Moreover, a declaratory ruling must be sought by adversary complaint." Why declaration of the meaning of the law did not
equally require a "concrete controversy" by the debtor and the existence of an adversary party are interesting questions that the opinion does
not answer. <a href="#4a">Return to article</a>

<a name="5">5</a> "The business conducted during this...period is essential to the success of both the plan of reorganization and the debtor's emergence
from bankruptcy.... These transfers...enabled NVR to remain a viable operation and avoid liquidation." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 518-519</a>. <a href="#5a">Return to article</a>

Journal Authors

Karen Cordry

Journal Date

Sunday, December 1, 2002 - 12:00

Bankruptcy Rule

2002