Rewriting a Debtors Tax Obligation Under the Code

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Jul/Aug 1999

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Who would have thought it was possible? If a debtor does not like its tax obligations, it can ask

the bankruptcy court to go back and retroactively change those tax bills. There is only one

requirement for the debtor to take advantage of this extraordinary remedy provided under the

Code: It must have done nothing to contest the tax bills. Section 505 is very powerful, and

practitioners would be wise to include it in their arsenal when handling a bankruptcy case with

significant tax claims.

<h3>Section 505(a)</h3>

Section 505(a)<a href="#1" name="1a">1</a> provides a broad grant of jurisdiction to the bankruptcy court to determine

the amount of any tax due from the debtor in the same forum addressing the debtor's overall

financial condition, allowing the prompt resolution of a debtor's tax liability where that

liability has not yet been adjudicated prior to the bankruptcy proceeding. Section 505(a) is

available to all debtors under the Code,<a href="#2" name="2a">2</a> including chapter 13.

In short, a debtor, as representative of the bankruptcy estate, is allowed to contest tax debts in

the bankruptcy court even though its prior inaction would bar it from contesting them

elsewhere. This remedy is permitted on the ground that taxes, with their special priority in a

bankruptcy case, pose a special problem for creditors, and creditors should not be prejudiced

by a debtor's inaction. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Ledgemere Land Corp., 135 B.R. 193 (Bankr. D. Mass. 1991)</a>. See

The broad jurisdictional grant under §505 does have some limitations, however. The

bankruptcy court may not liquidate a tax liability that has already been adjudicated by a

tribunal of competent jurisdiction before the bankruptcy petition is filed. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C.

§505(a)(2)(A)</a>.<a href="#4" name="4a">4</a> If litigation relating to a tax obligation is pending in another tribunal when

the bankruptcy petition is filed and no decision has yet been rendered, that proceeding would be

stayed, and the bankruptcy court could technically hear the matter. (Generally, a more

practical resolution is to modify the automatic say so that the prior case can be completed).

Further, §505 provides that a bankruptcy court may (not must) determine a debtor's tax

liability. In some situations, bankruptcy courts have declined to adjudicate a debtor's tax

liabilities in spite of their unquestioned jurisdiction to do so. The most frequently cited reasons

for abstention are: (i) situations where uniformity of assessment is of significant importance,

and (ii) circumstances where judicial economies come into play.

There are a number of factors that may be considered by a court when deciding whether to

undertake a §505 review. These factors include the complexity of the tax issues to be decided,

the need to administer the bankruptcy case in an orderly and efficient manner, the burden on the bankruptcy court's docket, the length of time required for trial

and decision, the asset and liability structure of the debtor, and the prejudice to the debtor and

potential prejudice to the taxing authority.<a href="#5" name="5a">5</a>

Cases that have dealt with the assessment of real estate taxes have raised interesting issues

resulting in decisions that reinforce the power of §505. In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Ledgemere Land Corp., 135

B.R. 193 (Bankr. D. Mass. 1991)</a>, the court was confronted with the issues of whether, under

§505, a bankruptcy court may adjudicate local real estate taxes assessed against a debtor where:

(1) no abatement application has been filed with the town and the time for filing the application

has lapsed; (2) an abatement application has been either granted or denied without a hearing,

and the debtor has taken no appeal; or (3) refunds are sought for real estate taxes paid but no

request for a refund has first been made to the town. Hon. James Queenan determined that since

the taxes were never contested, and therefore not adjudicated, the bankruptcy court could

determine the appropriateness of the tax assessments under §505. Judge Queenan noted that the

reason for the broad treatment under §505 was to prevent creditors from being prejudiced by a

debtor's failure, for whatever reason, to contest assessed taxes. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… B.R. at 196</a>.

In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Fairchild Aircraft Corp., 124 B.R. 488, 492 (Bankr. W.D. Tex. 1991)</a>, the taxing

authorities contended that the bankruptcy court could not adjust property values under

§505(a) because the valuation process had been handled by an appraisal district that did not

itself set, assess or levy property taxes. The court stated:

<blockquote>Simple logic demonstrates that property tax valuation is in fact a two-part process,

consisting of both valuation and tax rate adjustment. That the state authorities have

delegated these functions to two different agencies does not alter the fact that both

functions make up the single task of determining the amount and legality of a given tax. In

fact, only rarely do taxpayers individually contest the rates of taxation. More frequently,

they attack the valuation of their property. The use of §505 to, in effect, remove only

that valuation adjudication stage to the bankruptcy court is entirely consistent with the

intended function of that section and does not undermine the state property taxation

process.</blockquote>

<h3>Procedure</h3>

A proceeding under §505 is considered a proceeding to obtain a declaratory judgment<a href="#7" name="7a">7</a> and is an

adversary proceeding governed by the rules within Part VII of the Bankruptcy Rules. See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Am.

Jur. 2d Bankruptcy §579 (1991)</a>; <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=…. 7001(9)</a>. Generally, a debtor or trustee should

file a complaint under §505. However, there is authority to suggest that other creditors in a

bankruptcy proceeding can bring such an action. See, e.g., <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Major Dynamics, 14 B.R. 969 (Bankr. S.D. Cal. 1981)</a> (creditors' committee filed adversary proceeding for determination of

tax liability); see, also, Annotation, "Jurisdiction of Bankruptcy Court to Determine Tax

Liability of Individuals or Entities Other than the Debtor Under <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. Section 505(a)," 97 A.L.R. FED. 160 (1990)</a>; <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Ledgemere Land Corp., 135 B.R. 193 (Bankr. D. Mass. 1991)</a>.

<h3>Conclusion</h3>

Although a bankruptcy court is not required to determine the amount of a debtor's tax liability,

it has the power to do so under certain circumstances. Accordingly, if a debtor has significant

federal, state or municipal tax obligations and has not fully objected to or adjudicated the

propriety of those obligations, it would be wise to file a complaint under §505 in the debtor's

bankruptcy case. The §505 complaint could result in a substantial reduction in the tax

obligations, benefiting the debtor and its creditors.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Section 505. Determination of Tax Liability:

<blockquote>(a)(1) Except as provided in Paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to

tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent

jurisdiction.

<blockquote>(2) The court may not so determine—

(A) The amount or legality of tax, fine, penalty, or addition to tax if such amount or legality was contested before and adjudicated by a judicial or administrative tribunal of

competent jurisdiction before the commencement of the case under this title or

(B) Any right of the estate to a tax refund, before the earlier of—(i) 120 days after the trustee properly requests such refund from the governmental unit from which such refund is

claimed; or (ii) a determination by such governmental unit of such request.</blockquote></blockquote>

<a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §505(a) (1988)</a>, as amended. <a href="#1a">Return to article</a>

<a name="2">2</a> See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Poiroux, 167 B. R. 980 (Bankr. S.D. Ala. 1994)</a> (chapter 13 debtors are not precluded from attempting to litigate their tax liability in bankruptcy court, despite their

having executed an IRS form that waived their right to contest amount assessed until they had paid the amount the IRS claimed, where <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §505(a)</a> allows debtors to treat

bankruptcy court as a pre-payment forum and to litigate taxes that have been assessed but remain unpaid without first paying the amount of tax due in full and seeking refund). <a href="#2a">Return to article</a>

<a name="3">3</a> See, also, H.R. Rep. No. 595, 95th Cong. 1st Sess. 356 (1977). <a href="#3a">Return to article</a>

<a name="4">4</a> See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Teal, 16 F.3d 619 (5th Cir. 1994)</a> (bankruptcy court lacked jurisdiction to entertain claims regarding chapter 7 debtors' 1979 tax year liabilities, where the debtor had

full and fair opportunity to contest assessed penalties in tax court litigation). <a href="#4a">Return to article</a>

<a name="5">5</a> See, e.g., <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Galvano, 116 B.R. 367, 372 (E.D.N.Y. 1990)</a> (citations omitted) (court referred the matter disputing sales and use taxes for adjudication in tax court because the

debtor was not inactive or disinterested and had few creditors other than federal and state taxing authorities. The court determined that the impetus for bankruptcy filing was the

dissatisfaction with the decision of the tax bureau rather than the preservation of the estate). See, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Fairchild Aircraft Corp., 124 B.R. 488 (Bankr. W.D. Tex. 1991)</a>; <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=…

re Diez, 45 B.R. 137 (Bankr. S.D. Fla. 1984)</a>; <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Hunt, 95 B.R. 442 (Bankr. N.D. Tex. 1989)</a> (the possibility that related taxpayers would take different positions in the tax

court from those asserted in the bankruptcy court caused the court to refer adjudication to the tax court); <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Huddleston, 107 B.R. 102 (Bankr. E.D. La. 1989)</a> (court

determined that referring adjudication of a bankrupt taxpayer to tax court, where case was already pending, was in the interest of judicial economy and did not prejudice the

course of bankruptcy proceedings). <a href="#5a">Return to article</a>

<a name="6">6</a> See, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… of Amarillo v. Eakens, 399 F.2d 541, 544 (5th Cir. 1968), cert. denied, 393 U.S. 1051, 89 S.Ct. 688, 21 L.Ed.2d 692 (1969)</a> (affirming

bankruptcy referee's determination of tax liability via reconsideration of the valuation of the property taxed). <a href="#6a">Return to article</a>

<a name="7">7</a> Proceedings under §505 of the Code, relating to tax determinations, and under <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §1146</a>, setting forth special state and local tax provisions for

chapter 11 cases, are, along with actions brought under <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Revenue Code §7428</a>, excluded from the statutory provision that in a case of actual

controversy within its jurisdiction, any court of the United States, upon the filing of an appropriate pleading, may declare the rights and other legal relations

of any interested party seeing such declaration, whether or not further relief is or could be sought. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C.A. §2201(a)</a>. This exclusion was added to

§2201(a) by the <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Reform Act of 1978 (P.L. 95-598, Title II §249, 92 Stat. 2672</a>). See, generally, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Am. Jur. 2d Bankruptcy §579 (1991)</a>. <a href="#7a">Return to article</a>

Journal Authors

Daniel W. Sklar

Jo Ann J. Brighton

Journal Date

Thursday, July 1, 1999 - 12:00