When Will a Bankruptcy Court Hear a Tax Claim?

Despite lingering questions concerning the scope of a bankruptcy court’s jurisdiction in the wake of Supreme Court decisions in Stern v. Marshall[1] and Wellness Int’l Network, Ltd., et al v. Sharif,[2] the Bankruptcy Code has consistently been interpreted to confer the authority to determine tax questions on bankruptcy courts. Bankruptcy Code §§ 501 and 502[3] allow the bankruptcy court to estimate and determine the allowability of claims (including tax claims) against a bankruptcy estate. Additionally, § 505(a)[4] provides a broad grant of jurisdiction upon the bankruptcy court to determine the tax liability of a debtor or bankruptcy estate. But while § 505(a)(1) might lead many to believe that a debtor with a tax dispute could select the bankruptcy court as their chosen in which forum to litigate (as opposed to the traditional choices of tax court, district court or the court of federal claims), limitations on the bankruptcy court’s reach do exist.

Statutory Limitations

For example, § 505(a)(2)(A) prohibits a bankruptcy court from determining tax issues adjudicated prepetition by a court of competent jurisdiction. Additionally, § 505(a)(2)(C) was added to the Bankruptcy Code as part of BAPCPA and forbids a bankruptcy court from re-determining any ad valorem tax for debtors who did not object to the tax prior to the expiration of the applicable objection period under nonbankruptcy law.

As such, in In re Village at Oakwell Farms Ltd.,[5] the bankruptcy court held that it was required to abstain from hearing the debtor’s tax dispute by virtue of § 505(a)(2)(C). There, the debtor-taxpayer challenged the local taxing authority’s allegedly inflated valuation of an apartment building “good for little more than razing.”[6] The bankruptcy court initially found that it was not barred from hearing the challenge under § 505(a)(2)(A) because as of the petition date, the determination made by the taxing authority had not become final under Texas state law. The court went on to explain, however, that under § 505(a)(2)(C), the court lost the ability to re-determine the debtor’s property tax liability under Texas law for the year of the petition filing because the debtor had not sought re-determination of the tax prior to the expiration date for filing an action in state court.

However, in In re Ange,[7] the bankruptcy court held that § 505(a)(2)(C) does not prevent a bankruptcy court from determining the amount of a tax claim, including tax claims that are ad valorem in nature. The bankruptcy court in this case reasoned that it was not determining the amount or legality of the amount arising in connection with an ad valorem tax, which the court agreed was proscribed by § 505(a)(2)(C). Rather, the court found that it had been asked to determine the allowed amount and treatment of a tax claim, a request squarely within the court’s jurisdiction.

Perhaps the most important potential limitation, though, lies in the fact that bankruptcy courts have regularly construed the use of the word “may” in § 505(a)(1) to indicate that exercise of jurisdiction under the statute is discretionary, and in the proper case, allows a bankruptcy court to abstain from making any determination of tax liability.

General Factors

So what factors should a debtor with a tax dispute consider when attempting to discern whether the bankruptcy court will hear their contest? In formulating a decision to abstain from making a tax determination, courts examine the issue on a case-by-case basis. In each instance, the court must balance the dual purposes of § 505 — namely, the bankruptcy court’s need to administer the bankruptcy case in an orderly and efficient manner, and the need to provide an opportunity to the trustee, on behalf of the estate and its creditors, to contest the validity and amount of a tax claim where the debtor has been unwilling or unable to do so.

Other nonexhaustive factors include whether bankruptcy issues predominate, the complexity of the tax issues to be decided, the asset and liability structure of the debtor, the length of time required for trial and decision, judicial economy and efficiency, the burden on the bankruptcy court’s docket, the availability of an alternative forum, the prejudice to the debtor and the potential prejudice to the taxing authority resulting from inconsistent assessments.[8]

Chapter 7 No-Asset Cases

The decision to abstain has most often been seen in no-asset chapter 7 cases where no purpose of the bankruptcy estate would be served by the bankruptcy court hearing a tax dispute. For example, in Dees v. United States (In re Dees),[9] the court chose to abstain from hearing a tax dispute in a fully administered no-asset chapter 7 case that was reopened for the sole purpose of contesting the debtors’ potential tax liability. The debtors there had challenged the validity of agreements executed on the debtors’ behalf to extend the statute of limitations for assessment of the taxes in question. The court reasoned that if the extension agreements were found to be valid, the taxes would be assessable and therefore nondischargable, and alternatively, if the agreements were found to be void, the associated taxes would not be assessable and the debtors would have no tax liability. Since the rights of creditors and the administration of the case would not be affected, the court found little justification to exercise its power under § 505. Similarly, in Cunningham v. Georgia Dept. of Revenue (In re Cunningham),[10] the bankruptcy court explained that its decision to abstain rested on grounds that, due to the no-asset nature of the case, there would be no distribution to creditors and no bankruptcy purpose would be served by the bankruptcy court exercising its jurisdiction over the tax dispute in question.

Again, one of Congress’s primary justifications for including § 505 in the Bankruptcy Code was to allow the bankruptcy court to step in and decide a tax issue when the quick resolution of a bankruptcy case is necessary for reorganization or distribution to occur. In a no-asset chapter 7 case, however, reorganization and distribution are not the ultimate goals, and any tax litigation will generally have no bearing on any (nonexistent) dividend to unsecured creditors. Accordingly, absent some uniquely compelling circumstance such as lack of any alternative forum,[11] a considerable line of jurisprudence exists to support abstention in no-asset chapter 7 cases.

Abstention in Chapter 11 Cases

But what about cases filed under a different chapter? Does a chapter 11 debtor with a tax dispute fare any differently when contesting their tax liability in bankruptcy court? At first blush, a recently decided case out of Delaware would appear to resolve that question in the negative. In the case of In re Altegrity, Inc., et al.,[12] a corporate debtor sought determination of its liability for corporate income taxes owed to the state of Oklahoma. During the relevant tax periods, The Official Information Company (TOIC) owned 100 percent of HireRight and included HireRight in its Oklahoma consolidated corporate income tax return. HireRight sold 100 percent of its outstanding membership interest in Explore Information Services, LLC, triggering a federal taxable gain. Explore was a single-member limited liability company and a disregarded entity for tax purposes, with its headquarters located in Minnesota and no employees located in Oklahoma. On the Oklahoma tax return in question, TOIC excluded the aforementioned gain in calculating its taxable income. TOIC believed the gain was nonunitary income that should be allocated away from Oklahoma since Explore’s business was separate from the business run by HireRight and Explore was not domiciled in Oklahoma. The Oklahoma Tax Commission disagreed and issued a proposed assessment of additional tax in the amount of $17 million plus penalties and interest in the amount of $1.7 million.

TOIC and HireRight filed a protest with the Oklahoma Tax Commission arguing that the gain was properly allocable outside of Oklahoma. Alternatively, TOIC and HireRight asserted that even if the gain were to be considered apportionable income, TOIC should have been entitled to a deduction from its Oklahoma taxable income for the amount of the gain because it was a qualifying gain under Okla. Stat. tit. 68 § 2358(D)(1).[13] Finally, TOIC and HireRight argued that Okla. Stat. titl. 68 § 2358(D)(2)(a)[14] was unconstitutional because it limited the availability of the deduction to transactions involving Oklahoma companies.

While the tax dispute was pending before the Oklahoma Tax Commission, TOIC and HireRight filed voluntary chapter 11 petitions. The Oklahoma Tax Commission filed a proof of claim against TOIC, prompting the debtors to file a motion with the bankruptcy court for determination of their Oklahoma state income tax liability. The debtors argued that the bankruptcy court would be able to determine their tax liability in a streamlined manner unavailable in the Oklahoma system since the bankruptcy court had the power to determine the constitutionality of the relevant statute as an initial matter while the Oklahoma Tax Commission could not. Such an argument would seem to fall under the aforementioned “uniquely compelling circumstance” absent in most no-asset chapter 7 cases. The bankruptcy court, however, disagreed and chose to abstain from hearing the tax dispute.

Citing the purposes behind the promulgation of § 505, the court reasoned that exercising its jurisdiction was unnecessary to protect creditors from dissipation of estate assets due to an adverse tax determination that the debtors were unable or unwilling to contest since the debtors had been actively litigating the matter before the Oklahoma Tax Commission. Further, the bankruptcy court disagreed with the debtors’ argument that the bankruptcy court was better situated to efficiently adjudicate their constitutional challenge. Under the Supreme Court’s doctrine of constitutional avoidance, federal courts are required to decide questions of a constitutional nature only when absolutely necessary. Because dispositive, nonconstitutional-based defenses were potentially viable (i.e., if the debtors were correct that they had conducted a nonunitary business, then there would be no gain recognition in Oklahoma), the debtors’ proposed streamlined approach to resolving their tax dispute was without merit. Finally, the court cautioned against using § 505 as a vehicle to collaterally attack an adverse tax determination made in another nonbankruptcy forum.

What is relevant to note in the above case is that at the time that the debtors requested a determination of their tax liability from the bankruptcy court, a chapter 11 plan had been confirmed, the disputed claim had been provided for in the plan, and the plan had become effective. Accordingly, it seems as though the dominating determinative factor underlying a bankruptcy court’s decision to abstain is whether hearing the tax matter will somehow advance the bankruptcy proceeding through the court process. Debtors with tax controversies can predict, with a relatively high degree of certainty, that unless resolution of their tax dispute will have an effect on the bankruptcy estate, the bankruptcy court will exercise the permissive abstention granted to it by the language of § 505(a) and debtors would be better served by looking to more traditional forums for a determination.