Section 505 of the Bankruptcy Code allows trustees of debtor companies the opportunity to have a bankruptcy court potentially determine the amount of all tax liabilities during the course of a bankruptcy case. Section 505(b) also enables trustees to accelerate the resolution of tax issues, bring certainty in the amount of tax the estate may owe and close the of statute of limitations years ahead of schedule. Perhaps the most important advantage of using this provision is that it could eliminate any lingering trustee, officer and director liability in an expedited fashion. The benefits available under § 505(b) should encourage trustees and others to consider using this rather straightforward procedure in the administration of bankruptcy cases.
Section 505(b) permits a trustee to request prompt determination of tax liability from tax authorities. Specifically, under that subsection if a trustee (1) files a tax return, (2) pays the tax shown on that return and (3) requests a prompt determination of the liability, then the tax authority must decide within 60 days from the receipt of a request if they will conduct a review (i.e., audit) of that recently-filed tax return. If the taxing authority reviews the return, then the audit must be completed within 180 days of when the request was received, otherwise the tax paid with that return is final (a bankruptcy court judge overseeing the case does have discretion to grant additional time for the review). This procedure will not protect the debtor from additional taxes, interest, and penalties if a fraudulent tax return was filed.
The Internal Revenue Service (IRS) has established a formal procedure that must be strictly followed in order for a request for prompt determination to be valid.[1] For example, an exact copy of the filed tax return must be sent to the Centralized Insolvency Operation in Philadelphia, along with a letter that contains specific information and is signed under penalties of perjury. Many states also have similarly prescribed procedures that must be respected, in order to start the 60- or 180-day clock running.
The normal statute of limitations period for federal income taxes is three years (if there is no fraud or a significant understatement of income), which may well be beyond the period of when a reorganization or liquidation plan is confirmed and becomes effective. However, within a matter of months, tax issues and liabilities can be reviewed and finalized using the § 505(b) procedures.
Resolving tax issues in an accelerated timeframe may also give a debtor the ability to better defend its issues with tax authorities. Records and those familiar with transactions are more readily available if these matters are reviewed shortly after tax returns are filed rather than years later. Moreover, once the statute of limitation is closed, then voluminous records and other data can usually be discarded, eliminating the need to retain unneeded business records.
A request for prompt determination under § 505(b) can be used to determine tax liabilities, not only for federal income taxes, but also for state and local income as well as non-income taxes. This procedure is particularly desirable for so-called trust-fund taxes, such as sales, use and payroll taxes, which carry trustee, officer and director liability in most states. Having finality of trust-fund taxes will provide comfort that there are no lingering issues that could be raised by tax authorities years later, perhaps when all of the assets have been distributed and the debtor has been dissolved. Some non-trust-fund state taxes also carry responsible person liability (e.g., the Michigan Business Tax), so the use of this procedure can bring closure to those tax liabilities as well.
The request for prompt determination of state taxes can be fairly simple once a state’s procedures are known. For example, for sales/use tax returns, a letter containing the appropriate taxpayer information with a citation to § 505(b) should be attached to each return filed monthly, which starts the 60-day period that a taxing jurisdiction has to notify the taxpayer (debtor) that they will review the tax amount. It is unusual for a debtor to receive any response from the state, although, some jurisdictions will send a form letter indicating they have accepted the tax reported. Once 60 days have elapsed, the tax liability is final.
There are limitations on the use of this procedure to determine some tax liabilities. In particular, this process may not be used to accelerate a review of a tax-refund claim, and it cannot be used for partnership tax returns. A strict reading of § 505(b) suggests that it is limited only to the determination of any unpaid tax liability, so it may not apply to tax refunds since those taxes were already paid. Regarding partnership returns, the IRS has previously taken the position that such tax returns (Form 1065) are information returns only and any tax liability would actually be reported on a partner’s tax return (Forms 1040, 1120, etc). Since § 505(b) only allows the “trustee to request a determination of any unpaid liability of the estate,” it would not apply to information returns, since there are no tax amounts reported on those returns.
During the course of the tax return review/audit, if the taxing authority asserts that additional tax is due, the debtor has the option of requesting a bankruptcy court judge, pursuant to § 505(a), to review the tax deficiency and determine the proper amount of tax liability. Under that section, a judge has discretion on whether he or she will hear the matter. If the judge elects not to consider the request, then the taxpayer (debtor) will use the federal or state governments’ normal appeals process to resolve any disagreements. Unfortunately, the normal appeals procedures could take months, or even years, to resolve.
On its face, the advantages of § 505(b) appear to be limited as to the determination of tax liabilities incurred from the filing of the bankruptcy petition to the date that a liquidation or reorganization plan is confirmed and becomes effective. However, if a bankruptcy court retains jurisdiction during the liquidation of an estate, then § 505(b) may also be available for tax periods beyond the effective date, which could provide trustees and others even more reason to utilize this process.
The benefits of requesting prompt determination of tax liabilities under § 505(b) are numerous. Trustees should seriously consider using this fairly straightforward procedure to not only finalize the amount of taxes that are due, but also to shorten the statute of limitation periods for federal, state and local tax liabilities, and eliminate potential ongoing personal liability.