Federal Income Taxes for a ‘Straddle Year’ Are Administrative Priority Claims

Reversing the bankruptcy court, a district judge in Delaware ruled that federal income taxes for a “straddle year” are administrative priority claims.

In his July 27 opinion, District Judge Richard G. Andrews said that the issue has not been decided by any appellate court.

The corporate debtor sold most of its assets before filing a chapter 11 petition in October 2015. After the case converted to chapter 7, the trustee filed the 2015 federal tax return in September 2016.

For the 2015 taxes, the IRS filed a proof of claim for about $850,000. The government conceded that all of the transactions giving rise to the taxes had occurred before bankruptcy. The IRS nonetheless claimed that the taxes were entitled to administrative priority under Section 503(b)(1)(B)(i).

Bifurcating the claim into prepetition and postpetition, the bankruptcy court sustained the trustee’s objection to administrative status because all of the transactions giving rise to the taxes had occurred before filing. The bankruptcy court also ruled that “straddle year” taxes were not entitled to the eighth priority under Section 507(a)(8) because the taxes were not for a taxable year ending before filing.

The IRS appealed and won.

Columbia Gas Points to the Result

Section 503(b)(1)(B)(i) grants administrative priority to the “actual and necessary costs and expenses of preserving the estate, including . . . any tax, incurred by the estate, whether secured or unsecured . . . .”

The trustee argued that the taxes were not “incurred by the estate” because the activities giving rise to the taxes all occurred before bankruptcy when there was no bankrupt estate. Under applicable nonbankruptcy law, namely the IRS Code, the IRS took the position that the 2015 taxes accrued on the last day of the year, when the debtor was in bankruptcy.

For “straddle year” taxes, the question is whether the taxes were “incurred by the estate.”

Judge Andrews agreed with the IRS. He held that “corporate federal income tax liability accrues and becomes a fixed liability on the last day of the tax period – here, December 31, 2015. Accordingly, the tax at issue in the IRS Claim was incurred by the estate post-petition and should be entitled to priority as an administrative expense.”

In large part, Judge Andrews inferred the result from the Third Circuit’s opinion in Ross v. West Virginia Department of Tax and Revenue (In re Columbia Gas Transmission Corp.), 37 F.3d 982 (3d Cir. 1994).

In Columbia Gas, the Third Circuit said that state property taxes would have administrative status depending on when the tax liability was incurred. The appeals court said that the “determination of when a state tax is incurred is governed by state law.” Id. at 984.

The Columbia Gas debtor filed the return in May, before bankruptcy, for the taxable year ending the prior December 31. The state assessed the tax after bankruptcy. Although not assessed until after bankruptcy, the Third Circuit held that the tax was not entitled to administrative priority because the tax was based on ownership of the property in the prior year.

Judge Andrews took Columbia Gas to mean that the court looks to federal tax law to decide when the tax is incurred. The “plain language” of the IRS Code, he said, means that federal corporate income tax liability accrues and becomes fixed on the last day of the year. He also observed that income taxes are imposed “for an entire year, not individual events.”

Because the debtor was in bankruptcy before the last day of the year, Judge Andrews ruled that the income taxes had administrative priority, even though the sale of assets before bankruptcy had given rise to the tax liability.

Judge Andrews was careful to mention that all federal taxes do not arise at the same time. He said that employment taxes are incurred when wages are paid and that excise taxes are incurred at the time of the “event.”