Supreme Court Rules on Treatment of Taxes Arising from Sale of Farm Assets During Chapter 12 Bankruptcies

By Hamid R. Rafatjoo and Rob L. Smith

On May 14, the Supreme Court ruled in Hall v. United States, 132 S. Ct. 1882, that capital gains taxes incurred by individuals who had filed bankruptcy under Chapter 12 of the bankruptcy code were not taxes “incurred by the estate” and were therefore non-dischargeable under section 1222(a)(2)(A) of the code. This ruling has significant impact on family farmers and fisherman who are contemplating filing for relief under Chapter 12.

Chapter 12 is designed to provide special debt relief to financially distressed family farmers and fishermen. The goal of Chapter 12 is to confirm a plan for the restructuring of the claims of creditors. Subject to certain exceptions, the plan must repay all or part of the Chapter 12 debtor’s debts to creditors through installments made over the course of three to five years. Chapter 12 is also more streamlined, less complicated and less expensive than filing under Chapter 11 of the bankruptcy code. The protection of the family farmer has been an important part of the bankruptcy code for a number of reasons, including the fact that a farmer’s place of business is also his home.

The Supreme Court’s ruling in Hall resolved a split between certain appellate courts in the United States regarding the applicability of section 1222(a)(2)(a) of the bankruptcy code to the tax generated from the sale of a farm asset during a Chapter 12 case. That section provides that “[t]he plan shall provide for the full payment, in deferred cash payments, of all claims entitled to priority under 507, unless the claim is a claim owed to a governmental unit that arises as a result of the sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation, in which case the claim shall be treated as an unsecured claim that is not entitled to priority under section 507, but the debt shall be treated in such manner only if the debtor receives a discharge.” 11 U.S.C. § 1222(a) (2012) (emphasis added). The bankruptcy code provides that claims entitled to priority treatment under section 507 include “administrative expenses . . . including . . . any tax . . . incurred by the estate.”  11 U.S.C. § 503 (2012) (emphasis added).

Although the courts agree that section 1222(a)(2)(a) only applies to claims that are entitled to priority treatment under section 507, prior to the Hall decision, they disagreed over whether taxes generated from the sale of a farm asset during a Chapter 12 bankruptcy case are “incurred by the estate,” and therefore entitled to priority treatment under section 507. Knudsen v. IRS, 581 F.3d 696, 708 (8th Cir. 2009); United States of America v. Hall, 617 F.3d 1161, 1162 (9th Cir. 2010); United States of America v. Dawes (In re Dawes), 2011 U.S. App. LEXIS 12477, at *4 (10th Cir. 2011).

In analyzing whether the income taxes flowing from the sale of a farm asset during a Chapter 12 bankruptcy are taxes “incurred by the estate” and so subject to downgrade to general unsecured status and discharge under section 1222(a)(2)(a) of the bankruptcy code, the 9th and 10th circuit courts of appeals relied on the Internal Revenue Code in Hall and Dawes. Section 1399 of the Internal Revenue Code states that “no separate taxable entity shall result from the commencement of a case under the title of the United States Code, except in any case to which 26 U.S.C.S. § 1398 applies.” Section 1398 applies only to “any case under chapter 7 (relating to liquidations) or chapter 11 (relating to reorganizations) of title 11 of the United States Code in which the debtor is an individual.” Based on these two sections of the Internal Revenue Code, the 9th and 10th circuit courts of appeals for the in Hall and Dawes concluded that a Chapter 12 estate cannot incur taxes and that section 1222(a)(2)(a) is therefore inapplicable to the tax generated from the sale of a farm asset.

Unlike its sister circuits, the 8th Circuit Court of Appeals refused to consider the relevant tax authority in interpreting the operative phrase “incurred by the estate.” That court focused instead on the fact that a bankruptcy estate cannot incur liabilities until it comes into existence — upon the filing of bankruptcy case — in determining that the phrase “incurred by the estate” simply means “incurred post-petition.” Knudsen, 581 F.3d at 708-9. Even though not everything “incurred post-petition” is “incurred by the estate,” the 8th Circuit nevertheless concluded that a Chapter 12 estate can incur taxes and that section 1222(a)(2)(a) therefore applies to the tax generated from the sale of a farm asset during bankruptcy.

Unfortunately, in a decision supported by five justices and opposed by four, the U.S. Supreme Court agreed with the 9th and 10th circuits. The dissenting justices believe that the Hall ruling is “the very opposite of what Congress intended. Congress did not want to relegate to ordinary-unsecured-claim status only prepetition tax claims, i.e., tax claims that accrued well before the Chapter 12 proceedings began. Rather, Congress was concerned about the effect on the farmer of collected capital gains tax debts that arose during (and were connected with) the Chapter 12 proceedings themselves.” Hall, 132 S. Ct. 1882.

The Hall ruling has gotten the attention of Senator Chuck Grassley (R-IA) who stated that he will introduce legislation to clarify the provisions of the bankruptcy code. Until such legislation is introduced and passed, farmers contemplating bankruptcy filings will need to give greater consideration to the timing of filing for bankruptcy and the sale of their assets.

Hamid R. Rafatjoo is a partner at Venable LLP. Mr. Rafatjoo focuses his bankruptcy practice on insolvency and corporate restructurings, either through an out-of-court workout process or through a Chapter 11 filing.

Rob L. Smith serves as co-chair of Venable’s Legislative Practice Group. Mr. Smith uses his Capitol Hill knowledge to advise clients on all aspects of federal advocacy, including obtaining federal funding, marketing and sales to federal agencies and developing effective relationships with their constituent members of Congress and congressional staff.