In an appeal of a bankruptcy court’s decision, a district court judge recently addressed the treatment of the “straddle year” for federal income tax under the Bankruptcy Code, which “does not appear to have been decided by any appellate court.” In re Affirmative Ins. Holdings Inc. United States v. Beskrone, No. 15-12136-CSS, 2020 WL 4287375, at *1 (D. Del. July 27, 2020).
Affirmative Insurance Holdings, Inc., and certain affiliates filed for bankruptcy in 2015. The IRS filed an administrative expense claim for approximately $850,000 of taxes, penalties, and interest. The bankruptcy court ruled that the tax year should be bifurcated into pre-petition and post-petition periods, and that income tax obligations must be allocated across the two periods. Obligations incurred pre-petition during the straddle year should be treated as general unsecured claims, and tax obligations incurred post-petition should receive administrative priority treatment. In other words, “a claim for corporate income taxes for the straddle year is only entitled to administrative priority to the extent it is attributable to post-petition income.” Id.
Because the “tax events that gave rise to the tax obligations [likely] occurred pre-petition,” the bankruptcy court’s holding would treat the IRS’s claim as a general unsecured claim for which significant payment was unlikely. Id. The United States, on behalf of the IRS, appealed to the district court. Judge Richard G. Andrews issued a decision reversing the bankruptcy court.
On appeal, the United States argued that under the Internal Revenue Code (“IRC”), and as suggested by the legislative history of § 503, corporate annual income tax accrues on the last day of the tax year, bringing it within the post-petition period necessary for administrative priority treatment. The United States further argued that a tax year should not be bifurcated. The bankruptcy trustee argued that the bankruptcy court correctly held that income tax is incurred daily such that pre- and post-petition obligations may be bifurcated, based largely on the plain meaning of the operative statutes.
The central question on appeal was “[w]hether the federal income taxes for the full straddle year were incurred by the estate.” Id. at 3. Judge Andrews identified IRC section 503(b)(1)(B)(i) as the relevant statutory provision, and explained that “all taxes ‘incurred by the estate’ are administrative expenses entitled to priority”. Id. at 3.
Both parties to the appeal had looked to Hall v. United States, 566 U.S. 506, 508, 511-12 (2012), for guidance regarding the meaning of the phrase “incurred by the estate” as stated in § 503(b) of the Bankruptcy Code. Id. at 4. The United States asserted that the tax is “incurred by the estate” when it becomes liable for it, which does not happen until the last day of a debtor’s tax year. The trustee argued that Hall is consistent with his explanation that “[e]ach time a taxable event occurs, the taxpayer ‘becomes liable’ for a tax obligation that may arise as a result thereof, and it matters not that the liability may be contingent, disputed, or unliquidated.” Id. Judge Andrews observed that while the Bankruptcy Code does not define “incurred,” its plain meaning is “to become liable for.” Id. at 3.
He also noted that “any determination of whether and when a particular tax was incurred by the estate must be based on the underlying substantive tax law”. Id. at 6 (citing In re Columbia Gas Transmission Corp., 37 F.3d 982 (3d Cir. 1994)). Under the IRC, a corporation’s federal income tax accrues on the last day of the tax year. Because it “is only on the last day of the taxable year that all events giving rise to an income tax have occurred,” a corporation’s income tax is not a “fixed liability” until that day. Id at 8. Before the end of the tax year, a corporation may eliminate or reduce the liability through actions like charitable donations or incurred operating expenses, which further indicate that the liability is not “fixed.” Id. Judge Andrews also rejected the trustee’s argument that the income tax was incurred before the end of the tax year because “the IRC imposes a tax for an entire year, not individual events.” Id. Thus, he held that the tax at issue was incurred by the estate post-petition and was entitled to priority as an administrative expense.
