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Robert A. Leflar Law Center
Waterman Hall
University of Arkansas
Fayetteville, AR 72701

Phone: (479) 575-5601

The Supreme Court and Capital Gains Taxes in Bankruptcy and Credit Bidding in Cramdown Auctions

By · July 16, 2013 · 2013 Ark. L. Notes 1258
In categories: Business Law, Debtor/Creditor, Snapshot, Taxation

Two cases are mentioned here that came down in May 2012 from the Supreme Court. The first case, Hall, is important if you have a client with appreciated property who is in financial stress.[1] The second case, Radlax Gateway Hotel, is relevant if your client is a secured creditor who wishes to credit bid in a bankruptcy auction organized by the debtor.[2] Since you might represent the debtor or the creditor in bankruptcy both cases might be of interest. Hall is more likely to come into your life, perhaps. It will be discussed first.

Linwood Hall and his wife, Brenda, were farmers in Arizona. They had financial difficulties and decided to reorganize their farm in a Chapter 12 bankruptcy. I guess that reorganization did not work because the debtors proposed a plan to sell the farm in bankruptcy and use the proceeds to pay a portion of their debts. The sale of the farm was to be free and clear of liens. This is in section 363(f) and is one of the advantages in selling property after filing a bankruptcy petition. This is one of the sections not touched by the 2005 amendments.

The sale took place and the farm sold for $960,000. The Halls proposed to take this money and pay a portion of their debts. This was in their first plan. The IRS then submitted a claim for $29,000 in capital gains taxes. This caused the Halls to file an amended plan proposing to pay the capital gains taxes to the Internal Revenue Service in their Chapter 12 plan as an unsecured debt.[3] Payment under the plan would discharge the rest of the tax debt if money was not available. The IRS objected to the amended plan since it was likely they would get paid only a portion of their $29,000 debt. The IRS’s objection to this plan treatment ultimately got to the Supreme Court. The Court’s decision came down on May 14th, 2012.[4] It was a 5 to 4 split of the Court.

To understand the argument, three sections of the Bankruptcy Code must be mentioned. First the Halls were relying on section 1222(a)(2)(A).[5] This allows government claims arising from the sale of farm property to be treated as an unsecured debt if it is entitled to priority under section 507. As the Supreme Court explained, there are two places in section 507 where tax debt is given priority.[6] Section 507(a)(8) discusses various taxes but they have to be incurred before the bankruptcy petition is filed (prepetition). The only other place that taxes are discussed is in section 507(a)(2) which refers to claims entitled to priority as an administrative expense. This takes us to the last of the three relevant bankruptcy sections discussed by the Court, section 503(b)(B)(i). This section begins with “Any tax incurred by the estate…” This is the language on which the Supreme Court focuses.

The IRS argued that the capital gains taxes were not a tax incurred by the estate and therefore could not be included in the Hall’s chapter 12 plan. The farmer’s plan was to discharge the tax debt at the end of plan payments. This would pay only part of the debt. The IRS’s position was that the farmers would owe the taxes in full once their bankruptcy was finished. This way the farmers would have to pay the full $29,000 tax debt. The sale took place while the farmers were in Bankruptcy Court. This made all of the difference in the end.

You may think that farmers do not have much in the way of capital gains increases. In Arkansas from 2002 through 2007 farm land and buildings rose in value 58.2 percent. The same Arkansas farm land and buildings increased another 17.8 percent from 2008 to 2012 during the economic downturn. [7] This means there are a lot of capital gains taxed waiting to be paid by Arkansas farmers.

In contrast, the numbers for the corn belt are even bigger. From 2002 through 2007 the land and buildings increased 62.1 percent. During the economic downturn, farm land and buildings went up 50.3 percent from 2008 to 2012. Nothing like the ethanol mandate to affect land prices . [8]

The bankruptcy court agreed with the IRS. The district court reversed and sided with the debtors. The IRS appealed and the Ninth Circuit Court of Appeals agreed with the bankruptcy court.[9] This was the procedural picture of the case when the Supreme Court took the case fall 2011.

I should note here that the Eighth Circuit had ruled the other way in Knudsen v. IRS in 2009.[10] Thus, the Hall case will have an even bigger impact in this state with the Eighth Circuit’s case being overturned. The Eighth Circuit ruled on both sales before the bankruptcy petition and sales after the petition has been filed. It is only the discussion of post – petition taxes that is overturned by the Hall case.

The Supreme Court agreed with the Ninth Circuit that the capital gains taxes were not incurred by the estate. Part of the opinion analogizes to Chapter 13 practice. The Court suggested that this practice was clear that no bankruptcy estate for taxes was created. Since Chapter 12 was modeled on chapter13, this allowed that Court to use this practice in Chapter 13 to bolster its analysis of the issue. Part of the opinion relies on language of tax statutes.[11] The opinion was written by Justice Sotomayor. The dissent includes Justice Kennedy. It is a five to four split for the Court. The Court notes that some federal claims are paid as unsecured debt. But other than these, they have to have priority under section 507. This gets them to the administrative claims under section 503. This is how the Court focuses on whether this is a tax incurred by the estate.

This is why the farmer loses. His lawyer should have sold the farm before the bankruptcy petition is filed. This might be hard advice. The farmer may want to file bankruptcy in order to reorganize the farm and continue farming. It looks as if this was the case in Hall.

Nonetheless, the clear advice is not to sell an asset laden with capital gains during a Chapter 12 or 13 bankruptcy case. The Ninth Circuit’s case, U.S. v. Hall, suggested that the debtor should have sold the farm before they filed for bankruptcy.[12] They said that this would make the capital gains taxes a prepetition debt. Prepetition debts are generally discharged by the bankruptcy discharge.[13] Now section 507(a)(8) should apply. This of course is dicta.

There is, I think, a good reason to sell property during the bankruptcy. This allows a sale free and clear of liens. If the sale takes place before bankruptcy, it cannot be sold free and clear of liens. This now is the choice that needs to be made by the client.

Contrast a farmer who works out with his bank the discharge of $50,000 of the farmer’s debt. This is discharge of indebtedness income. This is ordinary income on that year’s tax return for the farmer unless this is done in bankruptcy or while insolvent. In bankruptcy this discharge of indebtedness income is discharged.[14] It would reduce tax attributes along the way if the debtor had them. These attributes include net operating losses for example. Should this difference be made? Good question. At least for now, there is this distinction. For capital gains taxes generated by the sale of assets once a bankruptcy petition has been filed, the farmer will have to pay the taxes after the bankruptcy case is finished unless this is a sale under Chapter 11.

Let me switch gears entirely to discuss briefly another Supreme Court case that came down in late May 2012. It involved a sale, this time in Chapter 11, free and clear of liens. Chapter 11 in contrast to Chapter 12, does have a taxable estate. But what the debtor did here was not allow the secured creditor to credit bid the amount of its loan in the auction. This would make a big difference to the secured creditor. The Third Circuit had earlier ruled that the secured creditor could not insist on credit bidding in the auction.[15]

Let me set the stage for these two cases. In both, the debtor proposed an auction of property free and clear of liens and the secured creditor wanted to at least credit bid the debt so if lesser amounts were bid the secured creditor would get the property. In the Third Circuit’s case it was the Philadelphia Enquirer and the Philadelphia Daily News and their assets that were put up for auction. A minority owner of the debtor was intending to bid. The Bankruptcy court allowed credit bidding. This would have given the lenders the property because they were owed so much more than the minority owners were bidding. The District court reversed and this opinion was affirmed by the Third Circuit.[16] In other words, this allowed the minority owner of the debtor to buy the newspapers at the auction. The secured party would have to be content to be paid a small portion of its debt and the rest would be discharged.

Even the Fifth Circuit has a case that somewhat bolstered the Third Circuit’s holding. In re Pacific Lumber,[17] the court allowed the sale to a third party in an amount equal to the appraised value of the property over the secured creditor’s objections. This was the circuit court of appeal rulings when the Seventh Circuit took the case directly from the bankruptcy court. It is not surprising that the Seventh Circuit went the other way.

In the Seventh Circuit’s case, the debtors were selling a hotel to a stalking horse somewhat like the minority owner in the Philadelphia newspapers. This too was to be a debtor organized auction sale. These plans also did not allow the unconsenting secured creditor to credit bid at the sale. The Seventh Circuit disagreed with the Third Circuit and held that the secured creditor should be allowed to credit bid. The stalking horse would lose out. This ruling was affirmed by the Supreme Court.[18] Unlike the Hall case, the Redlax case was a unanimous Court opinion. The opinion is authored by Justice Scalia.

This case is good for secured creditors and bad for debtors. This is especially true when the debtor has someone in mind to buy the asset being auctioned. If the secured creditor can credit bid the amount of their loan, they will win the bid unless the other entity is willing to bid more. The fight is whether the third party is unwilling to bid more and the secured party must absorb the loss. The Supreme Court has resolved this. If the creditor wants to credit bid their debt during the auction, they must be allowed to do so. Whether this also changes the Fifth Circuit’s case in the Pacific Lumber case is not clear. But I could make an argument that it should not be followed.

In the Redlax case the debtor wanted to sell the hotel to someone and did not want the creditor to credit bid so the third party could acquire the hotel. The issue before the Court was whether the secured creditor was receiving the indubitable equivalent of their claim if they were not allowed to credit bid their debt. As was the case in Philadelphia Newspapers, the debtor proposed to pay the secured creditor much less than the amount of the debt. This was a cram down of a plan over a refusal of the secured party to consent to plan treatment. This brought into play section 1129(b)(2)(A). Subsection (ii) specifically references credit bidding by referencing section 363(k). The Court notes that this should have been the section covering the debtor’s sale. But because the debtors wanted to block the credit bidding, they argued that section 1129(b)(2)(A)(ii) should not apply. Because of this the debtors were justifying their sale of the hotel and garage under section (iii). The Court spent most of the opinion discussing the interplay of subsections (ii) and (iii). Subsection (iii) says that the secured creditor must receive the “indubitable equivalent” of payment of their debt.

Justice Scalia used the cannon of construction that treats specific statutory language as an exception to general language covering the same things.[19] By using this canon of construction the Court was able to say that credit bidding was part of giving the secured creditor rights under subsection (ii). The Court reasons that the cannon of construction can be used when a specific section clearly applies and the general section has broad enough language to possibly cover the problem. When this happens, the specific statute will be the statute that applies. Subsection (ii) is talking about a sale of the property. Subsection (iii) is not so limited.

The debtor argued that the three sections gave the debtor a choice to use any of the three options provided by the statute and there was no need to use a canon of construction. It is interesting that the Court came to this conclusion even though subsection (ii) mentions credit bidding by referencing section 363(k) and subsection (iii) does not. But, as the Court points out, subsection (ii) mentions a sale and subsection (iii) does not.

One of my flower arrangements.

One of my flower arrangements. (click for larger version)

In Redlax the opinion of the Supreme Court is unanimous with the exception that Justice Kennedy took no part in the decision. It is also a quite short opinion given the normal length of Supreme Court opinions in general. The Seventh Circuit’s ruling also was unanimous. The Third Circuit’s opinion in Philadelphia Newspapers was not. It is surprising to me that the Third Circuit could rule the other way. I know that nationwide secured creditors are cheering. The IRS and taxpayers, other than the debtor, are cheering too.

You may want to read these two Supreme Court cases. I have left out much of the analysis of the Court that might be relevant for some of your cases. I hope that I have hit the highlights of the Court’s reasoning in both the Hall and Redlax opinions.


[1] Hall v. U.S., 132 S. Ct. 1882 (2012).

[2] Radlax Gateway Hotel v. Amalgamated Bank, 132 S. Ct. 2065 (2012).

[3] U. S. v. Hall, 617 F. 3d 1161, 1162 (9th Cir. 2010).

[4] Hall v. U.S., 132 S. Ct. 1882 (2012).

[5] This language was added to the Bankruptcy Code in 2005.

[6] Hall, 132 S. Ct. at 1885-86.

[7] http://www.quikstats.nass.usda.gov/results/7AB22CAR-2258-3065-8F-34-CD104F64DF8 (last visited July 12, 2013).

[8] http://www.quikstats.nass.usda.gov/results/A3SD0FB1-7D21-3DBD-B8A8-C9E238CCA35 (last visited July 12, 2013).

[9] 132 S. Ct. 1882 (2012).

[10] 581 F.3d 698 (8th Cir. 2009)(holding that the estate did incur the capital gains taxes so that section 122(a)(2)(A) did apply to sale of farm assets after bankruptcy was filed.). The court’s ruling on the treatment of a prepetition sale of farm assets has not been overturned.

[11] These Tax statutes are sections 1398 and 1399. According to the Court, section 1398 applies to chapter 7 and 11. The Court construes section 1399 as applying to chapters 12 and 13. These sections do not mention chapters 12 and 13 but says “[e]xcept in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a [bankruptcy] case.” 132 S. Ct. at 1887.

[12] 617 F.3d. 1161,63 (9th Cir. 2010).

[13] Id. at 1163.

[14] 26 U.S.C. ยค108.

[15] In re Philadelphia Newspapers, LLC., 599 F.3d298 (3rd Cir. 2010)(not allowing the secured creditor to credit bid its loan amount in the auction. The secured creditor had not agreed to the plan so this was a cramdown).

[16] Id. at 302-3.

[17] 584 F.3d 229 (2009).

[18] Radlax Gateway Hotel, LLC. v. Amalgamated Bank, 132 S. Ct. at 2073.

[19] Id. at 2071.

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