Hall v. United States (10-875)

Oral argument: Nov. 29, 2011

Appealed from: United States Court of Appeals for the Ninth Circuit (Aug. 16, 2010)

Petitioners Lynwood and Brenda Hall filed for Chapter 12 bankruptcy and subsequently sold their family farm, which resulted in a postpetition tax liability of approximately $29,000. The Halls proposed to treat this tax liability as an unsecured dischargeable claim. The IRS objected to the debtors’ plan based on Internal Revenue Code requirements. At trial, the Bankruptcy Court agreed with the IRS that the tax liability was not considered an administrative expense under Bankruptcy Code Section 507(a)(2), covered by Section 1222(a)(2)(A), or entitled to treatment as unsecured dischargeable debt, and therefore that the $29,000 was required to be paid in full outside of the bankruptcy context. On appeal, the Halls argue that their postpetition tax liability should be treated as an unsecured dischargeable debt under Section 1222(a)(2)(A) because, contrary to the Bankruptcy Court’s finding, the tax liability is an administrative expense under Section 507(a)(2). Furthermore, the Halls contend that a Chapter 12 estate can incur a tax liability. Respondent United States argues that postpetition debts are not included in Chapter 12 plans, and that, even if postpetition debts were included, a Chapter 12 estate cannot incur a tax liability because it is not a separate taxable entity. In this case, the Supreme Court will determine the proper application of Section 1222(a)(2)(A) to postpetition tax liabilities.

Question presented

Whether 11 U.S.C. 1222(a)(2)(A) authorizes the bankruptcy court, in a case brought under Chapter 12 of the Bankruptcy Code, to treat as a dischargeable non-priority claim a federal income tax debt arising out of the debtor’s postpetition sale of a farm asset.

Issue

After declaring Chapter 12 Bankruptcy and selling their farm, must farmers pay capital gains taxes on that sale, or can this tax be treated as a dischargeable debt that must be paid only after other, higher-priority creditors are satisfied.

Facts

Petitioners Lynwood and Brenda Hall owned a farm in Willcox, Arizona. See Brief for Petitioners, Lynwood D. Hall and Brenda A. Hall at 2. In August 2005, the Halls filed for bankruptcy under Chapter 12 of the Bankruptcy Code. See United States v. Hall, 617 F.3d 1161, 1162 (9th Cir. 2010). Chapter 12 is a special provision of the Bankruptcy Code that applies specifically to farmers, and is designed to ease the burden of bankruptcy on family farms. See Family Farmer or Family Fishermen Bankruptcy, Background. To this end, Chapter 12 lowers many of the hurdles that are normally associated with bankruptcy proceedings and allows farmers to discharge certain debts. See id. In 2005, Chapter 12 was amended so that debtors could discharge “claim[s] owed to a governmental unit that arise[] as a result of the sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation.” See 11 U.S.C. 1222(a)(2)(A).

As part of their bankruptcy reorganization plan, the Halls sold their farm for $960,000. See Hall, 617 F.3d at 1162. Because this sale price exceeded the Halls’ basis in the assets, the Halls made a capital gain on the sale and incurred a corresponding capital gains tax of $29,000. See id. The Halls attempted to discharge this tax as arising from the sale of a farm asset under Section 1222(a)(2)(A) of Chapter 12. See id. The Internal Revenue Service (“IRS”) objected to this discharge, asserting that when assets are sold after a bankruptcy petition has been filed, the tax on the sale is not dischargeable under Section 1222—only prepetition asset sales qualify for discharge under Section 1222. See id. at 1162, 1164.

The Federal Bankruptcy Court for the District of Arizona sustained the IRS’s objection to the discharge and held that the Halls were individually liable for the capital gains tax. See In Re Hall, 376 B.R. 741, 742 (Bankr. D. Ariz 2007). The bankruptcy court reasoned that, because a Chapter 12 estate is not a “separate taxable entity,” it does not have the ability to discharge governmental claims under Section 1222(a)(2)(A). See id. at 747. The Halls appealed to the U.S. District Court for the District of Arizona, which reversed the bankruptcy court and found for the Halls, reasoning that Chapter 12 was intended to help farming families keep possession of their farms, and that refusing to allow the Halls to treat the capital gains tax as dischargeable would not be consistent with this intent. See In Re Hall, 393 B.R. 857, 863–64 (D. Ariz. 2008) (relying on Knudsen v. IRS, 581 F.3d 696 (8th Cir. 2009)). The government then appealed to the United States Court of Appeals for the Ninth Circuit, which reversed the district court, holding that a Chapter 12 estate is not a separate taxable entity, and that a capital gains tax must therefore be assessed as an individual tax outside the bankruptcy proceedings. See Hall, 617 F.3d at 1163–65. The Ninth Circuit recognized that its holding created a circuit split with the Eighth Circuit, which had earlier ruled that a Chapter 12 estate can incur taxes and, consequentially, that postpetition capital gains taxes may be treated as dischargeable unsecured claims under Section 1222. See id. at 1164–65. The Halls petitioned for certiorari, and the Supreme Court granted the Halls’ petition to resolve the conflict between the two circuit courts.

Discussion

In this case, the Supreme Court will determine whether a farmer may discharge a capital gains tax that arises when the farmer sells a family farm during a Chapter 12 bankruptcy proceeding. Petitioners Lynwood and Brenda Hall argue that because family farm home values often appreciate over generations, capital gains taxes resulting from the sale of family farms are often substantial; thus, this decision will significantly affect the practical efficacy of Chapter 12 bankruptcy proceedings for many farmers. See Brief for Petitioners, Lynwood D. Hall and Brenda A. Hall at 23. The United States argues in response that assessing a capital gains tax on the sale of a farm outside of bankruptcy proceedings will not significantly frustrate the purpose of Chapter 12, which provides numerous other benefits to family farmers during bankruptcy. See Brief for Respondent, United States of America at 18.

The Purpose of Chapter 12

The Halls argue that Chapter 12 of the Bankruptcy Code, specifically Section 1222(a)(2)(A), is designed to aid distressed family farmers by affording them flexibility during the bankruptcy process and allowing them to discharge certain debts. See Brief for Petitioners at 23. The Halls look to the legislative history of the 2005 Amendments, which contained Section 1222(a)(2)(A), to support this proposition. See id. at 23–24. According to the Halls, before the 2005 Amendments to the Code, the IRS could effectively “veto” any proposed reorganization plan under Chapter 12 that did not provide for the full payments of all tax claims. See id. at 22–23. One of these tax claims is a capital gains tax assessed on the amount that a family farm has increased in value during the period between the time when the farm was first bought and the time at which it is sold. See id. The Halls maintain that, because family farms are often passed down through generations, these farms can appreciate significantly in value by the time they are sold, resulting in potentially astronomical capital gains taxes. See id. at 23. Indeed, the Halls argue that, before the 2005 Amendments, the prospect of this capital gains tax led many farmers to avoid Chapter 12 bankruptcy because of the tax implications of selling their family farms. See id.

The Halls also look to the statements of the 2005 Amendments’ primary sponsor, Senator Charles Grassley, to argue that Section 1222(a)(2)(A) was intended to afford farmers further flexibility under Chapter 12. See Brief for Petitioners at 23–24. The Halls maintain that during a Congressional debate over another bill designed to safeguard farmers, Grassley explained that the bill’s purpose was to “take[] [the veto] power away from the I.R.S. by reducing the priority of taxes during proceedings.” See id. at 24. According to Senator Grassley, reducing the priority of taxes would allow farmers to liquidate and reinvest assets more easily, which would “help farmers stay in the business of farming.” See id. Senator Grassley also argued in support of a comparable bill (the Bankruptcy Reform Act of 1999) that permitted farmers to discharge postpetition capital gains taxes, therefore allowing cash-starved farmers to sell assets and generate liquidity without the fear of stifling taxation. See id. at 24–25. The Halls argue that a similar purpose underlies Section 1222(a)(2)(A), which was also sponsored by Senator Grassley. See id. at 23–24. According to the Halls, the Ninth Circuit’s interpretation of Section 1222(a)(2)(A) frustrates its purpose by saddling farmers with crippling capital gains taxes that would make it more difficult to liquidate assets and reorganize debt in the hope of staying in business. See id.

In response, the United States contends that the Halls’ characterization of Section 1222(a)(2)(A)’s purpose is both overbroad and oversimplified. See Brief for Respondent at 19–20. The United States asserts that 1222(a)(2)(A) is narrowly and specifically tailored to offer relief to applicable debtors by allowing farmers to discharge certain “specified claims” that ordinarily must be paid during bankruptcy proceedings. See id. at 32–33. According to the United States, Section 1222(a)(2)(A) stops far short of “alter[ing] the established rules” regarding pre- and postpetition liabilities; such a significant extension of relief would have required much more than a “simple adjustment of the boundary between priority and non-priority claims.” See id. The United States asserts that the Halls’ interpretation of Section 1222(a)(2)(A) would pervert Congressional intent by imputing a purpose to Section 1222(a)(2)(A) that disrupts traditional bankruptcy norms, and is far more extensive than anything contemplated by Congress when it afforded relief to bankrupt family farmers by passing the 2005 Amendments. See id. at 32-33. The United States further argues that the statements of Senator Grassley are unavailing to the plaintiffs because they relate to the general purpose of the amendments, not to the specific question of whether postpetition taxes are dischargeable under Section 1222(a)(2)(A). See id. at 32. Moreover, according to the United States, Grassley’s statements are not necessarily reflective of the Congressional intent behind Section 1222(a)(2)(A) because they were made during debates on other legislation. See id.

Analysis

Chapter 12 of the Bankruptcy Code, added in 1986, allows family farmers to reorganize their debts. See Brief for Petitioners, Lynwood D. Hall and Brenda A. Hall at 2; Brief for Respondent, United States of America at 2. Under Section 1222(a)(2)(A) of Chapter 12, family farmers may treat certain governmental claims resulting from the sale of farm assets as dischargeable unsecured claims, not entitled to priority status under Section 507, despite the debtor repaying less than the full amount that is owed on the claim. See id. Lynwood and Brenda Hall contend that their approximately $29,000 postpetition tax liability should be treated as a non-priority, unsecured, and dischargeable debt under Section 1222(a)(2)(A). See Brief for Petitioners at 10–11. The Halls contend that their postpetition tax liability is entitled to such treatment under Section 1222(a)(2)(A) because it was “incurred by the estate” and thus qualifies as an “administrative expense” under Section 507(a)(2), which cross-references Section 503(b) for further requirements of an administrative tax. See id. 10–11, 15. In opposition, the United States contends that postpetition debts are not included in a Chapter 12 debtor’s plan, and therefore that the tax liability cannot fall within Section 1222(a)(2)(A) and must be collected outside of the bankruptcy context. See Brief for Respondent at 7–8. The United States also argues that a Chapter 12 estate cannot “incur” a postpetition tax liability because a Chapter 12 plan does not create an estate that the Internal Revenue Code (“IRC”) defines as a “separate taxable entity.” See id. at 22–23.

Do Chapter 12 Estates Include Postpetition Debts?

Section 1222(a)(2)(A) only applies to government priority claims under Section 507. See 11 U.S.C. § 1222(a)(2)(A). Section 507 includes two provisions dealing with taxes: Sections 507(a)(2) and 507(a)(8). See 11 U.S.C. § 507. Section 507(a)(8) applies only to prepetition government claims; therefore, a postpetition tax liability will fall under Section 1222(a)(2)(A) only if it is considered an “administrative expense” under Section 507(a)(2). See id.

The Halls contend that the plain language and legislative history of the Bankruptcy Code support the argument that their $29,000 postpetition tax liability falls within Section 1222(a)(2)(A) and should be included in their Chapter 12 estate as a non-priority, unsecured, and dischargeable claim. See Brief for Petitioners at 11–12, 22–23. Specifically, the Halls argue that their postpetition tax liability falls under Section 1222(a)(2)(A) as an “administrative expense” under Section 507(a)(2), because Congress drafted Section 1222(a)(2)(A) with the intent that it apply to all priority claims under Section 507. See id. at 12. The Halls argue that, had Congress intended for 1222(a)(2)(A) to apply exclusively to prepetition tax liabilities under Section 507(a)(8), it would have clearly drafted the provision to articulate this intention. See id. at 12–13. The Halls further contend that a postpetition tax liability is a “claim” in the Bankruptcy Code, despite its categorization as an “administrative expense” under Section 507(a)(2). See id. at 13–14. Finally, the Halls explain that the Bankruptcy Code defines “creditors” as entities with pre- or postpetition claims; therefore, if only prepetition claims were to be included in Chapter 12 estates, the Bankruptcy Code would not include postpetition claims in the definition of “creditors.” See id. at 14–15. In sum, the Halls contend that language and construction of the Bankruptcy Code require that the postpetition tax liability be included in their Chapter 12 estate as a non-priority, unsecured, and dischargeable debt under Section 1222(a)(2)(A). See id. at 11.

In opposition, the United States argues that Chapter 12 plans are limited to include only the discharge of prepetition claims, and that postpetition debts must be paid outside of the bankruptcy proceedings. See Brief for Respondent at 11. The United States, in direct contrast to the Halls’ contention, asserts that the Bankruptcy Code defines “creditors” as holders of prepetition claims only. See id. at 13. The United States argues that Section 1222(a)(2) refers to “claims” under Section 507 and not expenses, like the “administrative expenses” under Section 507(a)(2). See id. at 14. Thus, the United States argues that “administrative expenses” under Section 507(a)(2) cannot be treated as non-priority, unsecured, and dischargeable claims because they are not “claims” in the first place. See id. at 13–14. The United States also argues that one may look to Chapter 13, after which Congress modeled Chapter 12, for guidance in understanding Chapter 12’s provisions. See id. at 20–21. Chapter 13 includes a provision requiring that postpetition claims be treated as arising before the petition filing date; because this provision is not included in Chapter 12, the United States argues, it is clear that Congress did not intend for postpetition debts to be included in the Chapter 12 estate. See id. at 20–21.

Can a Chapter 12 Estate “Incur” a Postpetition Tax Liability?

For an “administrative expense” to qualify for priority treatment under Section 507(a)(2), it must be “incurred by the estate.” See Brief for Respondent at 22–23; Brief for Petitioners at 15. At issue is whether the debtor’s estate must be a “separate taxable entity” in order to incur these expenses. See Brief for Petitioners at 15. The IRC provides that the commencement of a bankruptcy case only creates a “separate taxable entity” where the debtor files under Chapter 7 and Chapter 11, and the debtor is an individual. See 26 U.S.C. §§ 1398–1399.

The Halls contend that the postpetition tax liability should be considered an “administrative expense” and given priority, even if the IRC does not recognize Chapter 12 estates as “separate taxable entities,” because the interpretation of the Bankruptcy Code does not depend on the IRC. See Brief for Petitioners at 33–34. The Halls argue that a Chapter 12 estate automatically “incurs” any tax liability arising after the bankruptcy petition date because, by definition, a bankruptcy estate does not exist until after the petition date. See id. at 17. The Halls contend that there is Supreme Court precedent in support of treating their postpetition tax liability as an administrative expense: the Supreme Court has previously held that a Chapter 11 corporate debtor‘s taxes arising postpetition were “administrative expenses.” See id. at 16–17 (citing Noland v. United States, 517 U.S. 535, 537, 541–42 (1996)). The Halls argue that the Court has also held that postpetition taxes should be given priority, despite the lack of a “separate taxable entity.” See id. (citing Nicholas v. United States, 384 U.S. 678, 687–88 (1966)). Lastly, the Halls contend that the legislative history shows the Bankruptcy Code to operate under a “long-standing rule” that a postpetition tax liability is entitled to treatment as administrative expense priority. See id. at 19.

In contrast, the United States argues that postpetition tax liabilities are not administrative expenses under the Bankruptcy Code and the IRC. See Brief for Respondent at 21. In particular, the United States contends that, unlike Chapter 7 and Chapter 11 bankruptcy estates, a Chapter 12 estate is not a “separate taxable entity” and therefore cannot incur a postpetition tax liability. See id. at 22–23. The United States argues that a Chapter 12 estate cannot incur a tax liability because a Chapter 12 trustee does not have the duty to file a tax return. See id. at 23. The United States distinguishes previous Supreme Court precedent by asserting that the relevant case involved a different type of tax and bankruptcy chapter, which made the debtor responsible for postpetition taxes despite the non-existence of a separate entity. See id. at 29–30. The United States also contends that the Halls’ use of legislative history is misguided because the cited history occurred before the enactment of the Bankruptcy Code sections establishing that a Chapter 12 estate does not create a “separate taxable entity.” See id. at 30–31. Lastly, the United States argues that a Chapter 12 estate cannot incur a postpetition tax liability because that is not permitted under Chapter 13, the chapter after which Chapter 12 was modeled. See id. at 37–38.

Conclusion

Chapter 12 of the Bankruptcy Code allows family farmers to reorganize their debts. In this case, the Supreme Court will decide whether a Chapter 12 debtor with a postpetition tax liability can benefit from Section 1222(a)(2)(A), which allows debtors to convert government claims to non-priority, unsecured, and dischargeable debts. The Halls argue that their Chapter 12 estate can “incur” a postpetition tax liability and that their tax liability is entitled to treatment as a non-priority unsecured claim. In contrast, the United States argues that a Chapter 12 estate cannot “incur” a tax liability because it is not a “separate taxable entity” under the Internal Revenue Code. The United States contends that Chapter 12 plans are limited to prepetition debts and, therefore, that the Halls’ postpetition tax liability cannot be discharged. This case will determine the proper application of Section 1222(a)(2)(A) to postpetition tax liabilities.

Authors

Prepared by: Alison Carrizales and Tom Schultz

Edited by: Jacqueline Bendert

Additional Sources

Edited by: