In the wake of the recent economic downturn caused by the COVID-19 pandemic, there will likely be a sharp rise in bankruptcy filings by businesses seeking to obtain relief from the burdens of excessive debt. The bankruptcy code is designed to provide debtors relief and protection from creditors, which includes the Internal Revenue Service (“IRS”). One of the benefits of bankruptcy court protection is the automatic stay, which will prevent the IRS from pursuing collection, such as liens and levies against the debtor. Accordingly, there will likely be an increased incidence of tax controversies adjudicated in bankruptcy courts in the future.
Jurisdiction of the Bankruptcy Court
One issue that often arises during bankruptcy proceedings involves the jurisdiction of the bankruptcy court to adjudicate tax claims filed by federal, state, or local taxing authorities. The nature, complexity, and timing of the tax claim will generally dictate whether the claim may be heard by the bankruptcy judge or referred to a federal district court or the United States Tax Court for hearing and adjudication. Although bankruptcy court judges are vested with broad judicial powers to hear any issue arising under the Bankruptcy Code, including tax claims, the bankruptcy court is a creature of legislation, hence the court’s authority to act is confined to the Bankruptcy Code and limited by the United States Constitution.
By constitutional design, federal district courts have original and exclusive jurisdiction over all cases governed by the Bankruptcy Code and original, but not exclusive, jurisdiction over all controversies that arise in or are related to a bankruptcy case. The district courts are also vested with exclusive in rem jurisdiction over all the debtor’s property as of the filing of a bankruptcy petition. Each of the federal judicial districts is also assigned a bankruptcy court that operates under the supervision of the district courts. In practice, district courts transfer bankruptcy cases to bankruptcy judges pursuant to standing orders of reference entered in every federal district in the United States. Once the cases are transferred, bankruptcy judges may adjudicate all cases and core proceedings referred to them by the district court and have the authority to issue final orders and judgments, which are appealable to the appropriate district court.
Section 157 of the Bankruptcy Code provides that the bankruptcy judge may hear and determine all cases under title 11 and all core proceedings arising under title 11 or arising in a case under title 11 and may enter appropriate orders and judgments. Section 157 also provides that a bankruptcy judge may hear a proceeding that is not a core proceeding but that is otherwise related to a case under title 11. Section 157 provides a nonexclusive list of core proceedings including, in part, proceedings concerning the administration of the estate, allowance or disallowance of creditors’ claims (including tax claims), validity and priority of liens, fraudulent conveyances, and confirmation of plans. The distinction between a “core” and “noncore” proceeding is important because a bankruptcy court may hold only jury trials in core proceedings—the district court’s de novo review of a bankruptcy court’s determination on a noncore claim prohibits a bankruptcy court from holding a jury trial in noncore proceedings. Moreover, the Second Circuit Court of Appeals has held that the core jurisdiction of the bankruptcy court should be given broad interpretation that is “close or congruent with constitutional limits.”
Bankruptcy Court Authority Under Section 505
The expansive grant of jurisdiction permitting the bankruptcy court to adjudicate a tax claim is codified in three provisions of the Bankruptcy Code. First, Bankruptcy Code §§ 501 and 502 permit the bankruptcy court to estimate and to determine the allowability of claims, including tax claims, against the estate. Second, Bankruptcy Code § 505 permits the bankruptcy court to rule on the merits of any tax claim involving an unpaid tax, fine, or penalty relating to a tax of the debtor or of the estate, regardless of whether the tax was previously assessed. Section 505 states that bankruptcy courts “may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal.” Thus, the broad sweep of § 505 provides taxpayers in bankruptcy court an alternative prepayment forum to the Tax Court and is an exception to the general rule requiring payment of the tax prior to non–Tax Court litigation.
A bankruptcy court’s authority to adjudicate a debtor’s tax liability often turns on the procedural stage at which the determination is sought and the tax is owed. Generally, a bankruptcy court may assert jurisdiction to determine tax matters involving pre-petition and post-petition pre-confirmation tax claims. Prepetition tax claims can be adjudicated by a bankruptcy judge under § 505, which permits a bankruptcy court to determine the merits of any pre-petition tax claim involving an unpaid tax, fine, or penalty. Bankruptcy courts may also determine any unpaid liability of the estate for any tax incurred during the administration of the case, which is covered by § 505(b) of the Bankruptcy Code. This is done by the trustee filing a tax return and requesting the IRS to expedite a review of the return. The procedure for filing a request for prompt determination is set forth in Rev. Proc. 2006-24. However, as to post-confirmation tax matters, the courts are not in agreement. For example, the Second Circuit has read § 505 narrowly, limiting it to actions brought by the trustee appointed by the bankruptcy court; this is not consistent with the Fifth and Sixth Circuit’s broader reading of § 505.
Although § 505 provides broad jurisdictional powers, Congress limited the exercise of such power by adding § 505(a)(2), which states that the bankruptcy court may not determine the amount or legality of a tax, fine, or penalty if the amount was adjudicated by a court or administrative tribunal before the commencement of the bankruptcy case. Thus, if a debtor has filed a petition in Tax Court and the IRS has answered and the debtor later defaults in Tax Court, the bankruptcy court lacks jurisdiction to adjudicate the same claim presented in Tax Court. However, § 362 of the Bankruptcy Code, allowing for the automatic stay, will provide the debtor protection and stay all pending litigation involving the debtor, including a Tax Court case.
The Bankruptcy Code places temporal restrictions on the debtor and the IRS. Section 505(a)(2) states that the bankruptcy court may not determine any right of the estate to a tax refund before the earlier of 120 days after the trustee requests this refund from the IRS or a determination is made denying that refund request by the IRS. As to the latter exception, § 6532 of the Code provides that a suit for the refund of federal taxes may not be filed until six months following the filing of an administrative claim for refund with the IRS. In bankruptcy cases, Congress decided to shorten the period during which the IRS must act to 120 days, recognizing the importance of expediting the bankruptcy process.
Withdrawal of the Reference
Notwithstanding the expansive breadth of § 505, the federal district court retains original, but not exclusive, jurisdiction over all bankruptcy proceedings. Once a bankruptcy proceeding has been referred to the bankruptcy court, the district court’s authority to withdraw the reference is governed by 28 U.S.C. § 157, which provides for both mandated and permissive withdrawal. Thus, by virtue of the Bankruptcy Code, the district court and bankruptcy court have concurrent jurisdiction. The same is true regarding a Tax Court case or refund case pending in the Court of Federal Claims at the time a bankruptcy proceeding is commenced. When there is concurrent jurisdiction, the taxpayer-debtor, as well as the government, may look to determine which court constitutes the best forum for litigating the merits of the tax claim. As a general matter, bankruptcy court judges may be less familiar with adjudicating substantive tax matters than Tax Court or district court judges, and this belief, coupled with the pro-debtor view of bankruptcy court, has led some creditors to believe that the bankruptcy court may be a less advantageous forum. Such generalities should be avoided. While true that the bankruptcy court has mainly reviewed tax claims related to collection, not assessment, important questions of substantive liability for taxes are becoming more commonly decided in bankruptcy cases. In increasing number, large corporations undergoing reorganization are electing to present significant, substantive tax issues involving complex law for decision by the bankruptcy court. Since the large majority of bankruptcy proceedings are voluntary, there is a significant element of forum shopping by taxpayers, especially given that bankruptcy courts are generally seen as “pro-debtor” and have procedural rules that favor litigation of tax issues. Therefore, before selecting a forum, taxpayers should consider the court most likely to provide a favorable opinion based on the law of the various jurisdictions as well as the judicial temperament and experience of the judge and the precedents of appellate courts with jurisdiction over them. Other forum considerations include the court’s respective evidentiary and discovery rules, the location of the trial and witnesses, congestion of court calendars, jurisdictional limitations, and limitations on the type of relief available.
If the bankruptcy court is determined not to be the best forum to adjudicate the tax claim, a motion for withdrawal of the proceeding may be heard by the district court—a bankruptcy judge may not conduct the hearing on a withdrawal motion. The party seeking withdrawal from the bankruptcy court bears the burden of establishing that withdrawal is appropriate under the circumstances.
Withdrawal from the bankruptcy court is mandatory under § 157(d) of the Bankruptcy Code where the district court determines that resolution of the proceeding requires consideration of both bankruptcy and other laws of the United States. Federal courts have interpreted § 157(d) to mandate withdrawal “only if [the] court can make an affirmative determination that resolution of the claims will require substantial and material consideration of . . . non-[Bankruptcy] Code statutes.” Thus, in the context of a tax claim, the federal court must decide whether resolution of a disputed tax matter requires substantial and material consideration of provisions of the Internal Revenue Code. Federal courts have agreed to withdraw the reference of tax claims related to a wide variety of tax issues, including (i) the deductibility of interest taken by a corporation on loans to fund life insurance policies for its employees; (ii) application of §§ 707 and 721 of the Code to partnership transactions; and (iii) tax claims requiring interaction between ERISA, the Internal Revenue Code, and the Bankruptcy Code.
Courts have recognized that a literal interpretation of §157(d) could result in an “escape hatch” through which most bankruptcy matters could routinely be removed to the district court. Accordingly, in determining whether withdrawal is required under §157(d), district courts generally apply a two-prong test to narrow the scope of §157(d) and avoid overloading the court. First, a need to consider “other laws,” outside of the Bankruptcy Code, for the resolution of the proceeding must be established. Second, consideration of these “other laws” must be “substantial and material.” Merely labeling a statutory term ambiguous is not sufficient to merit a “substantial and material consideration.” Thus, withdrawal of a tax claim from bankruptcy court will not be granted when only a straightforward application of a federal law is required for resolution of the pending issue. Application of this two-prong requirement furthers the underlying policy and legislative intent behind §157(d) and helps to distinguish a required “consideration” of federal law outside the Bankruptcy Code from its simple application.
In applying the two-prong standard for mandatory withdrawal, the party seeking withdrawal bears the burden of demonstrating that the two requirements are satisfied. Often, the movant argues that the tax claim involves a complicated legal question or a conflict between the circuits to justify withdrawal. The federal circuits agree that the mere application of settled tax law is not sufficient to mandate withdrawal.
As an alternative argument, the movant may argue that the bankruptcy court should withdraw the proceeding under the discretionary mechanism, provided in §157(d), on its own motion, or on a timely motion of any party, for “cause shown.” Courts have acknowledged that the requirement that cause be shown “creates a presumption” that Congress intended to have bankruptcy proceedings adjudicated in bankruptcy court. Although “cause” is not statutorily defined, some circuit courts of appeal have applied a multifactor test that a district court should consider in determining whether “cause” exists for discretionary withdrawal. These factors include (i) promoting uniformity of bankruptcy administration; (ii) reducing forum shopping and confusion; (iii) fostering economical use of debtor/creditor resources; (iv) expediting the bankruptcy process; (v) timing the request for withdrawal and (vi) considering whether the proceeding is “core” or “noncore.” In construing these factors, district courts have consistently stated that section 157(d)—for “cause shown”—should be construed narrowly.
As one can see, once the jurisdiction of the bankruptcy court has been properly invoked, that court has broad authority to determine the legality or amount of tax liabilities, including related interest and penalties. Thus, in many ways, the taxpayer may consider the bankruptcy court as a fourth litigation forum to be considered alongside the refund forums of the district courts and the Court of Federal Claims or the prepayment forum of the Tax Court. While appeals of bankruptcy court decisions go first to the local federal district court, the bankruptcy court is generally debtor-friendly and thus should be considered a potentially favorable forum in which to adjudicate tax claims.