Argument preview: Justices balance tax and bankruptcy policy
on Nov 22, 2011 at 10:30 am
The Justices get a textbook statutory construction puzzle next week when they hear arguments on November 29 in Hall v. United States. The case presents two diametrically opposed perspectives, each of which is based on the internal coherence of their own dedicated titles of the United States Code: petitioner Hall rests on the primacy of Title 11 (the Bankruptcy Code), while the Solicitor General asserts the primacy of Title 26 (the Internal Revenue Code).
The fact situation is so simple that it is surprising there can be any doubt about the result. The Halls own a farm in Arizona, which is in financial distress. Like most farmers who file for bankruptcy relief, they filed a petition under Chapter 12, a special chapter for the reorganization of family farms. While in bankruptcy, they were fortunate enough to find a purchaser for their farm who was willing to pay more than the outstanding debt against it. The sale went forward, but the proceeds have not yet been distributed to the Halls’ creditors because the Internal Revenue has interposed a claim to a large share of the proceeds as a tax on the capital gains from the sale of the farm. The basic question is whether the Bankruptcy Code discharges the Halls’ obligation to pay taxes when the debtors sell their farm during bankruptcy.
The case turns entirely on a provision in Chapter 12 that lowers the priority for certain taxes. Generally, a debtor in Chapter 12 can confirm a plan only if the plan provides for the full payment of “all claims entitled to priority.” Section 1222(a) (recently added to the Code) excepts from the full-payment requirement any “claim owed to a governmental unit that arises as the results of the sale * * * of [a] farm.”
The Halls’ argument follows the natural assumption of any bankruptcy lawyer. It proceeds from the concept of a bankrupt’s estate, which takes control of all of the debtor’s assets automatically at the moment a bankruptcy petition is filed. From this perspective, it was the estate that sold the farm, and thus the estate that incurred the tax liability. Because the liability is an obligation of the estate that arose after the petition was filed, it ordinarily would be an administrative expense entitled to priority under Section 507(a)(2). Accordingly, Section 1222(a) subordinates the Halls’ obligation to pay the tax. To the extent it is not paid under the plan, it is discharged like all of the other unsecured debts of the debtor.
The government approaches the case from an entirely different perspective. The government’s view is that Chapter 12 proceedings have no effect at all on post-petition obligations. Thus, they argue that the tax obligation is a personal obligation of the Halls that passes through the bankruptcy unaffected. The centerpiece of the government’s argument is a series of provisions in the Internal Revenue Code that define the circumstances in which separate taxable entities are created. Because Chapter 12 proceedings (unlike proceedings under Chapter 7 and 11) do not require the creation of a new taxable entity, the government argues, the estate cannot be regarded as obligated on the tax. Because the estate is not obligated for the tax, it cannot, under this reasoning, be an administrative expense that is subordinated (and ultimately discharged) by Section 1222(a).
This is not the first time the Court has confronted a conflict between the needs of the Internal Revenue Service and the Bankruptcy Code’s framework for responding to financial distress by reducing or eliminating the debtor’s financial obligations. Indeed, by my count this is the ninth such case. Interestingly, the IRS has done quite well in those cases: it has been fifteen years since the last time it lost a bankruptcy case in the Supreme Court (United States v. Noland in October Term 1995).
Perhaps I’m biased because I understand the bankruptcy perspective directly and find the tax perspective alien. But I think the government will have quite a difficult time here. For one thing, although not all of the Justices will care, the government’s argument is flatly inconsistent with the purpose of Section 1222, which originated as a bill introduced by Senator Grassley for the express purpose of allowing family farmers to avoid the payment of capital gains taxes when they sold their farms during bankruptcy. The government argues that the provision has some effect even under its reading – when the debtor has sold the farm just before the bankruptcy (a circumstance that involves a separate priority provision not at issue here). An excellent amicus brief by Supreme Court regular Eric Brunstad demolishes the idea that this is consistent with Grassley’s motivation in drafting this provision. So the government’s argument, at bottom, is that Grassley did not know enough about the Internal Revenue Code to draft an amendment adequate to accomplish his purposes.
Another argument likely to sway the Justices relates to traditional bankruptcy practice. Although the Bankruptcy Code unquestionably was intended to work a major reform of bankruptcy law, the Court has adopted a strong interpretive canon against reading the Code to change anything settled under pre-Code practice. And there is no doubt that in pre-Code practice tax obligations incurred by a bankrupt during the pendency of a proceeding were administrative expenses – the Court’s explanation of the point in Nicholas v. United States was detailed and precise. The most the government can say here is that the case involved the provisions of the Bankruptcy Act that were repealed in 1978.
The argument here could have some exciting fireworks. The Justices most assuredly will press the government to justify what seems to be an opportunistic shift of position – the Halls (and their amici) argue persuasively that the government sought administrative expense treatment for post-petition taxes regularly before the adoption of Section 1222(a) and that the argument presented here is wholly constructed to avoid the operation of that Section. And we can even hope for some discussion of the relative importance of tax and bankruptcy policy. This might not be the most famous case of the Term, but it is likely to be one of the more interesting moments of pure statutory interpretation.