Contributed by Yvanna Custodio and Max Goodman
Last year, we discussed a variety of tax issues here, here, and here, ranging from whether a debtor-subsidiary’s beneficial tax status as a particular kind of flow-through entity constitutes property of that debtor’s estate, to the application of what is now section 1146(b) of the Bankruptcy Code, which allows the bankruptcy court to rule on questions of law with respect to the state or local income tax consequences of a plan under section 346 of the Bankruptcy Code. This month, our “Breaking the Code” super-secret-section-generator (after having the right buttons pushed) coincidentally picked section 505(a) of the Bankruptcy Code, which governs the determination of tax liability by a bankruptcy court. This installment of “Breaking the Code” will feature the policy and purpose of section 505(a), which sets forth the authority of the bankruptcy court to rule on tax claims and the limits of such authority.
The Basic Rule
Under section 505(a)(1), the bankruptcy court may, subject to the exceptions in section 505(a)(2), determine the amount or legality of any tax, fine or penalty relating to a tax, or any addition to a tax, whether or not it has been previously assessed or paid. The provision applies both to prepetition and postpetition taxes.
Bankruptcy courts have observed that, in enacting section 505(a)(1), Congress intended to authorize bankruptcy courts to resolve tax issues necessary for the efficient administration of the estate in an expeditious manner. Its purpose was “to afford a forum for the ready determination of the legality or amount of tax claims, which determination, if left to other proceedings, might delay conclusion of the bankruptcy estate.”
Although the bankruptcy court is often viewed as a debtor-favorable forum for litigating tax disputes, the bankruptcy court generally has the discretion to abstain from hearing such disputes pursuant to section 505(a)(1) because of the word “may” in this provision.
The Limitations
Section 505(a)(2)(A), however, limits the court’s power to determine tax liability where the amount or legality of the tax was contested before and adjudicated by a judicial or administrative tribunal, in each case before the commencement of the bankruptcy case. The purpose of the section is to protect “the estate from the negligence or indifference of a debtor who has defaulted in tax assessment proceedings . . . .” Moreover, the section was enacted to address Congress’s concern “with protecting creditors from the dissipation of the estate’s assets which could result if the creditors were bound by a tax judgment which the debtor, due to his ailing financial condition, did not contest.” The exception in section 505(a)(2)(A) is premised, however, on res judicata principles and reflects the notion that these concerns do not apply when the debtor has diligently contested the tax claim before another tribunal and such tribunal has adjudicated the dispute.
In addition, section 505(a)(2)(B) provides that the court may not determine the right of the estate to a tax refund until the earlier of (i) 120 days after the estate properly requests such refund from the applicable taxing authority and (ii) a determination by the taxing authority with respect to the request. The purpose of this provision “is to afford the taxing authority a reasonable opportunity to review any refund claim under its normal administrative procedures. The 120-day time frame was felt to be [a] reasonable period of time to strike an appropriate balance between the needs of the taxing authorities and the need to promptly administer the bankruptcy estate.” At least with respect to federal tax refund claims, section 505(a)(2)(B) shortens the time frame from the usual six months.
Finally, the court may not, under section 505(a)(2)(C), determine “the amount or legality of any amount arising in connection with an ad valorem tax on real or personal property of the estate, if the applicable period for contesting or redetermining that amount under applicable nonbankruptcy law has expired.” When added to the Bankruptcy Code in 2005, this provision reversed a line of cases permitting debtors to challenge property tax assessments in bankruptcy court long after such challenges would have been barred under applicable state law.
A further discussion of section 505(a) may be found in Section 1013 of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2013 ed.).