Weil Restructuring

On Tax Day, the Debtor-Taxpayer Wins (But Not Quite)

Contributed by Yvanna Custodio
“This is a question too difficult for a mathematician. It should be asked of a philosopher.”

Albert Einstein, on preparing tax returns

In honor of Tax Day, April 17th, we feature In re Strategic Labor, Inc., No. 10-43245-MSH, 2012 WL 707175 (Bankr. D. Mass. Mar. 5, 2012), a recent case hailing from the United States Bankruptcy Court for the District of Massachusetts in which the Internal Revenue Service was a secured creditor.  In the decision, Judge Melvin S. Hoffman considered two motions:  one filed by the IRS for adequate protection, accounting, disgorgement, and payment, and the other, filed by the debtor, for recovery pursuant to section 506(c) of the Bankruptcy Code.  Although the court conducted a straightforward analysis of the requisites for surcharging the secured creditor’s collateral, the court reduced the section 506(c) award partially as a result of the debtor’s misconduct, noting that the debtor had (i) failed to preemptively seek the IRS’s approval for a carve out of the administrative expenses, (ii) spent the IRS’s cash collateral without authority, and (iii) paid its attorneys’ fees out of the IRS’s cash.
Background and Analysis
The debtor, Strategic Labor, Inc., a workforce scheduling software company, filed for bankruptcy protection under chapter 11 of the Bankruptcy Code on June 28, 2010 with the aim of consummating a sale of its assets.  The debtor’s schedules supporting the bankruptcy petition incorrectly listed only one secured creditor, failed to include the IRS as a secured creditor, and inaccurately scheduled the IRS’s claim as a priority unsecured claim.  Although the debtor’s schedules listed the IRS as a priority unsecured creditor, the debtor’s statement of financial affairs indicated that the IRS held a tax lien in an amount slightly higher than the IRS’s priority unsecured claim.  Moreover, the debtor’s schedules also conflicted with the affidavit supporting the debtor’s first day motions, which disclosed the IRS’s tax lien.
A few days later, the intended purchaser, Infor Global Solutions (Michigan), Inc., entered into an asset purchase agreement with the debtor to acquire substantially all of the debtor’s assets in connection with a “section 363 sale.”  The debtor also sought debtor in possession financing, requesting court approval to borrow funds from Infor, the stalking horse bidder under its sale motion.  Also in contrast to the debtor’s schedules, the DIP motion acknowledged the IRS’s tax lien.  The bankruptcy court granted the DIP motion, but subjected Infor’s security interest to “existing, valid, prior, and otherwise unavoidable, perfected liens and security interests . . . .”  The DIP motion neither included nor contemplated a request to use any secured creditor’s cash collateral.
Subsequently, the IRS filed a claim on the basis of the debtor’s unremitted payroll taxes and asserted a security interest over all of the debtor’s personal property.  The IRS also received a notice of the auction and sale hearing that was sent in connection with the debtor’s section 363 sale motion and did not oppose the sale, which the court approved.
Almost a year later, the debtor filed a motion to dismiss the case, again neglecting to disclose the IRS’s tax lien and secured creditor status.  The debtor’s motion to dismiss revealed for the first time that the debtor’s counsel, The Gordon Law Firm LLP, was holding in its IOLTA account only a portion of the sale proceeds, having already paid its own fees and expenses out of the proceeds.  The IRS, responding to this revelation, objected to the motion to dismiss.  At the hearing to consider the motion, it was discovered that, in addition to the IRS’s security interest over all of the debtor’s assets (which had attached to the proceeds of the sale), the debtor had never sought nor received authority to use the IRS’s cash collateral.  Agreeing with the IRS’s conclusion that the debtor had “burned through a great deal of the IRS’s cash collateral,” the bankruptcy court denied the motion to dismiss.
No longer the “slumbering giant,” the IRS then filed a motion for adequate protection, accounting, disgorgement, and payment, seeking immediate payment of all the funds remaining in the IOLTA account as well as disgorgement from The Gordon Law Firm of its prior fee award and expense reimbursements.  In response, the debtor filed a motion seeking to surcharge the IRS’s cash collateral pursuant to section 506(c).  The debtor argued that a section 506(c) surcharge was appropriate on the grounds that (i) the chapter 11 petition was filed for the sole purpose of consummating a section 363 sale, (ii) the IRS had received notice of the sale and, by not objecting to it, was deemed to have consented, and (iii) the sale precipitated a bidding war resulting in a 50% premium over the initial price.  The debtor primarily argued that filing for bankruptcy protection resulted in substantial benefit to the IRS; the costs, therefore, of achieving that benefit should likewise be charged to the IRS.
The bankruptcy court granted in part the debtor’s motion to surcharge the IRS’s collateral, noting that the costs eligible for section 506(c) treatment are “the costs directly associated with the sale to Infor.”  Citing to prior cases that analyze section 506(c), the court noted that section 506(c) provides an exception to the general principle of bankruptcy distribution that prefers secured creditors by allowing a trustee or debtor in possession to recover from the proceeds of the secured creditor’s collateral the reasonable, necessary costs and expenses related to preserving or disposing of the secured creditor’s collateral to the extent of any benefit to such creditor.  Although section 506(c) does not require the secured creditor’s advance consent, such consent is still “a relevant consideration.”  The court observed that because the IRS did not object to the sale, this was tantamount to the IRS’s acknowledgment of the desirability of the sale process.  The court analyzed the amounts the debtor sought to surcharge the IRS’s collateral then awarded an amount based on expenditures it considered “reasonable and necessary” and that had primarily benefited the IRS.  Unfortunately, the debtor had already spent more than the net 506(c) award, justifying the issuance of disgorgement orders to the debtor’s payees.  Moreover, because the debtor and its counsel had, among other things, spent the IRS’s cash collateral without authority and paid the debtor’s attorneys’ fees out of the IRS’s cash, the court apportioned the reduction of the 506(c) award for management costs and legal fees between both the debtor and its counsel.
In re Strategic Labor presents a situation in which the taxpayer-debtor wins a section 506(c) award and, by the same token, has such award reduced, not only because of the failure to demonstrate that the expenses incurred were reasonable, necessary, and primarily benefited the IRS as secured creditor, but also because of the misconduct of both debtor and its counsel.  On Tax Day, this case serves as a reminder of the oft-quoted saying, “The IRS always gets its money.”

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