The Peculiar World of Chapter 11 Bankruptcy Taxation

As the U.S. looks to come back from what Warren Buffett described as a “big one-two punch” of a pandemic and collapsing oil prices, many industries are facing disruptions in business performance resulting in rapid and severe financial distress. As the premier advisor for restructuring and turnaround of troubled companies, Alvarez & Marsal has a long history of guiding companies through the unique business and tax matters encountered throughout the Chapter 11 bankruptcy process timeline. In this issue of the Tax Advisory Weekly, we provide an overview of several key tax challenges facing companies in Chapter 11 bankruptcy.

Impact of the bankruptcy filing

Although pre-filing analysis may be done, the formal process of filing bankruptcy begins with a petition to the Bankruptcy Court. Pre-petition debts, including taxes, cannot be paid without court approval. However, post-petition debts are generally paid in the ordinary course of business. Placing tax obligations in the proper pre- or post-petition bucket is not always intuitive, particularly for non-income taxes like property tax. In addition, certain pre-petition tax obligations may have different bankruptcy priorities based on when the tax was incurred. A thorough inventory of the company’s tax obligations is required to insure no amounts are paid illegally.

The first day order

When the petition is filed, the Bankruptcy Court issues “first day orders”, which allow certain, otherwise impermissible pre-petition liabilities to be paid (such as utilities, payroll, etc.). Taxes are a key element of the first day orders declared by the court. At this time, equity and debt trading orders are often handed out to restrict trading of equity and debt interests and to preserve and protect tax attributes like net operating losses. Most importantly, the debtor company must receive authorization to pay trust fund taxes incurred before the petition is filed. Trust fund taxes typically include payroll withholding, sales taxes and certain excise taxes. The company’s officers have a vital interest in ensuring the collected taxes are paid since as “responsible persons”, they may have personal liability for trust fund taxes under federal or state law.

The claims process

All actual or potential creditors must be sent a notice of the bankruptcy filing. The court will set a “bar date,” which is normally 180 days after commencement of the case. Claims filed after the bar date are generally not allowed. It is vital that all tax jurisdictions with potential claims be notified so their bar date period begins to run.

As a result of the bankruptcy notification, the company filing bankruptcy may suffer a deluge of federal and state audits.  Excessive claims may also be filed as the jurisdiction seeks to protect its position until audits are completed and the correct amount owed is determined. All of these claims must be examined, reconciled and negotiated to ascertain the amount of allowed claim. If an agreement is not reached, the debtor may object to the claim, leaving the matter to be decided by the bankruptcy judge. This possibility encourages state and local taxing authorities to negotiate a reasonable settlement.

Priority of tax claims

In addition to the Internal Revenue Code (IRC), the Bankruptcy Code (B.C.) [1] includes many provisions that impact federal and state taxes, in which the Bankruptcy Court often becomes the final decision maker for tax issues. In particular, B.C. § 507(a)(8) defines which tax claims fall under the eighth priority in the pecking order of unsecured claims. Which taxes are included as a priority claim depends on the type of tax, filing date and other factors. Determining which claims are priority claims, however, can be complex…

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