Supreme Court Decision “Taxes” The Ability Of Debtors To Reorganize In Chapter 11
June 19, 2008

In a June 16 decision, the United States Supreme Court has resolved a disagreement among lower courts over the interpretation of a tax exemption that many debtors reorganizing under Chapter 11 of the Bankruptcy Code have used to redirect scarce dollars from taxing authorities into the hands of creditors. Agreeing with the Florida Department of Revenue, the Court held that only transfers of assets carried out pursuant to a confirmed Chapter 11 reorganization plan and after the plan is confirmed are exempt from transfer taxes.

Chapter 11 reorganization cases are expensive proceedings in which too may creditors fight over too few assets. Taxes assessed against reorganizing debtors soak up some of those precious assets, leaving creditors with even less to share.

To increase the likelihood of successful reorganizations, Congress gave reorganizing debtors breaks from paying certain taxes. One of those breaks is found in Section 1146(a) of the Bankruptcy Code which provides that “the making or delivery of an instrument of transfer under a plan confirmed under section 1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax.”

This tax break can be significant. While only approximately $40,000 in taxes were at stake in the Supreme Court case, in a 1999 case involving a real estate developer, the exemption, if applicable, would have saved the reorganizing developer over $8 million which could have been used to pay creditors or for working capital for the reorganized company.

While the statute refers to transfers under a plan confirmed under Bankruptcy Code section 1129, for many reasons, assets are rarely transferred under a confirmed plan. Getting a Chapter 11 plan confirmed involves multiple steps that take a long time to complete. Few interested buyers want to wait the months that it takes to achieve confirmation of a plan to acquire a business. Debtors short of cash are rarely able to operate a business optimally and the business may lose value, or even fail, before a plan can be confirmed. Creditors, too, want to close sales quickly when there is an interested buyer because they want to turn the business assets into cash before they decline in value.

Moreover, much of the plan negotiation process revolves around what will be available to pay creditor claims. If assets are not sold until after a plan is confirmed, the debtor and creditors have to negotiate a plan in a vacuum before they know how much money they will have to divide among the competing various classes of creditors.

Because of these kinds of practical issues, the common practice is for debtors to sell their assets first and then negotiate a plan that divides up the proceeds. Since an exemption from transfer taxes can significantly increase the likelihood of a successful reorganization, many bankruptcy courts have stretched the statutory language to help reorganizing debtors. It has been common for courts to hold that if a sale consummated before a plan was confirmed is necessary to make a plan confirmed after the sale feasible, the sale has a sufficient “nexus” to the plan that the tax exemption applies. That is what the lowers courts had done in the case decided by the Supreme Court.

The Supreme Court said that an interpretation of statute to make the tax exemption applicable to a transfer carried out before a plan is confirmed “places a greater strain on the statutory text than the simpler construction advanced by Florida.” Examining the language of the statute, the Court said that a transfer “cannot be `under a plan confirmed´ until the court confirms the plan in question.” Any other interpretation, the Court said, would violate the “federalism canon” that the federal government should not interfere lightly with the authority of states to tax and that Congress must “clearly express” an intention to exempt a transaction from state tax. Responding to the argument that “the `practical realities´ of Chapter 11 reorganizations are increasingly rendering postconfirmation transfers a thing of the past,” the Court said that “it is incumbent upon the Legislature, and not the Judiciary, to determine whether §1146(a) is in need of revision.”

At a time when bankruptcy cases are on the rise and state and local governments are facing shrinking property tax revenues because of declining real property values, the Supreme Court's decision will be welcome news to taxing authorities. For everyone else, the decision means that there will be less money to go around in Chapter 11 cases unless everyone waits until a plan is confirmed before assets are sold to pay creditors.

If you have questions, please contact:
Bill Hallam or Lou Ebert

(410) 752-2468