Bankruptcy - Robert B. Chapman

• Publication year: 2002

Bankruptcyby Robert B. Chapman^*

The body of 2001 published opinions from the Eleventh Circuit Court of Appeals and from district courts, bankruptcy courts, and state courts within the Eleventh Circuit cover a wide range of issues. Broad disagreements about fundamental questions remain,¹ including issues regarding subject matter jurisdiction, the relation between federal and state law judgments, property of the estate, the range of the bankruptcy courts' equitable powers, and the degree of deference to give Congress's "plain language," in short, the nature and scope of bankruptcy and bankruptcy law. These broad differences manifested themselves in rulings that revealed tensions and conflicts within and among the various courts that create bankruptcy law.

I. Supreme Court Cases

The Supreme Court decided no bankruptcy cases in 2001. But it granted certiorari on an important bankruptcy tax case in 2001, which it decided in 2002, and decided four other cases that may have more or less effect in bankruptcy. These cases include rulings on subchapter S corporation discharge of indebtedness, judicial estoppel, the effect of dismissal "with prejudice," and sovereign immunity.

A. Gitlitz v. Commissioner: S Corporation Discharge of Indebtedness

The one Supreme Court case in 2001 that is likely to have a significant short-term effect in bankruptcy, Gitlitz v. Commissioner,² is a tax case in which the Supreme Court held that Sec. 1367(a)(1) of the Internal Revenue Code permits "S corporation" shareholders to increase bases in their shares by the amount of the S corporation's discharge of indebtedness, which Sec. 108 excludes from gross income, and that the increase occurs before the reduction of the corporation's tax attributes.³ S corporations are essentially conduits through which income and loss pass to their shareholders.⁴ Shareholders are prohibited, however, from recognizing corporate losses in excess of their respective bases in their shares.⁵ Such excess losses are "suspended"⁶ until the shareholders' respective bases are later increased by, for example, the pass-through of corporate income.⁷ Discharge of indebtedness income is generally includible in gross income⁸ but not if the discharge occurs, among other circumstances, in a bankruptcy case or when a taxpayer is insolvent.⁹ In these circumstances, the income is excluded and certain "tax attributes," such as net operating losses or basis in property, are reduced by the amount of income excluded.¹⁰ In Gitlitz the Supreme Court resolved an intercircuit split as to the operation and interrelation of these rules in a manner virtually everyone concedes results in a "windfall"¹¹ or, as the Court described it, a "double windfall."¹² The Court held discharge of indebtedness income to be "income" for purposes of increasing a shareholder's basis, even though it is excluded from gross income, and the basis adjustment occurs before tax attributes (including suspended losses) are reduced.¹³

Shortly after the Court handed down its decision, commentators began speculating that Congress would overrule Gitlitz by legislation.¹⁴ In the Job Creation and Worker Assistance Act of 2002 ("JCWAA"),¹⁵ which President Bush signed on March 9, Congress amended Sec. 108 to overrule Gitlitz. Section 402(a) of the JCWAA amends Sec. 108(d)(7)(A) to provide that, in applying Sec. 108 at the corporate level, excluded discharge of indebtedness income does not pass through to the shareholders under Sec. 1366. It follows, therefore, that shareholders' bases are not increased under Sec. 1367. The losses suspended under Sec. 1366(d) are not available because they are reduced under Sec. 108(b)(2)(A) by the amount of the excluded discharge of indebtedness income.

The amendment generally applies to any discharge of indebtedness after October 11, 2001. It does not apply, however, to a subchapter S corporation that received a discharge before March 1, 2002, pursuant to a plan or reorganization filed on or before October 11, 2001. For plans filed after October 11, 2001, any discharge will be subject to the new rule.

Gitlitz might have made bankruptcy a more attractive possibility for S corporations because shareholders could have deducted suspended losses against passed-through discharge of indebtedness income and because the net operating loss would be reduced after the basis increase. Gitlitz would have raised a question, however, about the absolute priority rule. "Old equity" is frequently motivated by tax concerns to retain its interest in the debtor entity.¹⁶ Corporate tax attributes, such as net operating losses and various credits, are considered "property" for purposes of the rule.¹⁷ With an S corporation, tax attributes, although they exist,¹ are less numerous; the benefit described in Gitlitz inures only to the shareholders and not to the corporation. If the "old equity" received an increase in basis and could take suspended losses as a result of confirmation, would this violate the absolute priority rule if they receive it "on account of their junior claims?

In theory, shareholders of a debtor who fails to pay its unsecured creditors in full may be prevented from receiving or retaining any property because of their shares; however, in practice, many reorganizations violate the absolute priority rule.¹⁹ If shareholders believed they could do so, or if the court did not consider the basis jump to be property received or retained on account of their equity interest, Gitlitz would have made bankruptcy more attractive for S corporations.

If, however, the basis increase were considered property received on account of the shares, Gitlitz illustrates an important implication of North LaSalle Street.²⁰ There is no way for creditors, who in theory should become "new equity," to get the benefit of the increase in basis and take the losses themselves in the year of discharge. The relevant treasury regulation provides that disallowed losses are personal to the shareholder and "cannot in any manner be transferred to another person;" the regulation further specifies that if the shareholder transfers all of the stock in the corporation, the suspended loss is permanently disallowed.²¹ The shares of the debtor S corporation would have more value, efficient management issues aside, in the hands of the shareholders than in the hands of creditors.

Many bankruptcy experts have focused on various threats the parties have in bankruptcy.²² If the creditors had a threat of invoking the absolute priority rule against an S corporation, the shareholders would have an incentive to pay a premium to retain their shares.²³ The value of the threat would decrease, of course, according to each shareholder's marginal tax rate and reach equilibrium at the point at which the tax benefit from discharged indebtedness equals the amount of debt repaid to keep the shares. The shareholders and creditors, therefore, each would have an incentive to reach agreement somewhere in between.

B. Young u. United States (In re Young): Three Year Lookback Rule for Discharge of Taxes

The Supreme Court accepted an invitation to "fix" another tax-related "loophole" created by congressional oversight when it granted certiorari to review the decision of the First Circuit Court of Appeals in Young v. United States (In re Young).²⁴ * The First Circuit followed the Third,²⁵ Seventh,²⁶ Eighth,²⁷ Ninth,²⁸ and Tenth²⁹ Circuits in holding that the three-year lookback provision in Sec. 507(a)(8)(A)(i) is automatically tolled for any period during the three years in which the taxing authority is stayed by a prior bankruptcy.³⁰ The First Circuit rejected the more amorphous tests articulated by the Fifth,³¹ Sixth,³² and Eleventh Circuits.³³

The Eleventh Circuit has held that bankruptcy courts may use their equitable powers under Sec. 105 to toll the lookback period for priority and discharge for any period of a prior bankruptcy.³⁴ The court stated that "the equities will generally favor the government"³⁵ but acknowledged that "[t]here may factual scenarios, however, in which the equities favor the taxpayer."³⁶ The court specifically declined to "set forth the equitable considerations regarding Sec. 105(a), but [it] reject[ed] the notion espoused in In re Gore³⁷ . . . that a finding of dilatory conduct or bad faith is necessary to find the equities in favor of the government."³⁸ The Supreme Court decided Young in March 2002 and answered the question simply, without referring to the decision of the Fifth, Sixth, and Eleventh Circuits, to agree with the First Circuit: "Tolling is in our view appropriate regardless of petitioners' intentions when filing back-to-back Chapter 13 and Chapter 7 petitions—whether the Chapter 18 petition was filed in good faith or solely to run down the lookback period."³⁹

In 2001 two bankruptcy courts in the Eleventh Circuit held that courts may not toll the lookback period for the additional six months provided in 26 U.S.C. Sec. 6503(h).⁴⁰ That statute tolls the ten-year limitation on federal tax collection⁴¹ for the duration of any bankruptcy case and an additional six months. The courts held that because Sec. 6502 only tolls the limitation on collection and does not address liability, it is not directly applicable to the discharge; further, because it is a tax rather than a bankruptcy statute, a court's equitable powers under Sec. 105 to issue any order necessary to carry out the provisions of "this title" do not apply.⁴²

C. New Hampshire v. Maine: Judicial Estoppel

A string of 2001 decisions by Alabama and Georgia courts addressed whether debtors who omit causes of actions from their bankruptcy schedules are judicially estopped from asserting their claims in state court. The Georgia Supreme Court held that a Chapter 13 debtor who acquires a personal injury action during a Chapter 13 case and fails to amend her schedules is judicially estopped from suing on the claim because failure to list it is a "denial that such assets...