Tax and pension claims in bankruptcy.

• Author: DeGeorgio, Thomas J.
• Position: Part 1

EXECUTIVE SUMMARY

* Congress enacted bankruptcy laws to give debtors relief from the burdens of excessive debt and to provide equal treatment of similarly situated creditors.

* The distinction between secured and unsecured taxes is important, because it affects the priority of claims and the debtor's responsibilities after bankruptcy.

* The timing of tax, the type of tax and whether a claim is a tax are factors in determining priority.

Priority and status of tax and pension claims in bankruptcy are important to many, including the estate, debtors, creditors, employees and taxing authorities. Part I of this two-part article provides a summary of bankruptcy law and claims rules and discusses how they relate to tax liability.

Generally, tax practitioners look to Congress to set tax laws and to the courts to interpret them. Throughout the last decade, the bankruptcy courts have been changing the standard interpretation of tax laws, making it a source worthy of frequent reference.

Part I, below, discusses bankruptcy laws in general, the treatment of tax and pension claims in bankruptcy and why the treatment of such claims is so important. It addresses both individuals and corporations. Part II, in the September 2003 issue, will examine specific types of tax and pension claims, bifurcation and other planning considerations. The articles are relevant to tax or bankruptcy practitioners, whether they represent debtors, private creditors or government tax authorities.

Purpose of Bankruptcy Law

Congress originally enacted the bankruptcy laws to give debtors relief from the burdens of excessive debt and to provide equal treatment of similarly situated creditors. Bankruptcy can be filed by debtors to obtain relief from the pressures of creditors (i.e., voluntary bankruptcy) or be forced by creditors (i.e., involuntary bankruptcy).When a bankruptcy petition is filed, an estate is formed to aggregate the debtor's assets as of the bankruptcy petition date, so that they can be distributed fairly. Creditors of similar standing receive ratable proceeds; the debtor can be discharged of all nonexempted claims, providing the debtor with a "fresh start." While the case is pending before the bankruptcy court, stays of collection and of unsecured interest are in effect. When the debtor is highly leveraged and the interest expense is burdensome, the stay of interest alone is a valuable benefit. On completion of the bankruptcy case, all claims against the estate are discharged, except those exempted by statute or court order, which remain the debtor's responsibility (if the debtor continues to exist).

Types of Bankruptcy Cases

Bankruptcy petitions are filed with the bankruptcy court (an adjunct of the district court) and governed by the Bankruptcy Code. (1) Bankruptcy filings for individuals or corporations can constitute either a petition for complete liquidation (Chapter 7) or a reorganization of assets and debts (Chapter 11). Chapter 13, which provides temporary relief from creditor action for nonbusiness entities who plan to pay liabilities from future earnings, is available only for individuals.

Chapter 7

In a Chapter 7 filing, a trustee is appointed to liquidate the debtor's assets in a way that best satisfies creditors' claims. Because the client is not expected to emerge from bankruptcy, there is an emphasis on maintaining the corporate veil, which frees stockholders and managers from liability for corporate debts. However, corporate veils can be pierced (and managers and stockholders held responsible for debts) on isolated issues, like the trust fund portion of payroll taxes.

Chapter 11

In contrast, Chapter 11 companies plan to emerge from bankruptcy. Chapter 11 bankruptcies are filed...