collection of Federal taxes in bankruptcy cases. It should be noted, however, that a significant amount of litigation has occurred involving interpretation of the meaning of the 1966 amendments to section 17a of the Bankruptcy Act.

We are endeavoring to compile more extensive statistical data, which will be furnished to the Subcommittee.

CERTAIN STATUTORY AND COMMON-LAW LIENS (SEC. 4-606)

Under section 6321 of the Internal Revenue Code, a lien in favor of the United States arises whenever any person liable for any tax neglects or refuses to pay after demand. The lien attaches to all assets of the taxpayer, and after a notice of lien is filed, becomes perfected against certain classes of creditors. This lien continues until the tax is paid or becomes legally unenforceable. However, under section 4–606(a) of the bill, every federal tax lien on assets in the bankruptcy estate, which secures the Government's claim against the debtor, is invalid. It does not matter whether a notice of lien was filed before bankruptcy.

Furthermore, under section 4-606 (b) the trustee is entitled to recover any amounts paid or property transferred by the debtor, whether solvent or insolvent, within three months prior to the petition date to satisfy a federal tax lien vitiated under section 4-606(a). Thus, the trustee would be able to recover not only the amount of any voluntary payment made by the debtor, but also any property seized by the Service. All collection efforts by the Service within three months prior to the bankruptcy of a debtor would thus be curtailed.

The invalidation of federal tax liens in bankruptcy proceedings would impose a burden on the Government. Eliminating the Government's status as a secured claimant can be expected to reduce recovery of unpaid taxes from the assets of a bankruptcy estate. Furthermore, the proposal will provide great incentive for creditors to force debtors into bankruptcy so as to negate the effect of prior superior Federal tax liens, and thereby increase the amounts potential available for distribution to them. Thus, enactment of the proposal would result in an increase in the number of involuntary bankruptcies since in that fashion creditors can eliminate a prior lien of the Government.

For these reasons, we oppose this section of the bill as it affects the collection of Federal taxes.

PREFERENCES (SEC. 4-607)

Additionally, under section 4-607 of the bill, any payment made by or property seized from an insolvent debtor (insolvency is presumed) within three months prior to bankruptcy to satisfy a Federal tax liability more than five days old is a recoverable preference, if the amount paid or aggregate value of the property is $1,000 or more and such transfer enables the Government as of the petition date to obtain a greater percentage of its claim than other creditors of the same or higher class.

Substantial amounts of money and property may be recoverable from the Service as preferences under section 4-607, for example, payments made voluntarily, or involuntarily by seizure of bank accounts, etc., within three months prior to bankruptcy by insolvent taxpayers. Thus, the preference provision may in many circumstances even hinder the tax collection procedures of the Service during the three-month period preceding the bankruptcy of a taxpayer.

We therefore oppose this section of the bill as it affects the collection of Federal taxes.

DISTRIBUTION OF PROCEEDS (SEC. 4-045)

Section 4-405(a) provides the order of distribution of the proceeds of the bankruptcy estate. In general, the priorities for claims entitled to be paid ahead of prepetition tax claims have been expanded.

Section 4-405 (a) (5) establishes the priority for various types of prepetition taxes. Unlike present law, nondischargeability is not a criterion in the determination of priority. More significantly, however, the present priority accorded taxes legally due and owing within three years before bankruptcy is reduced, generally, to only those for which the due date of the tax return is within one year prior to bankruptcy or thereafter.

Priority is granted to income taxes for any taxable period ending on or before the petition date, if the due date for filing the return (or the extended due date) is within one year prior to the date of the petition or thereafter. The priority extends to taxes shown on a return filed by the debtor within such period, as well as to any deficiencies for that return that may later be determined and assessed by the Service (whether before or after the petition is filed).

Priority is also established for taxes that were withheld from wages paid by the debtor before bankruptcy. The general one-year time limitation is not ap plicable to this priority. Further, it appears the Commission may have meant to include the 100% penalty imposed by Internal Revenue Code section 6672 in this priority, rather than in the priority next discussed, though this is not clear.

With regard to wages earned prior to bankruptcy, priority is granted to employment taxes (employer's F.I.C.A., R.R.T.A., and F.U.T.A.) based on such wages if the due date for filing the return (or the extended due date) is within one year before the petition date or thereafter.

If an extension of time for payment of any type of tax was granted, priority is established for any installments payable within one year prior to the petition or thereafter.

Section 4-405 (c) provides that employment taxes on priority wage claims paid by the trustee are considered prepetition taxes. Additionally, the trustee is required to deduct the appropriate withholding taxes from priority wage claims paid and to remit such taxes to the Service.

The priorities established in section 4-405 (a) would be applicable to all bankruptcy cases. Thus, the Government would not be entitled proposed Chapters VII (Reorganizations) and IX (Railroad Reorganizations to full payment of all tax claims before payment to any secured or unsecured creditors, as it presently is in all railroad reorganization, corporate reorganization and real property arrangement cases.

H.R. 31 would not only reduce the present priority under Bankruptcy Act section 64a (4) for taxes accuring within three years of bankruptcy to taxes accruing within one year of bankruptcy, but it also abandons the priority presently accorded the Government under section 64a (4) for taxes more than three years old which are excepted from discharge under section 17a (1) due to justifiable delay in assessment and collection because the taxpayer is contesting a proposed deficiency.

As subsequently discussed, a discharge generally extinguishes an individual debtor's liability for any tax denied priority under section 4-405(a) (5). Therefore, a taxpayer who nonfraudulently understates his liability for an income tax on a return filed more than one year prior to bankruptcy could completely avoid payment by filling a voluntary petition in bankruptcy while exercising his appeal rights within the Service and the Tax Court if necessary.

The conclusion that the priority provisions of the bill will give the Service adequate time to collect taxes is misleading. The reduction of the present threeyear limitation on priority and nondischargeability to one year would place unrealistic burdens on the Service in collecting non-priority taxes prior to bankruptcy. The audit cycle for the examination and disposition of income tax returns is 26 months in the case of individuals and 27 months in the case of corporations. Thus, of necessity in most cases, deficiencies will not have even been determined by the Service as of the date of bankruptcy, let alone assessed and collected. In fact, the General Accounting Office recommended that the Bankruptcy Act be amended to have the three-year period run from the date of assessment because the Service has little or no time to collect the tax before bankruptcy. (Collection of Taxpayer Delinquent Accounts by the Internal Revenue Service GAO B137762, August 9, 1973.) We strongly support the recommendation of the General Accounting Office.

Even in the case of returns filed where the taxpayer has indicated a balance is due but fails to enclose payment, it is likely that the tax will not be collected within the one-year period. Presently, notwithstanding the highly computerized operations of the Service, it takes approximately five months for a Taxpayer Delinugent Account to be issued, let alone be collected. Since the trustee could generally recover payments made to the Service within three months prior to bankruptcy, this leaves four months for collection. We question if this is sufficient time to collect the taxes since the Revenue Officer must first receive the TDA, determine what collection action is appropriate, locate assets for seizure (if necessary). or even recommend the institution of a collection unit. There is little possibility that a judgment would ever he secured in this four-month period. If seizure is undertaken. the taxpayer could institute an infunction suit; notwithstanding the outcome of the suit, the one-year period would elapse without collection.

Under section 4-405(a) (5) (F), if an extension of time for payment of taxes was granted by the Service, a priority is established for any installments not ret payable on the petition date or payable within one year prior thereto. The bill would appear to discourage the use of deferred payment agreements, however,

since taxpayers probably would refrain from entering into such agreements if they are considering bankruptcy as a device to defeat the collection of nonpriority taxes.

We believe the general one-year priority period in section 4-405 (a) (5) should be changed to the three-year period from the date of assessment. This change would be in accord with the previously discussed recommendation of the General Accounting Office.

EXCEPTIONS FROM DISCHARGE (SEC. 4-506 (A) )

Section 4-506 lists the debts which the discharge of an individual debtor does not extinguish. (Although corporate debtors are not entitled to a discharge, in effect a corporation in a reorganization case obtains a discharge when a plan of reorganization binds its creditors to satisfaction of less than the total amounts of their claims.) All other debts of the debtor, whether or not allowable, are extinguished upon discharge.

The discharge of an individual debtor does not extinguish any tax liability for which: (A) a priority is granted under section 4-405(a)(5); (B) a required tax return was not filed more than one year before the petition date; or (C) a false or fraudulent return was made by the debtor, or the debtor willfully attempted in any manner to evade or defeat. As previously mentioned, unless an extension of time for payment has been granted, any income tax for which a return was filed more than one year before bankruptcy is dischargeable, even though delay in assessment or collection was justified. This is so even if a proposed deficiency was asserted on the day the return was filed.

If, as we recommend, the general one-year priority period in section 4-405(a) (5) is changed to the three-year period from the date of assessment of the tax, the taxes granted priority under the change would be excepted from discharge under section 4–506(a)(1)(A). Should this change not be made, it is recommended that whenever a tax is denied priority because a debtor has nonfraudulently understated his tax liability and the Service was prohibited from assessing the additional tax prior to bankruptcy, such tax be made nondischargeable. For example, if a taxpayer is protesting a proposed deficiency with the Service prior to the issuance of a notice of deficiency, he should not be able to completely escape liability therefor by filing a bankruptcy petition and having the additional tax subsequently discharged.

I would now like to turn to a discussion of those provisions of the bill, and the proposed amendments to the Internal Revenue Code contained in S. 236, which affect the tax liability of debtors and bankruptcy estates.

APPLICATION FOR DETERMINATION OF TAX LIABILITY (SEC. 4-402 (D))

This section provides that a trustee or debtor may seek a determination of any unpaid liability of the estate or the debtor for any tax incurred during the period of administration by filing a complaint with the bankruptcy court. If the court is satisfied such determination is necessary to allow expeditious closing of the estate, the Service would have to appear within a time set at the discretion of the court and show conclusively why the tax, if any, computed by the trustee or debtor (including any liability shown on any pro forma returns required by the proposal) should not be approved. This could result in the Service being forced to complete an audit prematurely in a particular case, if such a continuance were not granted. In addition, the Service cannot audit pro forma returns, since such returns are tentative and incomplete when filed.

There is no question that under existing law a trustee faces a major obstack if he desires to close an estate and the circumstances are such that the estate's tax liability is uncertain.

As a general proposition, we are in favor of remedial legislation in this area. However, the Service would be able to deal with this matter in a more efficent manner if the remedial provision were similar to those contained in sections 2204 and 6905 of the Internal Revenue Code. Under these provisions the executor of a decedent's estate may apply to the Service for a determination of the amount of tax owed and for a release from personal liability. Within 9 months from the time that the application is made the Service must notify the executor of the amount of tax due. The executor, on the payment of such amount, is discharged from personal liability for any deficiency in tax thereafter found to be due. For the reasons previously discussed, we oppose section 4-402 (d) in its present form.

INCOME TAXES AND LIQUIDATING BANKRUPTCY PROCEEDINGS (SEC. 5-104)

This section contains four subdivisions which will have a major effect on the income taxation of estates in liquidating proceedings. The section is applicable to corporate and noncorporate bankrupts. Under section 5-104(a) an estate in a liquidating bankruptcy proceeding will be exempt from income tax (including state and local income taxes) unless the estate turns out to be solvent. The exemption extends to operating income as well as gains realized on the disposition of assets. In the event of solvency the amount of the surplus acts as a limi on the amount of tax payable, and not as a limitation of the amount of income which is taxable. If the surplus is insufficient to pay all of the taxes, the tax claimants are to share in the surplus on a pro rata basis.

Under current law an estate in bankruptcy is taxable on operating and nonoperating income and capital gain generated during the administration of the estate. The resulting taxes are treated as administration expenses and given a first priority under section 64a (1) of the Bankruptcy Act. Under the proposed legislation the Government's position would be reduced from that of a first priority claimant to that of having no claim at all.

We are not in favor of exempting estates in liquidating bankruptcy proceedings from taxation. It is our view that income earned and gains realized during the liquidation of an insolvent estate should be subject to taxation to the same extent as if the liquidation involved a solvent taxpayer. Although the imposition of income tax on an insolvent taxpayer will have the effect of reducing the funds available for the payment of lower priority creditors the priority question has traditionally been resolved in the Government's favor by giving tax claims a high priority in insolvency situations-presumably with the thought that the business of Government is paramount and taxes are the lifeblood of the Government.

In lieu of completely exempting liquidating proceedings from income taxation we suggest that it would be appropriate to consider legislation that would reduce the number of returns required to be filed in such cases. For example. consideration might be given to granting a larger tax exemption to estates in liquidating bankruptcy proceedings. Under this approach estates would be relieved from the requirements to file a return when they have gross income of such a minimal amount that it is unlikely that taxable income will exist after the deduction of the expenses of administration.

TERMINATION OF TAXABLE PERIOD (SUBDIVISION (B))

Proposed section 5-104 (b) provides that a debtor's taxable period is to be terminated on the date a petition in bankruptcy is filed, and that the tax computed for such period may be allowed as a claim against the estate. In the case of an individual debtor the termination is to be tentative, and if the tax computed for the full taxable period (as if no petition had been filed) is less than the tax computed for the terminated period, then only the lesser amount shall be allowed as a claim against the estate.

If proposed section 5-104 (a) is not enacted (as we recommend), we would not favor terminating a corporation's taxable year. In this event we favor retaining the existing system whereby a corporation continues to file its return for an unbroken period as if bankruptcy had not occurred. The current system is feasible in the case of corporate debtors since the tax liability and funds to pay the liability follow the same route. That is, the trustee who must file the return for the unbroken period also has possession of the corporate assets.

We think that the proposal has merit with respect to individual taxpayers. The income tax liability of an individual bankrupt for the year in which the petition is filed remains his liability rather than a claim against the estate. The present system can produce unfortunate results when the taxes attributable to income accrued or collected prior to bankruptcy since the liability remains that of the bankrupt while the assets from which he might have paid the tax pass to his trustee.

LOSS CARRYOVERS AND CARRYBACKS (SUBDIVISION (C))

We support proposed section 5-104 (c) which provides that the trustee of the estate of an individual bankrupt shall have the benefit of any refund generated by loss carrybacks attributable to losses sustained prior to bankruptcy. If such losses cannot be utilized as carrybacks then the trustee may carry over the losses against income generated by the estate in bankruptcy during the period of administration.

ALLOCATION OF PARTNER'S TAX LIABILITY, REFUND or carrYOVER TO THE PARTNERSHIP (SUBDIVISION (D) )

We are opposed to the enactment of Subdivision (d) to the extent that it would apportion a partner's unpaid tax liabilities or loss carryovers to the partnership. We do not oppose Subdivision (d) to the extent that it would give the partnership trustee the right to any tax refund due to an individual partner to the extent the refund is "fairly apportionable" to unreimbursed partnership losses. However, we recommend that it be made clear that any such refund may first be setoff against any unpaid tax liability of the individual partner. We also suggest a provision to the effect that the refund check shall be payable to the individual partner or his trustee, and that the allocation of the refund is a matter to be resolved between the partner (or his trustee) and the partnership trustee.

REORGANIZATIONS-SPECIAL TAX PROVISIONS (SEC. 7-315)

Proposed Chapter VII would replace the debtor rehabilitation proceedings in the current Bankruptcy Act (Chapter X reorganizations, Chapter XI arrangements, and Chapter XII real property arrangements) with a new "reorganization" proceeding which would apply to corporate and noncorporate debtors. Proposed section 7-315 is comprised of numerous subdivisions containing special tax provisions applicable not only to the new Chapter VII "reorganization" proceeding but also to Chapter IX Railroad Reorganization by virtue of proposed section 9-101.

ADJUSTMENT OF INDEBTEDNESS AND TAX BASIS OF PROPERTY (SUBDIVISIONS (B) AND (D))

Subdivisions (b) and (d) of proposed section 7-315 are discussed hereafter in connection with the proposed amendment to Internal Revenue Code section 172 (d) contained in S. 236.

EXEMPTION FROM INCOME AS A RESULT Of sales of asSETS (SUBDIVISION (B))

Under this proposed subdivision no tax shall be "payable" on gains resulting from the sale of assets "... not in the ordinary course of business during the pendency of a case and prior to confirmation, or in respect to sales made pursuant to the provisions of a plan..." Losses on such sales would also be disallowed. An exception applies to this "nonrecognition" provision when the owners (whether they be shareholders, partners or a sole proprietor) retain an interest in the debtor. If the owners retain an interest, the tax on such gains will be allowed as an administration expense but only to the extent of the value of the retained interest.

This provision represents a departure from current law under which capital gains, other non-operating income and operating income are subject to tax. The proposal also differs from the proposed treatment of straight bankruptcy proceedings which would exempt from tax operating as well as non-operating income (proposed section 5–10(a)).

As in the case of liquidating bankruptcy proceedings, we recommend that income earned and gains realized during an insolvency proceeding be taxed in the usual manner.

We also favor taxing rehabilitation proceedings on the same basis as liquidating bankruptcy proceedings since the two types of proceedings are readily interchangeable under the current and proposed Bankruptcy Acts. For example, under the current Bankruptcy Act a debtor may convert a pending liquidating bankruptcy proceeding into a Chapter XI arrangement by filing a petition under section 321, and the Chapter XI proceeding may in turn be converted back into a liquidating proceeding in the event that the debtor is unable to persuade a sufficient number of creditors to agree to a plan of arrangement. A proceeding that starts off as a Chapter XI proceeding under section 322 of the Bankruptcy Act may likewise be converted to a liquidating proceeding if a plan of arrangement is not confirmed. Similar provisions apply in the Chapter X area. Liquidating and rehabilitation proceedings would also remain readily convertible under sections 5-103 and 7-112 of the proposed legislation. Due to the considerable fluidity between liquidating and rehabilitation proceedings it would appear far more practical to apply the same tax rules to each type of proceeding.