8. 236-I.R.C. AMENDMENTS With the exception of the discussion pertaining to Subdivisions (b) and (d) of proposed section 7-315, the following relates to the proposed amendments to the Internal Revenue Code contained in S. 236. INVESTMENT CREDIT RECAPTURE (I.R.C. § 47 (D)) We agree with the proposed amendment to section 47 (d) to the extent that the transfer from a bankrupt to a trustee would not trigger the recapture of investment credit. However, if the basis of section 38 property is subsequently reduced under Chapter VII or IX of the proposed Bankruptcy Act or under Internal Revenue Code section 1017 or if the trustee, debtor, or successor corporation subsequently makes a premature disposition then we think that it would be appropriate to recapture the excessive investment credit previously taken by the debtor, but as a claim against the estate or successor corporation rather than the debtor. EARNINGS AND profits ADJUSTMENT (I.R.C. § 312(N) AND (0)) Proposed subsection (n) provides that with certain exceptions earnings and profits shall be increased (or a deficit in earnings and profits shall be reduced) by the amount of debt cancelled in a proceeding under the Bankruptcy Act or otherwise. Under proposed section 312 (0) deficit earnings and profits would be reduced by the amount of the capital account attributable to shares extinguished in a proceeding under the Bankruptcy Act. We agree with these proposals. However, we suggest that proposed section 312 (n) be modified by the insertion of a provision to the effect that if debt owed to a shareholder or creditor is cancelled in exchange for shares in the debtor, the accrued interest portion of such debt shall be deemed to have been cancelled and earnings and profits shall be adjusted accordingly. EFFECT OF DEBT CANCELLATION ON DEDUCTIONS AND BASIS (ACT § 7-315 (B) AND (D) AND I.R.C. 172 (D)) The above provisions pertain to (1) the nonrealization of income due to debt cancellation, (2) the disallowance of loss carryovers and other deductions to the extent that they are traceable to cancelled obligations, and (3) basis reduce. In general, we concur with these proposals except we would prefer a pro tanto scaledown of loss carryovers rather than a procedure that requires tracing. INSOLVENCY REORGANIZATIONS (I.R.C. §§ 302 (B) (4), 354 (C), 356(D) (2) (B) (I), 371, 872 (A), 374, 381 AND 382) The above sections deal with numerous and complex aspects of corporate taxation including the area of corporate reorganizations. In general, the proposed amendments place railroad reorganizations on a par with other insolvency reorganizations and the latter on a par with non-insolvency reorganizations. We concur with these proposals except to the extent that proposed section 381(a) would operate to carry over the various tax attributes enumerated in section 381 (c) (such as net operating loss carryovers) in reorganizations in which the debtor corporation's assets are divided among more than one corporation and no one corporation acquires substantially all of the assets necessary to operate the debtor's trade or business or such part of the trade or business as is to be continued, We believe that it would be preferable to treat insolvency reorganizations on a par with normal reorganizations for purposes of applying section 381. Section 381 does not apply to divisive reorganizations, and only one corporation can acquire the transferor's tax attributes. In this regard the proposed amendment to section 381(a) appears to describe a situation that is more in the nature of a liquidation than a reorganization. My remarks today have been of a general tenor. The purpose was to acquaint the Subcommittee with the views of the Internal Revenue Service and the Department of the Treasury concerning H.R. 31, and the proposed amendments to the Internal Revenue Code contained in S. 236. Due to the length and complexity of the proposed legislation it is of course not feasible for me in this statement to provide a detailed analysis. We wish to work with the Subcommittee in its consideration of this important area. Our staff is ready and willing to discuss any aspect of the bills with your staff in an effort to accomplish a revision of the bankruptcy law which will not result in significant detrimental consequences for the Federal tax system. We are in the process of preparing a detailed analysis, including specific recommendations, which will be transmitted in the near future to the Subcommittee on Improvements in Judicial Machinery of the Senate Judiciary Committee to assist in its consideration of the companion bills S. 235 and S. 236. Upon completion, copies of that analysis will also be transmitted to this Subcommittee to assist in your consideration of H.R. 31 and H.R. 32. The Assistant Secretary of the Treasury for Tax Policy and the Tax Legislative Counsel are in agreement with the views expressed in this statement. CHART I.-ESTIMATED AMOUNTS OF FEDERAL TAXES CLAIMED AND COLLECTED PURSUANT TO PROOFS OF CLAIM FILED IN ASSET CASES Note: The estimated amounts collected relate only to collections during the base fiscal year through the following November, in asset cases commenced during the base fiscal year. Therefore, the estimated amounts collected do not include subsequent collections, CHART II.-Estimated amounts of Federal taxes collected under Bankruptcy Act § 64a (4) pursuant to proofs of claim filed in asset cases A. Taxes which became legally due and owing within 3 years preceding bankruptcy: Fiscal year 1974. Fiscal year 1975. Fiscal year 1976. B. Taxes which became legally due and owing more than 3 years pre ceding bankruptcy: 1. Not assessed and bankrupt failed to make timely return (§ 17a (1) (a)): Amount $1,500,000 2, 000, 000 2, 000, 000 Fiscal year 1974_ Fiscal year 1975 Fiscal year 1976_. 2. Assessed within 1 year preceding bankruptcy and bankrupt failed to make timely return (§ 17a (1)(b)): 7, 000, 000 9, 500, 000 10, 000, 000 Fiscal year 1974___. Fiscal year 1975_-_. Fiscal year 1976.. 3. Not reported on return and not assessed due to prohibition on assessment (§ 17a (1) (c)): Fiscal year 1974___. Fiscal year 1975. Fiscal year 1976_. 1 These amounts are not mutually exclusive. Thus, some overlay exists. 16,000 22, 000 24,000 62, 000 84, 000 90,000 4. When bankrupt made false or fraudulent return or willfully Fiscal year 1975. Fiscal year 1976_ 5. Collected or withheld by bankrupt but not paid over (§ 17a (1) (e)): Fiscal year 1974- Fiscal year 1975. Fiscal year 1976_. 4,000 53, 000 57,000 2, 000, 000 3, 000, 000 3, 000, 000 ANALYSIS OF THE TAX ASPECTS OF S. 235 and S. 236, 94TH CONGRESS, 1ST SESSION (1975) AND THE Report OF THE COMMISSION ON THE BANKRUPTCY LAWS OF THE UNITED STATES, H.R. Doc. No. 93-137, 93D CONGRESS, 1ST SESSION (1973) L. PROCEDURAL TAX PROVISIONS Section 4-606—Certain Statutory and Common-Law Liens Under section 4-606 (a), every federal tax lien on assets in the bankruptcy estate is invalid. For purposes of section 4-606 (a), it does not matter whether a notice of lien was filed before bankruptcy. Furthermore, the trustee is entitled under section 4-606(b) to recover any property transferred by the debtor, whether solvent or insolvent, within three months prior to the petition date to satisfy a tax liability secured by a lien invalidated under section 4-606 (a). Thus, if a federal tax lien had arisen regarding a tax liability of the debtor, the trustee would thereafter be able to recover under section 4-606 (b) not only the amount of any voluntary payment made by the debtor in satisfaction of such liability, but also any property of the debtor seized by the Service to collect the liability. It is not clear whether the trustee would be able to recover the amount received by the Service from the sale of such seized property, nor whether the trustee would be entitled to recover the property from the purchaser thereof. It is also unclear whether the trustee would be able to recover from the Service the amount of an overpayment made by the debtor, which had been setoff under Internal Revenue Code § 6402 during the three-month period prior to bankruptcy. Section 4-606 is applicable in cases under chapters V (Liquidations: Voluntary and Involuntary Bankruptcies); VI (Plans for Debtors with Regular Income); VII (Reorganizations); and IX (Railroad Reorganizations). Under present law, if a notice of lien pertaining to a federal tax assessment is filed prior to the filing of a petition in an ordinary bankruptcy proceeding, the federal tax lien is not invalidated and may be claimed as a secured debt against the trustee in his status as a judgment lien creditor under Bankruptcy Act § 70c. Under these circumstances, if any of the bankrupt's property to which the federal tax lien attached is seized by the Service before the petition date, such property does not become part of the bankruptcy estate. If the federal tax lien attached to real property of the bankrupt not seized prior to bankruptcy, the underlying tax liability is entitled to full satisfaction ahead of both priority and general creditors. However, if personal property to which the tax lien attached is not seized before bankruptcy, the underlying liability is subordinated under § 67c (3) to the priorities in § 64a (1) (administration expenses) and § 64a (2) (preferred wage claims). If a notice of federal tax lien has not been filed prior to bankruptcy, the lien is invalid against the trustee in his judgment lien creditor status. Thus, the underlying tax liability has the status of an unsecured claim, and is entitled to priority under Bankruptcy Act § 64a (4) if it is excepted from discharge under § 17a (1). If such tax liability is dischargeable, it is treated as a general, unsecured claim. The invalidation of federal tax liens pursuant to Bankruptcy Act § 70c, and their subordination under § 67c (3), do not affect the collection of federal taxes in cases under § 77 (Reorganization of Railroads Engaged in Interstate Commerce), chapter X (Corporate Reorganizations), or chapter XII (Real Property Arrangements). Rather, whether or not a notice of federal tax lien has been filed prior to bankruptcy, no reorganization plan or real property arrangement can be confirmed which does not provide for full payment of all claims for federal taxes (unless a lesser amount is accepted by the Government). In cases under chapters XI (Arrangements) and XIII (Wage Earners' Plans), it does make a dif 1 Four months under section 4-606(b) of S. 235. ference whether or not a notice of federal tax lien was filed before bankruptcy; secured creditors may not be affected by a chapter XI proceeding, whereas creditors with secured liens against the debtor's personal property may be affected if they accept a chapter XIII plan. Under both chapter XI and XIII, unsecured tax claims entitled to priority under Bankruptcy Act § 64a are required to be paid in full pursuant to a confirmed plan (unless a lesser amount is accepted by the Government). Discussion Noting that some statutory liens are "genuine property rights." whereas others are "essentially State-created priorities," Congress in 1966 revised Bankruptcy Act §67c (1). Rather than focusing on some of the ambiguities in present Bankruptcy Act § 67c (1), and thereby continuing to distinguish between statutory liens that are true property rights and those that are in reality priorities. the Commission instead concluded that all statutory liens are "disguised priorities." (Report, pt. 1, 21.) Thus, section 4-606 (a) invalidates every statutory lien against the assets of the bankruptcy estate, except those pertaining to the repair or improvement of specific property, ad valorem taxes, special improvement cost assessments, or attorneys' fees. Federal tax liens for which notices have been filed are in the nature of "genuine property rights”, rather than “disguised priorities.” They are as much a property right as a mortgage or deed of trust on real property or a security interest under the Uniform Commercial Code. The primary distinction is that federal tax liens are nonconsensual. If anything, the Government has a superior equitable claim to that of secured creditors, since it cannot pick and choose its debtors. In 1973 the Service projected that $5,190,758 would be collected in calendar year 1973 on federal tax liens having secured status against trustees in bankruptcy proceedings. (See Report, pt. I, 234 n. 228.) The invalidation of federal tax liens in bankruptcy proceedings would thus impose an unfair burden on the Government since eliminating the Government's status as a secured claimant could significantly reduce or eliminate its recovery from the assets of a bankruptcy estate. Also, the invalidation of federal tax liens in bankruptcy proceedings may cause delinquencies to soar. The opportunity for unsecured creditors to eliminate the effects of tax liens for which notices have been filed against the property of debtors may result in a substantial increase in the number of involuntary bankruptcies, and thus the amounts of federal taxes involved therein. Additionally, under section 4-606(b), any property transferred by the debtor, whether or not voluntarily, within three months before bankruptcy to satisfy a federal tax liability secured by a lien invalidated under section 4-606 (a) is unconditionally recoverable by the trustee. All collection efforts by the Service within three months prior to the bankruptcy of a debtor would, therefore, be completely futile if the trustee recovers the amount collected. Recommendation Section 4-606 (a) would in all probability significantly reduce the collection of federal taxes in bankruptcy proceedings, and may result in an increase in the number of involuntary petitions filed against debtors. More importantly, section 4-606(b) would, in most circumstances, render the tax collection procedures of the Service inoperative during the three-month period preceding bankruptcy. For these reasons, the invalidation of federal tax liens under section 4-606(a), and the recoverability under section 4-606(b) of payments made to or property seized by the Service, are opposed. We therefore recommend that present clause (2) of section 4-606 (a) be changed to read: "(2) which secures a tax imposed by the United States, any state, or any subdivision of any state". Section 4-607-Preferences Section 4-607(a)(1) provides that the trustee may recover property of the debtor which was transferred to pay or secure an antecedent debt, if the transfer was made while the debtor was insolvent and within three months prior to bankruptcy. As provided in section 4-607 (b) (1), however, the trustee may not Under section 4-205 (c), which generally substitutes the equity test of insolvency for an act of bankruptcy, an involuntary petition may be filed if it is shown the debtor "will be generally unable" or "has generally failed" to pay the debts he owes when they become due. Additionally, the requirement of an act of bankruptcy is eliminated, as well as that several creditors join in the petition. Four months under section 4-607 (a) (1) of S. 235. 59-591-76-pt. 4- -2 avoid such transfer if the aggregate value of all property transferred to a creditor is less than $1,000. Further, section 4-607(b)(3) provides that the trustee may not avoid a transfer which does not enable the benefited creditor, as of the date of the petition, to obtain a greater percentage of his claim than other creditors of the same class, so long as there are no creditors of a higher class who are unpaid. A presumption of insolvency throughout the three-month period preceding bankruptcy is created by section 4–607 (f), and section 4–607 (g) (1) defines "antecedent debt" as a "debt incurred more than five days before a transfer paying or securing the debt." Thus, any payment made by or property seized from an insolvent debtor within three months prior to bankruptcy to satisfy or secure a federal tax liability more than five days old (whether or not a lien had arisen thereon) would be a recoverable preference under section 4-607 (a) if: (1) the amount paid and/or the aggregate value of the seized property were $1,000 or more; and (2) the result of such transfer, measured as of the petition date, enabled the Service to obtain a greater percentage of its claim than other creditors of the same class. It is unclear whether the trustee could recover under section 4-607(a) either the amount received by the Service from the sale of such property, or the property itself from its purchaser. It is also not clear whether the pre-bankruptcy setoff under Internal Revenue Code § 6402 of an overpayment made by an insolvent debtor within three months before the petition date would constitute the transfer of property and thus could be recoverable as a preference if the other elements of a preference were in existence. (See generally Report, pt. I, 211.) Section 4-607 is applicable in cases under chapters V (Liquidations); VI (Plans for Debtors with Regular Income); VII (Reorganizations); and IX (Railroad Reorganizations). Present Bankruptcy Act § 67b provides that federal tax liens, which arise or are filed while the debtor is insolvent and within four months prior to the filing of the bankruptcy petition, are not voidable by the trustee as preferences under § 60. Furthermore, it appears that neither the payment made by an insolvent bankrupt to satisfy his tax liability, the seizure of his property or rights to property, nor the setoff of his tax liability pursuant to Internal Revenue Code § 6402, is considered a preference under § 60. Bankruptcy Act § 60 applies in proceedings under § 77 (Railroad Reorganizations), Chapter X (Corporate Reorganization), chapter XI (Arrangements), chapter XII (Real Property Arrangements), and chapter XIII (Wage Earners' Plans). Discussion Due to the fact section 4-606 (b) is applicable to both solvent and insolvent debtors and contains none of the exceptions found in section 4-607(b) (aggregate value requirements, etc.) it appears a trustee would almost always use section 4-606(b) to recover from the Service any payment made by or property seized from a debtor within three months prior to bankruptcy to satisfy a tax liability on which a lien had arisen. We have assumed that installment payments of estimated income tax by individuals and corporations, as well as federal tax deposits made by employers, would not be recoverable as preferences under 4-607(a) since such a payment or deposit does not pertain to an "antecedent debt" but rather a future tax liability. However, we think the Committee reports should specifically state that section 4-607 does not apply to estimated tax payments and federal tax deposits, so as to avoid future tax litigation. If we are wrong in this assumption, we would be vehemently opposed to the applicability of section 4-607 to estimated tax payments and federal tax deposits. The recoverability of these remittances as preferences would be extremely disruptive and would have severe adverse consequences to employee-debtors, e.g., the reversal of income, F.I.C.A. and R.R.T.A. withholding tax credits, with the accompanying increase in income tax liability due to such reversal of credits. Moreover, if section 4-607 is applicable to federal tax deposits, it is probable that a substantial amount of withholding taxes will be recovered by trustees in bankruptcy proceedings. In this regard, it is noted that during fiscal year 1975 the Service collected over $185 billion in income taxes withheld by employers and F.I.C.A. taxes. (See 1975 COMM'R of INT. REV. ANN. REP. 14.) This provision is not contained in S. 235. |