Opinion
No. 90-01585-LM11
June 17, 1991
Taxes — Administrative Expenses — Corporations — Parent-Subsidiary — Income. — An indirect benefit given to a bankruptcy debtor-corporation is not an administrative claim entitled to first priority. The debtor here, a parent corporation, saw its subsidiary receive disbursements from the Resolution Trust Corporation, that the Internal Revenue Service argued was income to the parent. But this qualified as no more than an indirect benefit, falling outside the "actual and necessary expense" concept for administrative treatment. If this distribution could be considered income to the parent — by increasing the value of the subsidiary — than no corporate or partnership distributions would be exempt from the rule, clearly not a result intended by Congress.
See Sec. 503(b) at ¶ 9016 and Sec. 507(a)(1) at ¶ 9027.
Taxes — Priorities — Postpetition Realization. — The income taxes in issue could not be considered entitled to a seventh priority under Section 507(a)(7) because they were incurred postpetition. Only prepetition tax claims are covered by the latter section.
See Sec. 507(a)(7) at ¶ 9032.
Taxes — Objections — Burden of Proof. — The IRS failed to meet its burden of proof — a reversed burden, from the typical tax case — to show that its audit assessments showing an increased tax liability were correct.
See Sec. 502(b) at ¶ 9006 and Sec. 502(c) at ¶ 9007.
On December 17, 1990, this court announced in open court her tentative decision that the advances by the Resolution Trust Corporation ("RTC") to Imperial Federal Savings and Loan Association ("IFSA") were taxable income to IFSA, which would result in an assessment of taxes to IFSA and its parent corporation, Imperial Corporation of America ("ICA"). I incorporate those findings and conclusions into this decision. The court estimated those taxes to be $89.75 million for the period ending September 29, 1990. The court reserved for further ruling the issue of priority of the tax claim, if any, in ICA's Chapter 11 case.
The court was required to estimate the tax claims of the IRS arising out of the RTC advances to IFSA because of the provision in ICA's confirmed second amended plan of reorganization, which committed to pay any tax attributable to events occurring prior to the date of confirmation. The Official Creditors' Committee ("OCC") and the debtor agreed to withhold distribution under the plan until an estimation of the amount of any such obligation could be made and its priority determined.
Although there are no specific procedural guidelines for estimating claims, after consultation with counsel, the court proposed and counsel accepted a summary procedure in which each side was limited to 41/2 hours of direct or cross-examination and 1/2 hour for opening statements and closing argument.
The parties agreed to submit direct evidence by way of declaration with supporting exhibits, and examination of the declarants was limited to cross-examination. Testimony of rebuttal witnesses was also offered, subject to the agreed time limitations.
At the conclusion of the hearing on December 4, the parties had adequately presented their case in the allotted time and the procedures, although summary and accelerated, have given the court a firm basis on which to make an estimate of the IRS claim.
Although the court suggested at the time of the December 17 ruling that it was unnecessary to address and estimation of the other components of the Internal Revenue Service's ("IRS'") claim by reason of the ruling, upon further reflection and study, the court believes her initial impression to be erroneous. Because of that, this decision addresses not only the issue of priority for advances by the RTC to IFSA, but also those additional claims for deficiency arising from IRS audit adjustments for the tax years 1985-89. Further, this decision also addresses the question of additional tax claimed to be due which would arise out of a declaration of worthlessness of Imperial Savings Association ("ISA") stock.
PRIORITY OF TAXES ARISING OUT OF RTC ADVANCES TO IFSA
The IRS argues in the alternative: That the 1990 tax liability estimated at $89.75 million is entitled to treatment as a first priority administrative claim under 11 U.S.C. § 507(a)(1) or as a seventh priority tax claim under 11 U.S.C. § 507(a)(7). The court will address these contentions in that order.
In order to be a first priority claim under 11 U.S.C. § 507(a)(1), the court must find that the estimated tax is an administrative expense allowable under § 503(b). Section 503(b)(1)(B)(i) states that an administrative expense priority is accorded to any tax incurred by the estate except for a § 507(a)(7) tax. The critical question to resolve is whether this estimated tax was incurred by the estate of ICA.
The IRS suggests that taxes primarily incurred by IFSA as recipient of the RTC advances are taxes incurred by ICA. In doing so, relies upon Treasury Regulation 1.1502-6 which provides:
[T]he common parent corporation and each subsidiary which was a member of the group during any part of the consolidated return year shall be severally liable for the tax for such year. . . .
There is little authority cited by the parties to this dispute which discusses the nature of the liability of other affiliated group members for the taxes incurred by all of their members. The only case cited is American Standard, Inc. v. United States, 602 F.2d 256 (Ct.Cl. 1979), which states:
The single entity framework does not mean that all items of income, deductions, and credit for the affiliated corporations are combined into single accounts as if the corporations were one. The consolidated return regulations, in fact, primarily deal with the affiliated corporations as separate corporate entities. This treatment as separate entities under the regulations is shown by the first item in computing consolidated taxable income which is "separate taxable income." Treas. Reg. § 1.1502-11(a). Separate taxable income of a member is basically the taxable income of a member which would be reported if separate income tax returns were filed . . . . Id. at 261-62.
The debtor and OCC argue that the nature of the relationship between the members of an affiliated group is that each member is a surety for the tax obligations of the other group members. The American Standard holding appears to support that construction.
The only bankruptcy case which has addressed the issue is the decision in In re Alton, 81 B.R. 97 (Bankr. M.D. Fla. 1987). In Alton, the State of Florida pressed to have an unpaid unemployment tax claim charged against the individual general partner's Chapter 11 estate as a first priority claim under § 507(a)(1). The liability arose out of the operation of a hotel, which was also in Chapter 11 proceedings and which had failed to pay the taxes. The State contended that as the general partner of the hotel, the individual debtor was liable for the debts of the hotel and, since the debt was incurred post-petition during the individual's Chapter 11 case, the debt was properly chargeable against the individual debtor as an administrative claim. Although the bankruptcy judge agreed that a general partner was legally liable for the debts of a partnership, he went on to state:
This liability is only secondary, and the partnership which in fact incurred the indebtedness, in this case Madison Hotel, is the primary obligor. Id. at 99.
The Alton court proceeded to discuss the more critical question which arises from a claim of this nature, namely: . . . whether or not such liability could be charged against his estate as an actual and necessary cost and expense of preserving his estate." Admittedly, the IRS claim is not one which would be considered a typical administrative expense such as post-petition wages, salaries, rent and professional fees. Although this court agrees with the IRS that the list of possible administrative expenses is not limited by the categories set out in $503(b)(1)(8), underlying the entire concept of administrative expense priorities is the requirement that any claim accorded this status must benefit the estate as a whole. See, Christian Life Center Litigation Defense Comm. v. Silva, 821 F.2d 1370, 1373 (9th Cir. 1987). When measured against this principle, the IRS has not met its burden of showing that the taxes arising from the RTC advances to IFSA benefitted the ICA estate as a whole.
Although it might be argued that the RTC's advances to IFSA somehow preserved the subsidiary's value as an asset of ICA and that the tax incurred as a result of the loans should be treated as adminstrative expenses for this reason, the Alton court persuasively rejected a similar argument in the partnership context, stating:
The difficulty with this proposition should be evident if one considers the logic of the argument which, if accepted, would inevitably lead to the conclusion that all debts incurred by a partnership under Chapter 11 are properly chargeable as administrative expenses against the estate of the individual general partner. This result would inevitably lead to total frustration of the individual partner's ability to achieve reorganization. Moreover, as administrative expenses and priorities in general are narrowly construed, see Trustees of the Amalgamated Ins. Fund v. McFarlin's Inc., 789 F.2d 98 (2d Cir. 1986), this court is satisfied that Congress did not intend that an indirect expense such as the one incurred by the Debtor in this case should be given first priority status under § 507(a)(1) of the Bankruptcy Code. 81 B.R. at 99.
The next question is whether the tax obligation which will arise out of the RTC advances to IFSA qualifies as a seventh priority tax claim under 11 U.S.C. § 507(a)(7). That section provides a priority for income taxes which are either a claim for a taxable year ending on or before the filing of the petition and due after three years before the date of filing the petition; assessed within 240 days prior to filing the petition or any other tax other than the kind specified in § 523(a)(1)(B) or (C) which was not assessed before but is assessable under applicable law or agreement after the commencement of the case.
The debtor and the OCC argue that because the RTC advances were made post-petition, they could not have been "due" or "assessed" prior to the filing of ICA's petition. The income which IFSA has realized from the RTC advances is to be reflected on a tax return for the ICA consolidated group for the year ending September 30, 1990.
The date on which a tax is due is the date on which a return must be filed:
Taxpayer misconstrues the meaning of the phrase "return of tax." As that phrase is employed in Section 6151(a), it refers to a report disclosing taxpayer's income tax for a complete taxable year . . . . As of the date such a return must be filed, the tax for the year covered by the return becomes due and payable and interest upon that debt starts to accumulate. United States v. Northwestern, Mut. Ins. Co., 315 F.2d 723, 725 (9th Cir. 1963).
See also, Brookhurst, Inc. v. United States, 931 F.2d 554, 557-558 (9th Cir. 1991).
Logically, the 1990 tax claim cannot be entitled to priority under § 507(a)(7)(A)(i) or (ii) under the plain limitations expressed in those sections, both of which require the tax to be due pre-petition. Section 507(a)(7)(A)(iii) would allow a priority to any other kind of tax which could have been assessed prior to the debtor's petition, but was not, either because of the automatic stay or because of an agreement. Neither circumstance applies to the IRS' 1990 tax claim and, therefore, it is not entitled to seventh priority under this section either.
1985-89 IRS AUDIT ADJUSTMENTS
The IRS has been engaged in an extensive audit of ICA and its subsidiaries, reviewing not only taxable years 1981-84, but also, more recently, taxable years 1985-89. The 1981-84 audit adjustments resulted in an increase in taxable income and a concomitant increase in tax to ICA. ICA paid the tax which came due by reason of the adjustments and then filed a suit against the IRS claiming a refund, challenging the validity of the 1981-84 adjustments.
When the IRS filed its proofs of claim for taxes arising during the 1985-89 period, it did so in the alternative. Postulating that its audit adjustments to the years 1981-84 would be sustained by the district court in the refund litigation, Analysis No. 1 estimated the debtor's revised 1985-89 tax liability was $41,885, 742 (Declaration of Lynn Shields, filed November 26, 1990, Exhibit "A"). In its alternate analysis, assuming that the 1981-84 IRS audit adjustments were not sustained in the district court refund litigation, the IRS estimated the debtor's liability for the 1985-89 period at $91,804,805 (Declaration of Lynn Shields, supra).
Regardless of whether the 1981-84 IRS audit adjustments are sustained, the IRS claims taxes of such magnitude as to consume the entire balance on hand for distribution to creditors. Accordingly, it becomes critical to examine the components of the 1985-89 audit adjustments which give rise to these tax claims. Although a properly filed proof of claim constitutes prima facie evidence of its validity, where a debtor files an objection to the claim, the evidentiary burden of Bankruptcy Rule 3001(f) requires the objecting party to go forward with evidence contradicting the validity or amount of the claim. Global Western Dev. Corp. v. Northern Orange County Credit Serv., Inc., 759 F.2d 724, 727 (9th Cir. 1985).
The court has assumed, for purposes of this decision, that the IRS claims are entitled to be accorded the Rule 3001(f) presumption. It is at least questionable whether they shold be. At least one bankruptcy court has held that an estimated tax claim is not entitled to the B.R. 3001(f) presumption. See In re Mobile Mfg. Co., Bk. Cs. #82A-01195 (Bankr. C.D. Utah, slip. op. May 8, 1985) (LEXIS, Bkrtcy. Library, Cases File). Here, the IRS filed its proofs of claim based on estimates without supporting documentation of any kind.
Once the objecting party adduces sufficient evidence to overcome the prima facie effect of the proof of claim, the ultimate burden of persuasion rests upon the claimant. In re Hough, 4 B.R. 217, 219 n. 4 (Bankr. S.D. Cal. 1980); In re Texline Corp., 28 B.R. 525, 528 (Bankr. S.D.N.Y. 1983). Proof of the validity of a claim must be made by a preponderance of the evidence. California State Bd. of Equalization v. Official Unsecured Creditors' Comm., 837 F.2d 696, 698 (5th Cir. 1988); In re DeLorean Motor Co., 39 B.R. 157, 158 (Bankr. E.D. Mich. 1984). This is so even if the claimant is the IRS. In re Fidelity Holding Co., 837 F.2d at 698; In re Brady, 110 B.R. 16, 18 (Bankr. D. Nev. 1990); In re Butcher, 100 B.R. 363, 367 (Bankr. E.D. Tenn. 1989).
A party making a priority claim must introduce evidence supporting its claim to a priority. Central Rubber Prod., Inc. v. Stafford Higgins Indus., Inc., 31 B.R. 865, 868 (Bankr. D. Conn. 1983). Since the IRS has claimed priority under § 507(a)(1) and (7) of the Bankruptcy Code, it must establish all requisite elements of its claim. In re Electronic Theatre Restaurants, Inc., 85 B.R. 45, 47 (Bankr. N.D. Ohio 1988); In re O.P.M. Leasing Servs., Inc., 60 B.R. 679, 680 (Bankr. S.D.N.Y. 1986). In re D.W.G.K. Restaurants, Inc., 84 B.R. 684, 689 (Bankr. S.D. Cal. 1988). In summary, the burden of proof and of going forward is reversed from that in the ordinary tax case. Applying these principles, I turn to an examination of the major components of the IRS audit adjustments for the 1985-89 period.
1. Loan Discount Fee Treatment
The first major component of the IRS adjustments to ISA's taxable income is to the treatment of loan fees (loan origination fees, loan discount fees and fees for services) received by ISA as a part of loan transactions. The IRS hypothesizes that rather than reporting the receipt of loan fees as income in the year received, ISA would amortize the recognition of the loan fee income over the life of the loan.
The debtor and the OCC raised an evidentiary objection to Ms. Shields' testimony on this point, contending that there was no foundation for paragraph 21 of her declaration. The court sustained the objection, finding that a foundation had not been laid. (R.T., 12/3/90, 38:20-25; 39:1-8). As paragraph 21 of the declaration relied for its conclusions on a "typical transaction" for which a foundation had not been properly laid, paragraphs 22-28 of the Shields' declaration and Exhibits 33-38, which purported to amplify and support this conclusion were likewise excluded from evidence. (R.T. 12/3/90, 113:25, 114:1-25; 115:1-11).
Because the testimony of Ms. Shields on the proposed adjustments arising out of the loan fee treatment was barred for lack of foundation, the IRS has not proved by a preponderance of the evidence that its claim for additional tax based on adjustments to the loan fee treatment during the 1985-89 period is valid. The court assigns a value of zero as an estimate of the IRS claim for taxes arising from this proposed adjustment.
2. Mortgage Pool Interests as "Coupon Strips".
The next major components of the IRS' proposed adjustments relates to the "coupon stripping" issue. According to paragraph 30 of the Shields' declaration, this issue arose in the context of ISA-created A/B mortgage pools in which ISA sold to investors an undivided interest in the principal amount of the pooled mortgages, together with a fixed rate of return (the "A" piece). ISA retained an interest in the mortgage pool (the "B" piece) as well as the right to service the mortgages for a fee. The "B" piece was subordinated in payment to the "A" piece and bore the risk of nonpayment. The IRS contends that ISA failed to allocate any basis to its retained interest in the mortgage pool, thereby increasing the basis of "A" piece and either decreasing the gain or increasing the loss reported by ISA upon the sale of the "A" piece. The IRS proposes to attribute the servicing fee income to the value of the retained interests (the "B" piece) and to apply the coupon-stripping rules of IRC § 1286 to value those interests.
The declaration of Ms. Virginia N. Leek (filed November 28, 1990), in paragraphs 12 through 14, explains the reasons for ISA's position that it had properly allocated the basis to the "B" piece of the A/B mortgage pool. With this testimony the debtor sustained its burden of going forward with evidence contradicting the prima facie validity of the amount of the claim.
The OCC lodged an evidentiary objection to Ms. Shields' testimony contained in her declaration on the basis that she lacked competence to value the retained interest in the mortgage pools. The court agreed, finding that Ms. Shields was not qualified by education or training to perform a present value analysis of ISA's retained interest in the mortgage pool and struck paragraphs 31 and 32, along with Exhibits "E-40" and "F-21" from consideration. (R.T. 12/3/90, 141:11-18).
Since the IRS has not proven by a preponderance of the evidence that an increase in taxable income for the years 1985-89 should be made by increasing ISA's basis in its retained interest in the mortgage pool, the court estimates the value of the IRS claim arising from this proposed adjustment at zero.
3. Loss Recognition On Sale To REMICs.
The third major area of adjustment to taxable income proposed by the IRS for the 1987-89 period arises out of the disallowance of ISA's loss on the sale of mortgage loans to two Real Estate Mortgage Investment Conduits (REMICs). Ms. Shields' declaration (paragraphs 33-36) contends that taxable income should be increased by more than $28 million because 26 U.S.C. § 860(F)(b)(i) provides that no loss is to be recognized by a transferor upon the transfer of property to a REMIC.
Ms. Virginia Leek, former Director of Taxes for ICA, testified in her declaration (filed November 28, 1990) that in ISA's view, there were two distinct transactions involved: First, ISA's sale of approximately $360 million in loans to the two REMICs in exchange for cash; second, ISA's purchase of an approximate two percent residual interest in each pool sold. Ms. Leek's explanation of the theory on which ISA reported its loss on the transfer is as credible as Ms. Shield's claims that the loss should be disallowed. Since the IRS has the burden of showing by a preponderance of the evidence the validity of its claim (see pages 9 and 10 above) and no preponderance has been achieved, the proposed adjustment to taxable income and concomitant increase in tax to ISA's treatment of its claimed loss on sale to the REMICs is estimated at zero.
DECLARATION OF WORTHLESSNESS OF ISA STOCK
The last major component of the IRS' proposed adjustments to ICA's taxable income is the IRS' contention that the stock of ISA, ICA's wholly-owned subsidiary, became worthless in the 1989 taxable year. A declaration of worthlessness of the stock would result in the recognition of income by ICA as a result of the recapture of the excess loss account created by prior negative earnings and profits of ISA. Depending upon the disposition of the tax refund suit, the excess loss account attributable to ISA could be between $107 million and $112 million.
In making its objections to an IRS claim based on the declaration of worthlessness of ISA stock, the debtor, through the Declaration of George Kilcrease, filed November 28, 1990, took the position that the ISA stock was not wholly worthless on September 30, 1989, for the reasons set forth in paragraph 11(a)-(e) of that Declaration. Therefore, the debtor sustained its burden of going forward with evidence contradicting the validity or amount of the claim.
Motions were made by the OCC to strike the direct testimony contained in declarations of Ms. Shields and Mr. Orville Thompson which expressed their opinions that the ISA stock was worthless as of September 30, 1989. The court reviewed the qualifications of both Ms. Shields and Mr. Thompson and determined that as accountants they were not qualified by experience or training to value assets for the purpose of determining whether ISA's stock was worthless. Accordingly, all direct testimony contained in the Shields' declaration and the declaration of Orville Thompson filed November 26, 1990, was stricken (R.T. 12/4/90, 49:17-25; 50:1-25; 51:1-25, and 52:1-9).
Since it is the burden of the IRS to establish by a preponderance of the evidence that the ISA stock should be declared worthless in taxable year 1989 and the IRS has adduced no competent evidence to sustain that position, the court finds that for purposes of this claim estimation, the excess loss account was not recaptured by ICA during taxable year 1989 and any claim for taxes arising out of a declaration of worthlessness of the stock should be estimated at zero.
Having addressed the four major premises on which the IRS predicates its audit adjustments for taxable years 1985-89 and having concluded that in each instance the IRS has failed to carry its burden of showing that upward adjustments in taxable income and, therefore, tax due are valid, the court now turns to the remaining testimony on which an estimation of the claim must be based. Essentially, the sources of information are two: First, the Declaration of Richard Hughes filed November 28, 1990; and, second, the testimony of George Kilcrease.
As rebuttal testimony, Mr. Kilcrease offered Exhibit 1046 which was his re-computation of the proposed IRS adjustments after taking into consideration the evidentiary rulings by this court during the course of the claim estimation hearing. As a starting point, Mr. Kilcrease relied on the calculations performed by Ms. Shields, which were reflected in Exhibit "A" to her declaration. In Exhibit 1046, he then excised the adjustments she made with respect to the loan fee issue and the coupon stripping issue. Further, he assumed, for purposes of his calculation, that the excess loss account was not recaptured in taxable year 1989, a position which has since been sustained by this court. Assuming that the IRS' position on the 1981-84 adjustments was sustained in the tax refund litigation, he recalculated the income tax for 1985-89. After making the revisions to the IRS adjustments as reflected in Exhibit "A" to Ms. Shields' declaration, it was his conclusion that the debtor would not only owe no tax but rather be entitled to a refund of $6,705,544.
Further, Mr. Kilcrease testified that even if an alterantive minimum tax of $5,974,918 were due, (as reflected by the debtor's return for taxable year 1988 (Exhibit 1013)), there would still be sufficient refund due to off-set the amount of minimum tax. That testimony is essentially unrebutted.
Mr. Richard Hughes' declaration, filed November 28, 1990, addresses ICA's tax obligations for taxable year 1990. His unrebutted testimony contained in that declaration was to the effect that ICA and its subsidiaries would have a net operating loss of no less than $115 million for taxable year 1990 unless the ISA stock were determined to be wholly or partially worthless during that year, in which case the excess loss account recapture could possibly be triggered, resulting in a positive adjustment to income. He testified on cross-examination by IRS counsel that it was ICA's intention to claim the ISA stock as partially or wholly worthless, depending on whether some or all of its holdings of high-yield corporate debt instruments had been classified by regulators as worthless. However, he could not testify with any accuracy what the amount of the declaration of worthlessness might be. There is no conclusive evidence from any source as to what the amount of that tax might be were the declaration of worthlessness made in taxable year 1990.
In summary, the court finds that for purposes of estimation of the IRS claim, the position of the ICA with regard to taxes due for taxable years 1985-89 must be sustained. The IRS has failed to carry its burden to show by a preponderance of the evidence that it has a tax claim in any amount for those years. The court concludes the IRS claim for those years must be estimated at zero.
Further, the court concludes with respect to taxable year 1990, that even if taxes might be due by reason of the declaration of worthlessness of ISA stock in taxable year 1990, such tax would not be entitled to seventh priority treatment under 11 U.S.C. § 507(a)(7) for the same reasons that taxes assessable by reason of the RTC advances to IFSA are not: Namely, that the taxes could not be "due" or "assessed" prior to the filing of ICA's petition. In any event, there is no evidence of the amount of any such tax from which the court could make such an estimation.
Counsel for the Official Creditors' Committee is directed to prepare an order in conformance with this Memorandum Decision within ten (10) days from the date of its entry.