Opinion
CIVIL ACTION NO. 3-00-CV-0142-P
December 21, 2001
MEMORANDUM OPINION AND ORDER
Now before the Court is an appeal from the rulings and judgment of the United States Bankruptcy Court for the Northern District of Texas, during and after the trial of the Trustee's First Amended Motion to Determine Tax Liability in Connection with the Chama Estates' Alleged Federal Income Tax Liability for 1995. The Trustee petitioned the bankruptcy court under 11 U.S.C. § 505 for a determination of the bankruptcy debtors' 1995 federal income tax liabilities. The court considers the Brief of the Appellant, Brief of the Appellee, and Reply Brief of the Appellant, as well as relevant evidence from the record below. The court holds that the bankruptcy court erred in allocating all payments from the Trustee to the Gary Entities as distributions on account of stock rather than in part as settlement of claims for damages. Further, the court finds that two Qualified Settlement Funds were established through the Plan Confirmation. This court REVERSES the bankruptcy court's ruling and REMANDS the case to the bankruptcy court to allocate damages and as described in this opinion.
PROCEEDINGS IN THE COURT BELOW
The statement of the proceedings below is not significantly disputed. In November 1993, the debtors filed for Chapter 11 bankruptcy. Walter O'Cheskey was appointed to serve as the Chapter 11 Trustee.
In July 1997, the Trustee filed a motion for determination of tax liability under 11 U.S.C. § 505 requesting the bankruptcy court to determine that he had properly allocated between damage deductions and nondeductible distributions for stock redemption on the debtors' 1995 income tax returns. In August 1997, the IRS issued Notices of Deficiency to the Trustee disallowing the deductions, and proposing income tax deficiencies in excess of $3 million. In November of that year, the bankruptcy court denied the IRS' motion to dismiss for lack of jurisdiction. The Trustee filed amended income tax returns increasing the deductions for the plan distributions made to Gary and Regency, and filed petitions in the Tax Court to redetermine the proposed deficiencies. The Tax Court cases are still pending.
In October 1997, The United States filed a motion to dismiss the Trustee's motion for determination of tax liability, which was opposed by the Trustee, Regency, and Gary. In December 1997, the bankruptcy court entered a memorandum opinion and order denying the government's motion to dismiss. The court determined that the Trustee's motion was a core proceeding under 28 U.S.C. § 157(b)(2)(B) and Bankr. R. 9014, that the tax issues were not complex, and that because of its experience with the parties and transactions, it was in the best position to determine the essential issue of how to characterize the plan distributions to Gary and Regency.
In September 1998, the Trustee amended his motion to determine tax liability after filing second amended returns, on which he further increased the claimed damage deductions. He also claimed for the first time that a Treas. Reg. § 1.468B-1 qualified settlement fund was established upon plan confirmation and that Holdings, AEC, and the Lodge should be disregarded for federal income tax purposes. In March 1999, the bankruptcy court held a two-day trial. On August 11, 1999, after hearing final arguments, the bankruptcy court preliminarily ruled that the plan distributions made to Regency and Gary were non-deductible, reasoning that they were for stock redemption, and that no qualified settlement fund had been established.
In September 1999, the Trustee filed a motion to present newly discovered evidence, which the court denied on November 8, 1999. On November 18, 1999, the Trustee filed a notice of appeal.
On November 15, 1999, the bankruptcy court entered Findings of Fact and Conclusions of Law and an Order denying the Trustee's amended motion for determination of tax liability, disallowing the Trustee's deductions and refund claims, and sustaining the deficiencies. On November 24, 1999, the Trustee filed a notice of appeal from the Court's adverse tax determination. This court consolidated those appeals on June 5, 2000.
BACKGROUND
The facts of this case are undisputed except as explained within this opinion. Appellant draws from the bankruptcy court's 1995 Findings of Fact and Conclusions of Law Regarding Order Confirming Trustee's Plan of Reorganization, Plan of Reorganization for Grady H. Vaughn III, and Debtor's Plan of Reorganization, Filed by the Antigone Corporation, Liquidating Claims and Interests of Malcolm Kelso and Legal Econometrics, Inc. and Approving Settlements Pursuant to Bankruptcy Rule 9011, R005817-R00583 (the "Confirmation Findings"). Appellee relies on the facts from the Court's 1999 tax determination.
The Vaughn Family Holdings. In the 1980s, Grady H. Vaughn, III ("Grady") was engaged in the oil and gas and real estate business in Dallas, Texas, and was the owner, along with his brother Gary, of all stock of Chama LC, the assets of which were a 32,000 acre game ranch in Northern New Mexico plus various improvements and wildlife, (the "Ranch"), as well as two 3,200-acre Class A game parks licensed by the state of New Mexico. Grady formed The Antigone Corporation ("Antigone") as a Texas corporation in December 1986. Grady was obligated on notes to financial institutions, including approximately $24 million held by NCNB, which were later assigned to "Regency" (which includes all its predecessors in interest). Gary was the beneficiary of trust assets greater than $8 million, and was otherwise without debt. The Regency notes were secured by Grady's oil and gas interests, certain real estate, and Grady's Chama LC shares, which represented 68.8% of the Chama LC common stock, the remainder being held by Gary.
The 1990 Transactions. In 1989, Grady retained Malcolm M. Kelso, a "crisis manager," to reorganize his bank debt and to assist him in dealing with State of New Mexico authorities who were concluding an investigation of Chama and its on-site management. Kelso undertook a series of transactions beginning in early 1990 that were allegedly designed to protect Chama's assets from New Mexico and from Grady's creditors, including Regency, but which were in part designed to give Kelso control over the Ranch (and over Grady's and Gary's other assets) and to dilute Regency's interest as pledgee of 68.8% of the stock of Chama LC. (R005821-5828). Three new holdings were incorporated in 1990 and filed federal income tax returns: the Lodge, AEC, and AEC Holdings (the "New Chama Corporations"), and 100-year leases of the Ranch's real property and transfers of elk and game park licenses were made to the new corporations. Kelso used Antigone Corp. to shield Grady's oil and gas interests and to funnel Grady and Gary's liquid assets to the New Chama Corporations. Substantially all of the value of the Ranch was thus transferred away from Chama. Kelso also gained control by issuing warrants, stock, and creating voting trusts. The bankruptcy court found in 1995 at the close of the confirmation hearing that any separateness of the Chama Estates resulted from "contrived transactions" which ostensibly protected Chama but in reality gave improper control to Kelso in breach of his fiduciary duty, and diluted the security interest in Chama of Regency's predecessor in interest. (R-005825-31). Prior to the 1990 Transactions, the shareholders of Chama were Grady and Gary. Gary had not been a party to Grady's engagement of Kelso, yet Kelso's actions dramatically decreased the value of Gary's stock in Chama and caused damages of probably over $28 million. (R005827).
The Chapter 11 Cases. After much litigation, the Chama Debtors, Grady, Antigone, and Kelso filed for Chapter 11 bankruptcy in 1993. In March of 1995 the bankruptcy court approved the Trustee's motion to sell the Chama Estate's assets, including the Ranch, to the Jicarilla Apache Indian Tribe. (R0I7436-37). The cash sale price would provide the basis for the Trustee's plan to reorganize the Chama Estates (the "Chama Plan"). (R002198-3680). While the sale was pending, all the principals except Kelso proposed settlements and joined the Trustee's Plan. Plans were also proposed for Grady and Antigone. Kelso litigated his claims against the bankruptcy estates. After a trial in July 1995, Kelso's objections to the plans were denied, his claims were disallowed, and the plans were confirmed including the settlements within them.
It is contested whether the Plan released "all claims and equity interests of any kind asserted by the Gary Entities and Regency against or in the Chama Estates" unconditionally or whether such term did not take effect when Kelso refused certain consensual treatment under the Plan, leaving instead the release among the settling parties, which the Appellant argues did not deal with any release of equity interests, but which only dealt with "all actual or potential claims, demands, damages, actions, requests for sanctions and causes of action, torts, obligations, and any and all other liabilities, whether known or unknown of any other kind or description Whatsoever. . . ." (R017885, R006338-006349). It is not clear whether the latter provision includes equity interests. The Plan also provided that the release dismissed all pending litigation among the parties and enjoined further litigation absent the court's permission, transferred all equity interests in the Chama Estates to the Trustee for the purpose of dissolving the corporations, and reserved the Chama Estates' tax liability for later determination under Bankruptcy Code § 505. (R006318-19).
Gary's and Regency's Claims. There is dispute over how much and what type of damage Gary suffered to his stock and his trust assets due to the Chama debtors. In 1993 Regency asserted a claim against Grady for money owed under promissory notes that were secured in part by a security interest in Grady's shares of 68.8% of the stock of Chama LC. It then became aware of the transactions leading to the New Chama Corporations. Appellant asserts further facts about Regency's claims for the promissory notes and for damages to its security interests: that Regency asserted joint and several liability for all debtors for damaging Regency's collateral; that the litigation and settlement encompassed all the related bankruptcy cases and numerous legal theories; and that the bankruptcy court never made final rulings on the litigated claims and theories since the parties ultimately settled their disputes. Appellant argues the bankruptcy court took Regency's Motion for Entry of Judgment under advisement, considering but not entering judgment in May of 1994 rejecting Regency's fraud claims against Kelso and Grady. Nor, Appellant contends, did the bankruptcy court rule on the remainder of Regency's claims, including constructive fraud, breaches of statutory and equitable duties, and for rescission. (R017452-017495).
After the 1995 Confirmation hearing, the bankruptcy court found that the settling parties conferred value on the estates by settling for amounts that likely were less than the value of their claims. (R005827). The Trustee's Plan did not allocate the plan distributions to be made to Gary and Regency between claims and equity interests. No other settlement agreements among these three parties so allocated the distributions. (R01886). The mutual release signed by Gary, Regency, and the Trustee, among others, purported to release all claims the parties may have had against each other, but did not recite any amounts to be paid in exchange for the release. Nor was any final judgment determining the amount or nature of the damages entered in the various adversary proceedings brought by Gary or Regency against the debtors. (R017887).
The Confirmation Order.
Appellant contends that after the exhaustion of appeals, the 1995 Confirmation Order was final in early 1998, when Kelso's litigation was concluded. Appellee contends the IRS had not been a party to the confirmation hearings since it had withdrawn its estimated claim for taxes against Chama in 1994. (R002227).
STANDARD OF REVIEW AND BURDEN OF PROOF
This court has jurisdiction over this appeal pursuant to 28 U.S.C. § 158(a). "When reviewing a bankruptcy court's decision in a `core proceeding,' a district court functions as an appellate court and applies the standard of review generally applied in federal courts of appeals." Reserve Life Ins. Co. v. Webb (In re Webb), 954 F.2d 1102, 1103-04 (5th Cir. 1992). Accordingly, the bankruptcy court's factual determinations are subject to a "clearly erroneous" standard of review. MBank Waco, N.A. v. Kennard (In re Kennard), 970 F.2d 1455, 1457 (5th Cir. 1992); Nationwide Mutual Ins. Co. v. Berryman Prods., Inc. (In re Berryman), 183 B.R. 463, 466 (N.D. Tex. 1995). A bankruptcy court's conclusions of law are reviewed de novo. Kennard, 970 F.2d at 1458. Furthermore, the legal effects of findings of fact are reviewed de novo. See Brunner v. N.Y. State Higher Educ. Serv. Corp., 831 F.2d 395, 396 (2d Cir. 1987); Bass v. Denny (Matter of Bass), 171 F.3d 1016, 1021 (5th Cir. 1999) (mixed questions of law and fact subject to de novo review).
"A `core proceeding' is one that `invokes a substantive right provided by Title 11 [the Bankruptcy Code] or is a proceeding that by its nature could arise only in the context of a bankruptcy case.'" Reserve Life Ins. Co. v. Webb (In re Webb), 954 F.2d 1102, 1103 n. 1 (5th Cir. 1992) (citing In the Matter of Wood, 825 F.2d 90, 97 (5th Cir. 1987)).
"[A]n income tax deduction is a matter of legislative grace and the burden of clearly showing the right to the claimed deduction is on the taxpayer." Indopco, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). In the Fifth Circuit, the ultimate burden of proof on tax issues is on the taxpayer in the non-bankruptcy context. Woodall v. Commissioner, 964 F.2d 361, 363 (5th Cir. 1992); Patton v. Commissioner, 799 F.2d 166, 170 (5th Cir. 1986); C.A. White Trucking Co., Inc. v. Commissioner, 601 F.2d 867, 869 (5th Cir. 1979). The burden of proof is not shifted to the government when the claim is litigated in a taxpayer's bankruptcy case, but remains where the substantive law placed it, on the Trustee in bankruptcy. See Raleigh v. Illinois, 120 S.Ct. 1951, 1953 (2000). The Trustee thus has the burden of proof.
Appellee contends that the new I.R.C. § 7491, which permits the shifting of the burden of proof to the government in income tax cases when the taxpayer complies with certain conditions, applies only to court proceedings arising in connection with examinations commencing after its enactment on July 22, 1998 by the Internal Revenue Service Restructuring and Reform Act of 1998. Appellee states that the examination in this case was commenced in 1996, so the new provision does not apply. The Court accepts this undisputed analysis.
DISCUSSION
A. TREATMENT OF TRUSTEE'S DISTRIBUTIONS AS DISTRIBUTIONS ON ACCOUNT OF STOCK
Appellant claims that it was error for the bankruptcy court to conclude that all of the distributions by the Trustee to the Gary Entities ("Gary") and Regency were on account of Gary and Regency's ownership of stock, and not as settlement payments for Gary and Regency's claims for damages. Appellant argues multiple legal errors.
1. Legal Effect of Prior Rulings and Cases
Appellant argues that the bankruptcy court violated the law of the case doctrine by failing to conform to his prior ruling that the claims of both Gary and Regency against the Chama Debtors exceed the amounts they would be awarded under the settlements contained in the Chama Plan. (Confirmation Findings, p. 12 para 8-10, R005827). According to Appellant, the finding necessarily implies that the Trustee's payments to Gary and Regency were to settle their claims against the Chama debtors, and thus were deductible business expenses. Generally, the law of the case doctrine holds that "when a court decides upon a rule of law, that decision should continue to govern the same issues in subsequent stages in the same case." Christianson v. Colt. Indus. Operating Corp., 486 U.S. 800, 815-16 (1988). The doctrine applies to issues whether decided expressly or by necessary implication. Dickinson v. Auto Center Mfg. Co., 733 F.2d 1092, 1098 (5th Cir. 1983).
This court sees no error in the distinction recognized by the bankruptcy court's August 11, 1999 bench ruling: the bankruptcy court's finding that the settlement agreements in the Plans were fair, equitable and reasonable for confirmation purposes was not a decision as to whether the Trustee is entitled to claim an income tax deduction. (R004046-004048). See also Matter of Cajun Elec. Power Co-op., Inc., 119 F.3d 349 (5th Cir. 1997) (applying the standard to judge the compromise settlement of a bankruptcy debtor's claim). Only the issue of a settlement between settling parties was tried, and the issues involving the Internal Revenue Code and the distinction between recovery or deduction of damages and distributions to shareholders were not before the court. Id.
The question remains whether the "fair and equitable" ruling of the bankruptcy court necessarily implied that the settlements were made primarily to settle Gary and Regency's claims for damages rather than to extinguish their stock interests, as argued by the Appellant. This court cannot agree. The use of the fairness standard from Cajun Electric does not prove that the settlement was driven by claims for damages rather than by payout of equity interests; the distinction is not clearly made. Further, a finding that Gary's and Regency's claims exceeded what they would receive under their settlements with the Trustee still does not necessarily imply that the settlement was primarily with damages in mind, even if it is arguably evidence of such a fact. Even if this implication were necessary, the amount of damages to be deducted was not finally determined. Consequently, the bankruptcy court was not bound by law of the case.
Appellant argues additionally that stare decisis would have the same end result as his law of the case argument. According to Appellant, stare decisis applies to the bankruptcy court's prior findings that Gary and Regency were accepting less than the amount and value of their claims. (Conf. Finding p. 12, para. 8, R006395). Assuming arguendo that stare decisis could apply here, this court's analysis is unchanged. The bankruptcy court's findings with respect to the Confirmation Plan does not address whether the Trustee's payouts were to satisfy damages claims rather than equity interests, or the allocation between the two.
Nor was the IRS collaterally estopped from arguing that Gary and Regency had no deductible claims for damages against the Chama Debtors. Collateral estoppel applies only when the issue at stake is identical to the one involved in the prior action, the issue was actually litigated in the prior action, and the determination of the issue in the prior action was part of the judgment of the earlier action. In re Southmark Corp., 163 F.3d 925, 932 (5th Cir. 1999), cert. denied, 527 U.S. 1004. "Relitigation of an issue is not precluded unless the facts and the legal standard used to assess them are the same in both proceedings." Id. As discussed above, the bankruptcy court's findings with respect to confirmation are not dispositive of the tax treatment of the distributions to Gary and Regency. Hence, the issue was also not actually litigated in the confirmation hearing. "[C]onfirmation of a plan does not itself invoke the tax determination process." Matter of Taylor, 132 F.3d 256, 263 (5th Cir. 1998). Having failed these two elements of the test, the court need not consider the question of whether any earlier judgment determined any issue of damages.
Appellant contends that one of the bankruptcy court's basis for its decision, whether there was a final judgment, is irrelevant because a final judgment is not necessary in order for a settlement to be deductible. Appellant further contends that requiring such a final judgment would discourage settlements, contravening sound judicial policy. However, the bankruptcy court did not conclude that a final judgment was required to support the deducibility of a settlement payment. Instead, it noted that the Internal Revenue Code does not expressly provide for a deduction for damages or settlement payments, or even judgments. As noted by Appellee, the bankruptcy court also was correct to note that payments for damages or settlements are deductible as general business expenses under I.R.C. § 162 if all the requirements are met, and that the deductions are strictly construed. (R017916).
The bankruptcy court did not use the fact that there was no final judgment to misapply the standard set forth in Old Town Corp. v. Commissioner of Internal Revenue, 37 T.C. 845, 858-59 (1962). That case construes one of the requirements for showing a business expense was "necessary", and thus deductible: whether the taxpayer was entirely confident that any suit against him would not succeed. Id. at 858.
This decision discusses the application of the "necessary" requirement of deductible business expenses later in the opinion.
Appellant further argues that the bankruptcy court improperly applied res judicata with respect to Regency's damages claims. Following the bankruptcy court's denial of Regency's claims against the Chama Debtors and determination that Regency could not prove any causes of action against the Debtors in the July 1994 adversary hearing, the ruling was treated as res judicata as to Regency's claim of damages at the tax hearing in 1999. See Tax Decision Findings, pp. 44-45, para. 79, R017918-R017919. Appellant argues that the court never entered judgment against Regency following its ruling in the adversary hearing in 1994. Regency moved on other grounds for entry of judgment in its favor in September 1994. The court took Regency's motion under advisement and never ruled upon the ultimate merit of Regency's claims, but did rule on them in 1995 to the extent needed to approve the reasonableness of the settlement. The court found that Regency had valuable claims and that the comprehensive settlement of all disputes among the Trustee, Grady Vaughn, Gary Vaughn, Antigone, and Regency was fair, reasonable, and in the best interests of the estates. (Confirmation Findings at pp. 11-12, para. 8.).
Federal Rule of Civil Procedure 58 as incorporated by Federal Rule of Bankruptcy Procedure 9021, directs every judgment entered in an adversary proceeding or contested matter to be set forth on a separate document. Without entry of judgment, the appeal period never began. Baker v. Mercedes Benz of North America, 114 F.3d 57, 60 (5th Cir. 1997). No such judgment was entered.
Though Regency's appeal period would not begin without a final judgment, any failure to comply with Rule 58 does not necessarily destroy the validity of the bankruptcy court's conclusion of res judicata on the matter. Baker makes clear that the purpose of Rule 58 is to preserve the appeals period for the losing party when no separate judgment is entered. Id. at 59-60. Baker cites Banker's Trust Co. v. Mallis, 435 U.S. 381 (1978) for the proposition that "where the parties voluntarily proceed on appeal from an otherwise final and appealable order but lack a Rule 58 separate judgment, the courts of appeals may hear the appeal;" otherwise, the appeal period does not begin. Baker at 60. The parties may effectively waive Rule 58's requirements, and under certain circumstances, a document that fails to comply with Rule 58 can be a final judgment for appellate jurisdiction purposes. Baker at 60 (citing Mallis). Rule 58 does not mandate that the bankruptcy court's ruling would not have the force of a judgment if it were not in compliance with the Rule. The case speaks to appealability, not res judicata. Appellant's other cited case also deals primarily with appealability. See Theriot v. ASW Well Service, Inc., 951 F.2d 84, 87 (5th Cir. 1992).
Appellant contends that the requirements of res judicata were not met, most obviously the final judgment prong, as set out in Ellis v. Amex Life Ins. Co., 211 F.3d 953, 937 (5th Cir. 2000). The Ellis case found that res judicata is "appropriate if: 1) the parties to both actions are identical (or at least in privity); 2) the judgment in the first action is rendered by a court of competent jurisdiction; 3) the first action concluded with a final judgment on the merits; and 4) the same claim or cause of action is involved in both suits." Id. Other than the language quoted, the case is not particularly instructive on applying res judicata. In any event, even if the court's previous ruling was not res judicata, the bankruptcy court was entitled to rely on its previous findings in the case, especially in light of the concession made by counsel for Regency at the July 28, 1995 confirmation hearing that Regency's claims had been tried and lost. Given the court's prior findings, it was not error for the court to prevent Appellant from relitigating the issue.
2. Damages Payment versus Distribution of Stock
Appellant argues that the legal requirements for distribution as payment for damages were met and that damages had been established. Appellant draws a legal distinction between distributions to a stockholder on account of his creditor status to a corporation as opposed to his stock ownership. According to Appellant, I.R.C. § 301(a) states that a corporate distribution constitutes a distribution by a corporation to a shareholder with respect to its stock. According to General Counsel Memorandum 38714 from the IRS:
Treas. Reg. § 1.301-1(c) makes clear that the phrase `with respect to its stock' contained in section 301(a) is intended to limit the applicability of section 301 to a distribution made by a corporation to a shareholder in the shareholder's status as an owner of stock in the corporation. That regulation states, `[s]ection 301 is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such.' This regulatory provision is undoubtedly derived from the Senate Finance Committee report, accompanying the enactment of section 301, that illustrates the limiting nature of the `with respect to its stock' language by stating, `[f]or example, a distribution of property to a shareholder who is a creditor of the corporation in satisfaction of his claim against the corporation is not within the scope of section 301.'.See Loftin Woodward, Inc. v. United States, 577 F.2d 1206 (5th Cir. 1978) ("interest paid to a stockholder who is a bona fide creditor is not a dividend. . . ."). Appellant additionally cites the bankruptcy court's finding that Gary suffered actual damages over $28 million. See (Confirmation Findings, p. 12, para 10, R005827). The Chama Estates would face joint and several liability for Gary's claims.
Appellee counters with I.R.C. § 302(a), which holds (subject to limitations) that a stock redemption by a corporation is treated as a distribution in part or full payment in exchange for stock. Stock is redeemed if the corporation acquires the stock in exchange for property (I.R.C. § 317(b)), i.e. money (I.R.C. § 317(a)). Stock redemption by a dissolving corporation generally results in capital gain or loss to the shareholders. See Treas. Reg. § 1.331-1(e). Appellee's argument does little to advance any of its contentions. The Court's reading of § 302 is that whatever money was received by Gary and Regency in exchange for their stock would fully compensate them for that stock; but the section does not speak to distributions for damages.
The Trustee would deduct payments to Regency for any claims confirmed by the bankruptcy court. Evidence from the Trustee's outside accountant indicated that the amount of payments to Regency attributable to damages settlement should be at least 20% of the net sale price of the Ranch. This figure was derived from the difference between what Regency's stock interest in Chama prior to the 1990 transactions would have entitled it to (68.8%), and the lesser portion of the value of Chama that Regency would receive under the Plan settlement. The Trustee insists that Regency had viable damage claims against the debtors at the time of the settlements. The Trustee bases this argument in part on the bankruptcy court's statements at the confirmation hearing that Gary and Regency had claims against the debtors in excess of what they received in settlement. Yet as previously discussed, prior to confirmation Regency had lost its adversary proceeding against the debtors for the 1990 Transactions. The court finds the Trustee's reliance on this isolated statement by the bankruptcy court to be misplaced. The fact remained that at the time of the confirmation, Regency had lost its adversary proceeding against the debtors, leaving it only a creditor of Grady. Thus, with respect to Regency, the court's statement could have referred only to equity claims. Since Regency had previously lost its damage claims against the debtors, there is no apparent reason that all debtors would pay damages to Regency as part of the settlement. Thus, the court agrees with the bankruptcy court that the payments to Regency were in satisfaction of its stock holdings and not as payment for damages.
With respect to Gary, the Trustee also maintains that there is no record evidence to support Gary's assertion that he had damages claims of approximately $28 million. The Trustee notes that Gary did not testify at the confirmation hearing in 1995 or the tax hearing in 1999, and argues that no evidence exists that Gary was damaged by the debtors. However, as noted previously in this order, there was record evidence of the damages incurred by Gary, and of the potential liability to Gary faced by the debtors. Moreover, there were specific findings by the bankruptcy court at the confirmation hearing as to Gary's damages claims, and Gary had not previously lost his claims for damages against the debtors, as Regency had. Gary only held stock interests in Chama LC, yet the Trustee settled with him on behalf of all of the Chama Estates. Thus, it appears that at least some of the Trustee's distributions to Gary might not be stock equity since Gary did not have stock in all of the Chama Estates, and Gary still had viable damage claims against the debtors.
Nevertheless, the extent to which Gary was compensated for damages remains unknown. The Trustee's plan required Gary and Regency to irrevocably transfer their equity interests in the debtors to the Trustee in exchange for the right to receive Plan distributions. The Plan did not allocate the distributions to Gary and Regency between damages and equity. It instead provided that the Trustee would seek a tax liability determination under 11 U.S.C. § 505 from the bankruptcy court, which would determine how to allocate distributions between damages and equity. The mutual release among the settling parties released all claims among the parties but did not specify the consideration for the exchange. The transfer of equity interests without specification of their particular worth, coupled with the mutual exchange of releases for all claims without recitation of their consideration, make it impossible on the record before the court to determine which money should be allocated to damages simply by tracing Gary equity interests to some debtors or defendants but not others. Assuming the joint and several liability of all Chama Debtors for claims by Gary, the court still can not effectively determine the amount of money that satisfied Gary's equity rights versus damages claims.
Evidently Regency had greater equity claims than Gary in Chama LC, while Gary had greater damages claims than Regency. Though they were not equal shareholders, their distributions were each 48.33%. This is consistent with an understanding that Gary had viable damages claims but Regency did not. Appellee's contention that non pro rata distributions should be treated as pro rata distributions for tax purposes is not supported by the citation it offers, Treas. Reg. § 1.33 1-1(e). The court can thus conclude that at least some of the payments by the Trustee to Gary must have constituted payment for damages and not for stock distribution. However, as noted above, it is not obvious how to derive the proper ratio of damages to equity.
Appellee is correct that a court is not bound by the settling parties' allocation between tort damages and other compensation for tax purposes, but may ascertain the proper allocation for itself. Robinson v. Commissioner, 102 T.C. 116 (1994), aff'd in relevant part, 70 F.3d 34 (5th Cir. 1995). Appellee notes that the Trustee's allocations between damages and equity changed between the debtors' original and amended returns. Appellee offers undisputed evidence of ongoing cooperation among the Trustee, Regency, and Gary Entities in deciding how to characterize the plan distributions on the debtors' tax returns. From evidence that the Gary Entities and Regency wanted the Trustee to treat their distributions as damages, Appellee would infer an undue deference by the Trustee, in deference to Regency and Gary's status as shareholders. Even if this were true, it does not indicate that the distributions created through the cooperation of the parties would not be properly characterized as damages rather than as stock distributions. Further, this evidence seems equally consistent with an effort by Appellant to establish consistency of treatment of the plan distributions on each party's tax return, and the desire by the distributees to maximize their distributions by freeing up more money by way of a business expense deduction by the Trustee.
In sum, the court finds that the bankruptcy court did not err in finding that the payments to Regency were for redemption of stock and not for payment of damages. However, with respect to Gary, the bankruptcy court erred in not allocating some of the distributions to Gary as payment for damages.
3. Regency and Gary's Treatment of Payments
Appellant challenges the bankruptcy court's reliance on a finding that Regency and Gary treated the payments from the Chama Debtors in a manner inconsistent with having received them in a settlement of claims for damages as incorrect and based upon a non-existent legal standard. The bankruptcy court noted that "neither the Gary entities nor Regency reported the distributions received from the Trustee in 1995 as damages on their 1995 federal income tax returns, which is inconsistent with the treatment claimed by the Trustee on the Debtor's 1995 return. This inconsistent treatment of the distributions by the Gary Entities and Regency undercuts the Trustee's argument that the distributions are deductible." (Tax Decision Findings, p. 43, para. 75, R017917).
The court has been cited to no law or provision of the Internal Revenue Code that explicitly supports the proposition that the payor and payee must both treat the payment alike on their returns if it is to be deductible by the payor as one made on account of damages. However, the Internal Revenue Manual contains the general proposition that consistency of treatment among taxpayers to a transaction is a primary objective in IRS examinations in order to avoid being "whipsawed." See Internal Revenue Manual 4.2.7.4.9. In re Hunt describes the whipsaw effect as one in which two taxpayers take up logically inconsistent positions, yet first one and then the other prevails against the government due to jurisdictional or procedural reasons. 95 B.R. 442, 446 (Bankr.N.D. Tex 1989). Inconsistent treatment of a transaction between taxpayers has the potential to unfairly injure the government.
Appellant argues that different treatment of the amount on each taxpayer's return does not necessarily mean "inconsistent" treatment. Appellant points to Regency's treatment of all receipts as a recovery on promissory notes, and thus ordinary income, as required by Regency's "cost recovery" method of accounting. (Tr. R003913, 14). The income was not divided into receipts for claims for damages versus other payments, but was nevertheless not inconsistent with the Trustee's deductions for damages. Appellant notes that Gary reported a small part of his 1995 distribution as capital gain (R003938), but later reported the additional distributions as damages and has agreed to file an amended 1995 return when this litigation concludes (R003940).
Conceivably, Regency reported its 1995 distributions as "other income" because it had already recovered the cost of the NCNB Notes, not because they were considered damages. None of the Gary entities reported plan distributions as damages (ordinary income) on their 1995 returns, but instead as repayment of notes, accounts receivable, or stock redemption (capital gain). The Trustee's and Gary's inconsistent positions could create a whipsaw for the IRS, and Gary's as yet unamended 1995 return supports a finding of the parties' tax motivations. According to Appellee, Gary refused to extend the statute of limitations which was soon to expire, preventing the IRS from challenging Gary's treatment of the Trustee's distribution on Gary's taxes unless it filed a Notice of Deficiency to Gary.
Since inconsistent treatment between taxpayers could lead to adverse consequences for the government, it was not error for the bankruptcy court to consider evidence of apparent inconsistent treatment, as a "whipsaw" might be the result.
4. Motion to Present Evidence Post-Trial
Appellant challenges the bankruptcy court's decision excluding as irrelevant a letter from the IRS allegedly indicating the IRS took a position with the Gary entities inconsistent with its position in front of the bankruptcy court. The IRS sent an assessment letter to Gary dated September 10, 1999 notifying him of an alleged deficiency for his tax years ending the year 1995. The letter stated the IRS position that all payments to the Gary entities must be treated as payments for settlement of damages that are taxable to their recipients, and none could be treated as liquidating distributions on account of stock. Of course, this position is the opposite of its contention in this case that none of the distributions may be treated as stemming from settlement claims for damages. The bankruptcy court excluded the letter as irrelevant.
The IRS sent the letter, a Notice of Deficiency, in order to avoid a possible "whipsaw." Without Gary's agreement to sign an extension of the statute of limitation, and without a final order resolving the tax consequences of the transactions in this case, the IRS faced losing the revenue from the distribution transaction. The IRS sent its Notice of Deficiency to protect itself in case the Trustee's distributions to Gary were ruled to be deductible damages. The IRS' action is not unprecedented. See Wickert v. Commissioner, 842 F.2d 1005, 1006 (8th Cir. 1988) (IRS filed Notice of Deficiency to two different taxpayers because their inconsistent treatment of the same item threatened a whipsaw); Streber v. Hunter, 14 F. Supp.2d 978, 981 (W.D.Tex. 1998) (assessing the same tax on two taxpayers is not uncommon in whipsaw situations). The court finds no abuse of discretion in the bankruptcy court's ruling.
Even if the Notice of Deficiency should not have been excluded, this court does not find the letter to have any reasonable possibility of altering the bankruptcy court's decisions. Any error in excluding the evidence was harmless. See Fed.R.Civ.P. 61 (error in excluding evidence merits no action to modify judgment unless inconsistent with substantial justice).
B. DEDUCTION OF PAYMENTS AS BUSINESS EXPENSES
Appellant argues that the bankruptcy court failed to apply the test of whether making settlement payments to obtain a release of claims constituted a deductible "ordinary and necessary" business expense. I.R.C. para. 162(a) defines a deductible business expense as the "ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. . . ." Generally, deductible business expenses "include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business. . . ." Treas. Reg. para. 1.161-1(a). The three requirements for deducting a settlement payment as a business expense are that the payment have the requisite relationship to the taxpayer's business, be "ordinary," and be "necessary." See Graphic Business Systems, Inc. v. Commissioner of Internal Revenue, 43 T.C.M. (CCH) 957, 960 (1982).
There is no dispute that the expenses were related to the taxpayer's business, as the Trustee's payments to settle the claims of Gary and Regency related to the fraud of the Chama Debtors in the 1990 Transactions. See, e.g., Redwood Empire Savings Loan Ass'n v. Commissioner of Internal Revenue ( hereinafter "Commissioner"), 628 F.2d 516, 520 (9th Cir. 1980). The ordinary nature of this expense is also not disputed. See Welch v. Helvering, 290 U.S. 111, 114 (1933) (discussing the ordinariness of counsel fees in defending a lawsuit).
The contentious point is whether the expenses were necessary. A three-part test determines whether an expense paid to settle a lawsuit is "necessary": "(1) Was the taxpayer entirely confident that any suit which the plaintiff might bring could not succeed? (2) did the taxpayer make the payment in question only for the purpose of avoiding the damage to the taxpayer's credit, reputation, and business generally which might result from such a suit? and (3) was any such fear which the taxpayer may have had so far justified that a reasonable person in the taxpayer's place would have thought a settlement at that figure less than the damage which would follow from such a suit?" Musgrave v. Commissioner, 73 T.C.M. (CCH) 1721 (1997), citing Old Town, 37 T.C. at 858-859. Appellee contests each point.
First, Appellee challenges the Trustee's belief in the seriousness of Gary and Regency's claims by arguing that the Trastee offered no evidence that his attorney Mr. Tarbox so believed or advised settlement, or that the Trastee relied on this advice, as Mr. Tarbox did not testify at the 1995 Confirmation hearings or the 1999 tax determination trial. Appellant directly contradicts Appellee, stating that the Trastee testified that Mr. Tarbox advised him on these matters. (Tr. 3/12/99 p. 96, R003953-56). Appellant further replies that the Trastee testified at the tax trial that he considered the claim "serious," (Tr. 3/11/99 p. 79, R003759); he foresaw liability; ( Id. at p. 81, R003761); that the claims exceed the value of the property and the litigation costs threatened the bankruptcy estate, (Tr. 3/12/99 p. 83, R003953); and that the Estates were open to breach of fiduciary claims from Gary, ( Id. p. 84, R003954). A Ms. Meyers' testimony at the tax trial is also offered as to the large liabilities that a jury could impose, Id. p. 89, R003769, as well as a Mr. Lammiman's testimony that Regency recovered less than the amount of its claims under the settlement with the Chama Entities. (Tr. 3/11/99 p. 112-13, R003792-93). Appellant further offers the Confirmation Findings in which the bankruptcy court found that Regency and Gary, in entering settling agreements with the Trustee, conferred value to the estates by agreeing to accept less than the amount and value of their claims. (Conf. Findings, pp. 11-12, para. 8, R0063 94-95). The 1995 Confirmation Findings indicated that damages to Gary probably exceeded $28 million, more than he would likely receive under the Plan. (Conf. Finding, p. 12, para. 10, R006395). Appellant cites the bankruptcy court's language, "it is likely that Regency has claims against each of the Debtors which exceed the value it will receive under these Plans. . . ." (Conf. Findings, p. 12, para. 9, R006395). However, the statement occurred after the court had ruled against Regency's claims; thus the settlement was reached after Regency had, in effect, lost. It would be difficult for the Trustee to reasonably believe that Regency's damages claims had any chance of success after Regency had already lost in the adversary proceeding. The claims referred to here evidently allude to Regency's equity holdings instead of damages. Yet the Trustee still could expect damages claims from Gary as well as equity claims from Regency and Gary. The first prong of the test is satisfied as to Gary, since the Trustee could fear damages claims from him, but not as to Regency.
Second, the debtors were in bankruptcy, the Trustee appointed, and the assets liquidated. However, the Trustee testified at trial that it was in the best interest of the Chama Estates to settle with Gary and Regency in order to preserve the assets of the other creditors, including avoiding defense costs. (Tr. 3/12/99 p. 85, R003955-56). Thus, the plan distributions might be made in carrying on a business or solely for the purpose of avoiding damage to the debtor's credit, reputation, and business. The court finds that the evidence supports Appellant's contention that the settlement was intended to help the Chama Estates' business, by properly administering the bankruptcy on behalf of the debtors and creditors. Further, just because the assets were liquidated and the Debtors were no longer conducting business does not mean Gary's damages claim cannot qualify as necessary. Under such logic, no settlement of claims in a bankruptcy where the assets are liquidated could ever be "necessary," a position which Appellee does not support with precedent. But again, the court cannot discern any interest for Regency other than its equity interest. Appellant thus satisfies the second prong of the test as to Gary only.
In considering the third prong, reasonableness, the court notes that the bankruptcy court found the settlement to be necessary to the success of the Chama Plan in 1995 (and thus a "reasonable response"):
Regency, Gary Vaughn, and other non-debtor settling parties have conferred value to the estates by negotiating and entering into these settlements by agreeing to accept less than the amount and value of their claims and by actively participating in the confirmation of these plans.
(Confirmation Findings, p. 12, para 8, R005827). Deducibility does not depend on the validity of the claims settled. See Entwicklungs and Finanzierungs A.G., 68 T.C. 749, 766 n. 9 (1977). Otherwise the claims would have to be tried to final judgment before they could be deducted. A year before plan confirmation, the bankruptcy court, in Regency's adversary proceedings concerning the 1990 Transactions, had dismissed Regency's fraudulent transfer claims against the defendants for lack of standing and denied all of Regency's claims against the debtors as unapprovable. No reasonable person would make the remaining plan distributions to Regency to settle claims that had been adversely adjudicated against Regency, nor would such person have thought that the settlement amount would be less than the damages from a suit. The Appellee claims that the bankruptcy court so discerned at trial. (R003997-003999).
Appellant replies that the bankruptcy court found the settlements were reasonable in its Confirmation Findings when it found:
The Court finds that pursuant to Rule 9019, Fed.R.Bank.P., and based on the evidence adduced at the Confirmation trial, the settlement agreements embodied in these Plans among the Settling Parties are fair, equitable, and reasonable settlements for each of the Debtors. Such settlements are reasonable in light of the measure of likelihood of success of litigation and the costs related thereto, and the degree of difficulty in establishing the merits of the claims and defenses. Regency, Gary Vaughn, and other non-debtor Settling Parties have conferred value to the estates by negotiating and entering into these settlements, by agreeing to accept less than the amount and value of their claims. . . .
(Conf. Findings, pp. 11-12, para. 8, R006394-95).
See Matter of AWECO, Inc., 725 F.2d 293, 298 (5th Cir. 1984) (stating in a bankruptcy case that a court may only approve a compromise or settlement that is "fair and equitable"). The bankruptcy court's statement could just as easily have referred to equity claims as damages claims since Regency had such claims and Gary had both kinds of claims. The court finds that only Gary has satisfied the reasonableness standard since only Gary had valid damages claims.
By meeting the three criteria as to Gary, Appellant has established that proper payments to Gary to settle any damage claims against the Chama Estates may be deductible as ordinary and necessary business expenses.
C. SUBSTANTIVE CONSOLIDATION OF SOME CHAMA DEBTORS
Appellant maintains that the bankruptcy court should have treated the Chama Estates as substantively consolidated for tax purposes since he had previously substantively consolidated them under the Chama plan. The bankruptcy court consolidated the Chama Entities as provided in the Plan, thus pooling all of the assets of the four Chama Estates for payment of claims against any of them. (Chama Plan, p. 10, para. 8(c), R006318). Appellant argues that the substantive consolidation effectively made each of the Chama Debtors jointly and severally liable for any valid claim against any of them. See, e.g., In re Molnar Bros., 200 B.R. 555, 560 (Bankr. D.N.J. 1996) ("Substantive consolidation is the merger of assets and liabilities of two or more estates, creating a common fund of assets and a single body of creditors"). Appellant maintains that this court should treat the four Chama Estates as one entity for tax purposes in order to conform with economic reality and value substance over form. Though a taxpayer cannot rely simply on the economic reality of his transaction to override the form of the transaction, a taxpayer may argue substance over form when necessary to prevent unjust results because of mistake, undue influence, or fraud. Smith v. Commissioner, 65 F.3d 37, 40 (5th Cir. 1995). See also Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) ("To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress."); Estate of Kluener v. Commissioner, 154 F.3d 630, 634 (6th Cir. 1998) (considering the substance over form doctrine for a transaction).
It is unclear why, however, the Trustee chose not to claim a damage deduction for distributions to Regency and Gary on either the initial or amended 1995 returns of The Lodge, as Appellee points out. (R003889, R003979).
Appellant sees no difference in the legal standards governing substantive consolidation in bankruptcy and for tax purposes, and invokes law of the case to compel identical conclusions. This court cannot reach that conclusion because Appellant has not set forth the requirements for consolidation in bankruptcy, nor are the cases cited specific enough to the issue at hand.
Both parties invoke Moline Properties v. Commissioner, 319 U.S. 436, 438-39 (1943), which explained the doctrine of corporate entity:
Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity.Id. Moline Properties explicated an exception to the doctrine: "In matters relating to revenue, the corporate form may be disregarded where it is a sham or unreal. In such situations the form is a bald and mischievous fiction." Id. at 439.
Appellant relies upon Second Circuit law for the definition of "business activity" stated in Moline Properties. Judge Learned Hand explained the case in which a taxpayer's deduction was disallowed, stating "to be a separate jural person for purposes of taxation, a corporation must engage in some industrial, commercial, or other activity besides avoiding taxation." National Investors Corp. v. Hoey, 144 F.2d 466, 467-68 (2d Cir. 1944). A dummy company that merely takes and holds title to property and serves only to deter creditors need not be regarded as separate; yet obtaining a loan from a third party may still constitute business activity even in the absence of recordkeeping and corporate offices and meetings. Paymer v. Commissioner, 150 F.2d 334, 336-37 (2d Cir. 1945). See also Jackson v. Commissioner, 233 F.2d 289 (2d Cir. 1956) (looking both to the intent in creating a corporation and whether it actually undertook business activity). Business activity must be continuous and regular, not sporadic, with the primary purpose of creating income or profit. See Commissioner v. Groetziner, 480 U.S. 23, 35 (1987). A corporation not intended to have a real business purpose that only holds and conveys title to real property, with attendant ministerial functions, can be disregarded as a separate entity for tax purposes. See Lukins v. Commissioner, 64 T.C.M. (CCH) 899 (1992).
However, the Supreme Court tempers the search for economic reality by recognizing the unfairness to the government if a taxpayer tries to reap the benefit of a chosen corporate form without acknowledging the attendant consequences and responsibilities. "[W]hile a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not." Commissioner v. National Alfalfa Dehydrating and Milling Co., 417 U.S. 134, 149 (1974).
The evidence in this case indicates that the most the dispersion of Chama assets may have accomplished was to shield the assets from creditors. In the Regency adversary proceeding concerning the 1990 Transactions, the bankruptcy court found that the dispersion of Chama's equity interests ultimately preserved its assets from threat of forfeiture. In re Legal Econometrics, Inc., 169 B.R. 876, 885 (Bankr. N.D. Tex. 1994). Yet in a later proceeding, the bankruptcy court's decision in favor of consolidation of the Chama Entities included findings that the New Chama Corporations were the result of "contrived transactions" and that the Chama Estates always had been operated as a single economic entity, with creditors dealing with them as such. (Confirmation Findings, p. 10-11, para. 7, R005825-26). Additionally, in a third-party action by Grady concerning the 1990 Transactions, Grady did not deny that the purpose of the 1990 transactions was to protect the Chama assets, but instead asserted that the corporate restructuring turned out to have been unnecessarily pervasive, and that the perceived threat of forfeiture of Chama's assets was exaggerated by Kelso. Vaughn v. Akin, Gump, 1997 WL 560617 (N.D. Tex. 1997).
The evidence cited by Appellant indicates that the New Chama Entities did not function as separate business entities. The creditors and shareholders treated them as indistinct: assets were transferred from one entity to another without proper corporate authority; the corporations reported their financial results on consolidated financial statements; the entities advanced funds to each other as necessary to meet operating and debt service requirements; and the entities have always been under common management. (Conf. Findings p. 10-11, para 7, R006393-006394).
It is not disputed that the Trustee has taken inconsistent positions in filing the Debtors' 1995 returns by filing separate returns for the debtors for the years 1995 through 1997. (R003889, R003979). It is also not disputed that the second amended returns indicating the Trustee's position that consolidation was proper were not filed until June 1998, well after the tax determination motion was filed with the Bankruptcy Court. No one disputes that consolidation would increase the Chama debtors' refunds. The Trustee's treatment of the Entities as separate on the tax returns does not necessarily indicate an intent to unfairly evade taxes, since the Trustee had no ruling from the bankruptcy court permitting consolidated treatment. But regardless of why the Trustee's tax filings have been inconsistent, Appellant's position is not obviously contrary to the law. The case law suggested by the Second Circuit indicates that evading creditors is not a sufficient business purpose under Moline Properties to justify viewing entities as separate, as does the Lukins case.
None of the cases cited by appellant mandate that the Chama Entities be consolidated for tax purposes, but only counsel to do so to prevent injustice. See Smith, 65 F.3d at 40. The Smith case supports the appellant's argument that consolidation for tax purposes is in the interests of justice, since the dispersion was evidently accomplished either by the fraud of Kelso or under a mistaken belief that such dispersion was more necessary than it actually was. See id. Since consolidating the Chama Estates for tax purposes was within the bankruptcy court's purview, the real remaining question is whether the court should have done so given the benefit of protection from creditors that the dispersion may have bestowed. The National Alfalfa case counsels against permitting the taxpayer to have it both ways, to benefit from one form while later claiming another.
Applying the facts of this case, this court finds that the first "purpose" prong of Moline Properties is consistent with consolidating the Estates for tax purposes. The New Chama Entities acted with a unity of interest as one entity. There was no evidence of intent of a separate business purpose that would demand separate corporate treatment, nor that the dispersion of assets served any "business purpose." If the Chama dispersion was intended to serve the useful purpose of evading creditors, it still is not carrying on a business purpose. If the dispersion was instead merely a series of fraudulent conveyances by Kelso, then the policy of elevating substance over form counsels for consolidation.
But a close reading of the second prong of Moline Properties and the case law cited yields the conclusion that even if the transactions creating the corporations had no "business purpose," the entities are taxable separately as long as the transactions were "followed by the carrying on of business by a corporation." 319 U.S. 438-39. The evidence before the court suggests that, unlike in the cases cited by Appellant, the New Chama Entities were not merely dummies that held property or protected the assets from creditors; they actually conducted business. In order to overturn and ignore the separate corporate status of the New Chama entities for tax purposes, the court would need evidence that the Entities did nothing other than hold title to property and shield assets from creditors. The evidence instead is equally consistent with the conclusion that the New Chama Entities functioned as corporations. In fact, the Trustee's continued treatment of the New Chama Entities as separate long into the litigation process suggests that separate treatment was the Trustee's preference; the court has been cited no evidence that the shareholders ever sought to re-consolidate the Chama Entities prior to bankruptcy, even though the Entities functioned so closely together. The fact that the shareholders of the entities ignored corporate formalities and worked for each other's mutual benefit does not mean that each Entity was not carrying on business activities as described in Moline Properties. Moline Properties and the attendant case law support ignoring the corporate form when an entity has no business purpose or carries on no business. On the contrary in this case, even if the dispersion transaction had no "business purpose," the resultant corporations carried on with business activity; the evidence does not suggest that they were mere lifeless "dummies." The corporations evidently supported each other in order to carry out those business activities. The failure of Appellant to prove that the Entities were not carrying on actual business means the Entities were not shams as contemplated by Moline Properties.
The evidence is inconclusive as to whether any benefit derived from the dispersion makes it unjust to permit the Trustee to argue for consolidated treatment in order to reduce tax liability. The mere fact that the Trustee benefits from consolidation does not mean his petition is unjust. But the court cannot say based on the evidence before it that the Chama Entities did not benefit from the separate corporate status their administrators chose. The court does not believe that declining to consolidate the Entities for tax purposes fails to address any injustice under Smith. National Alfalfa counsels that Appellant accept the consequences of the corporate form it has chosen.
The court is not persuaded by the fact that the Entities were consolidated for bankruptcy purposes but not consolidated for tax purposes. Given the close and cooperative economic activities and relationship among the New Chama Entities, their consolidation for bankruptcy is hardly surprising; but as discussed above, this factor does not control whether they should be taxed together as one entity. Appellant's cited case is consistent with linking consolidated bankruptcy treatment with similar tax treatment, but does not advance it: the case held that a married couple who filed jointly under the Bankruptcy code maintained two separate bankruptcy estates absent a substantive consolidation by the court, entitling them each to separate tax treatment and their attendant deductions. In re Knobel, 167 B.R. 436 (Bankr.W.D.Tex. 1994). In that case, the debtors, unlike appellant, desired separate tax treatment in order to merit more deductions. The case construed a specific statutory provision of the Bankruptcy Code which permits an individual and spouse to file together, and discusses consolidation. While the case suggests that substantive consolidation under that provision might yield consolidated tax treatment, Appellant does not demonstrate any application whatsoever of this case outside the specific context of husband and wife filing under the provision in question. The bankruptcy court did not commit error in refusing to consolidate the Chama Estates for tax purposes.
D. DECISION NOT TO DETERMINE LOSSES AVAILABLE FOR CARRYBACK
Appellant argues that the bankruptcy court should have decided the issue of whether net operating losses after 1995 could be carried back to reduce the taxable income for the Chama Estates for 1995. Appellant would have the bankruptcy court examine the tax years 1996 and 1997 solely to determine whether those years yielded net operating losses.
First, this court must consider the bankruptcy court's jurisdiction to determine carrybacks from the post-confirmation periods of 1996 and 1997. The Tax Court "may determine the correct amount of taxable income or NOL for a year not in issue (whether or not the assessment of a deficiency for that year is barred) as a preliminary step in determining the correct amount of an NOL carryover to a taxable year in issue." Calumet Industric, Inc. and Subsidiaries v. Commissioner, 95 T.C. 257, 274 (1990). Section 505(a)(1) of the Bankruptcy Code provides in pertinent part that ". . . the court may determine the amount of legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid. . . ." 11 U.S.C. § 505(a)(1). The Declaratory Judgment Act, 28 U.S.C. § 2201(a) provides for the determinations of tax liability under 11 U.S.C. § 505 and 1146.
The court finds that these statutory provisions apply to post-confirmation periods when federal taxes are concerned. The cases Appellee cites to show that the bankruptcy court cannot consider these post-confirmation periods are distinguishable. In re Hartman Material Handling Systems, 141 B.R. 802 (Bankr.S.D.N.Y. 1992) states that the court could not "consider post-confirmation events which were not even known at the time of the confirmation to determine a speculative future tax liability of the former debtor." Id. at 812. But Appellant only seeks the bankruptcy court to consider events occurring prior to Confirmation. The court in In re Maley, 152 B.R. 789 (Bankr.W.D.N.Y. 1992) did not conclude that it did not have jurisdiction under § 505 to determine post-confirmation tax liabilities.
This court sees no need to consider Appellee's claim that collateral estoppel prevents the carryback of net operating losses based on damage deductions for plan distributions to Gary and Regency, which it states without explanation or support. Further, Appellee does not explain its claim that the United States cannot be bound by a Confirmation Plan with respect to taxes that become due after confirmation; the taxes in question are for the 1995 tax year, while the liabilities for 1996 and 1997 would not be adjudicated, only the carrybacks. See Holywell Corp. v. Smith, 503 U.S. 47, 58 (1992).
The question remains whether the bankruptcy court was compelled to consider any 1996 and 1997 carrybacks, considering the court had agreed to adjudicate the 1995 Chama tax liabilities. This court sees no basis in law that the bankruptcy court must determine carrybacks from post-confirmation tax years. The court agrees with Appellee that the use of the word "may" in § 505 appears intended to grant the bankruptcy court discretion as to whether it will determine taxes. Judge Abramson concluded in In re Hunt that the reported decisions offer little guidance as to when the bankruptcy court should exercise its discretion. Id. at 445. Judge Abramson considered the need for speedy administration of the bankruptcy case, the complexity of the tax issues involved, the asset and liability structure of the debtor, the length of time required for trial and decision, judicial economy and efficiency, the burden on the bankruptcy court's docket, and any prejudice to the debtor or taxing authority. Id. See also In re Maley, 152 B.R. at 792 (stating one ground that might compel the bankruptcy court to exercise its discretion is that an adjudication outside the bankruptcy court would unduly delay the administration of the estate). Unfortunately, the parties offer this court no discussion of these factors. It does not appear that Appellant could show undue delay in administration since, with suit already pending in the Tax Court, it is unclear that a remand to the bankruptcy court would result in a faster determination. In the absence of a showing to the contrary, this court must conclude that the bankruptcy court did not abuse its discretion in declining to decide the 1996 and 1997 net operating losses. It is undisputed that a Tax Court adjudication is still available to the Trustee.
E. QUALIFIED SETTLEMENT FUND CREATION
The court must decide whether the bankruptcy court should have found that two Qualified Settlement Funds (QSFs) were established through the Plan Confirmation in 1995. A QSF permits a taxpayer to deduct payments made to the fund in the year in which the QSF was established even though the payments are not made from the fund to the creditor until a subsequent tax year. The bankruptcy court relied on the fact that no one intended to establish two such funds as QSFs when the funds were created, and denied the corresponding tax benefits from those funds for 1995. (Tax Decision Findings, p. 35-42, para. 22-61, R017909-16). The court also appeared concerned that the assets of the funds that were created were designated by the Trustee's Plan for the payment of all distributions under the plan (rather than an qualified subset of distributions). Id.
There are three basic requirements for the establishment of a QSF. First, a governmental entity (such as a judge) must approve setting up a fund for payment of certain kinds of claims and have continuing jurisdiction over that fund. Treas. Reg. § 1.458B-1(c)(1). Second, the fund must be established to "resolve or satisfy" certain kinds of claims including tort, breach of contract, or other claims for violations of a statute, rather than trade claims or equity claims. Treas. Reg. § 1.458B-1(c)(2). Third, the fund must be held in trust or in a fund segregated from other assets of the transferor (the Chama Estates). Treas. Reg. § 1.458B-1(c)(3).
Appellant contends that each requirement was met by two of the funds created by orders of Judge Abramson in 1995. The first fund segregated $1 million of the price paid by the Jicarilla for the Ranch into an account at the Registry of Court to satisfy an environmental holdback provision under the purchase agreement. Following the confirmation of the Chama Plan, the bankruptcy court also created a second segregated fund when he held back $1.75 million from the monies otherwise to be distributed by the Trustee to Gary and Regency under the Plan, as a fund that would be released only when Kelso's appeal of the confirmation order was dismissed by the district court. (R0058095-5816, R005881-5890).
Appellant successfully establishes that the basic requirements of a QSF have been met. First, both funds were ordered by the bankruptcy court, placed in the Registry of Court, and made subject to continuing judicial supervision. Second, each of the funds was reserved to pay the required categories of claims: the environmental fund for environmental claims relating to any violations of federal or state environmental laws detected within a year following the closing of the sale, and the Kelso hold-back to pay any breach of contract claims Kelso might have if he were successful in his appeal of the Confirmation Order. The residue of each fund would be paid to Gary and Regency to settle their tort claims against the Chama Debtors. Third, the funds were segregated by placing them in specific accounts in the Registry of Court by Judge Abramson's order. The funds were established in 1995 with money from the Chama Estates, so deductions may be proper for the 1995 tax year. "Economic performance" was satisfied in 1995 upon transfer of the funds. Treas Reg. § 1.468-B-3(c)(1); Treas. Reg. § 1.468-1(j)(1).
Appellee argues, and the bankruptcy court accepted, that a QSF is not formed without the proper intent to do so. However, this proposition does not appear to find support in the law. The Preamble to the Treasury regulations issued under I.R.C. § 468B states that the regulations "mandate qualified settlement fund treatment for a fund, account, or trust that satisfies the requirements of a qualified settlement fund." T.D. 8459, 57 F.R. #60983. The IRS and Treasury Department rejected the idea of making the QSF rules elective, in the interest of consistency of tax treatment. Id.
Appellee's contention that the governmental approval requirement is not met if the bankruptcy court did not specifically designate the funds as QSFs is not supported by case law or the Treasury regulations. Appellee contends that the Trustee did not ask the bankruptcy court to approve a QSF, and that the bankruptcy court's confirmation order and findings and conclusions do not even mention a QSF. (R003991, 003992). Yet the statute and the evidently deliberate omission of an intent requirement lead this court to conclude that mere creation of the fund is sufficient to give it QSF status without government designation of its status, as long the court approved of the funds themselves and the other requirements are met.
Appellee challenges whether the segregation requirement was met. Appellee claims that distributions were made by the Trustee "from the same Chama account" to pay general creditors as well as Gary and Regency, as well as various other expenses. But Appellee fails to show that the account used to pay general creditors was either one of the two accounts under consideration for QSF status.
The appellee also argues that a QSF was not established because Appellant did not comply with the administrative requirements of a QSF. The record shows that the fund administrator never filed a tax return for the funds as required. See Treas. Reg. § 1.468B-2(k)(2), 2(k)(3); R003991). The Trustee did not designate a plan administrator, nor obtain a taxpayer identification number for these funds, and no statement of transfer was filed. See Treas. Reg. § 1.468(b)-3(e); (R017914-15). However, these regulations appear to be requirements once the fund has been established; they are not required to establish the fund itself.
Appellee argues that Appellant failed to argue the QSF issue before the bankruptcy court as to the two alleged QSFs now at issue on appeal. But Appellant cites testimony from the tax trial in which Mr. Bowman and Mr. Lammiman apparently identified the funds that would be entitled to QSF treatment. (Tr. 3/11/99 p. 20, 123-24, R003700, 003803-04). The issue thus seems to have been brought to the attention of the bankruptcy court.
Appellee contends that naming the funds as QSFs was a tax-motivated afterthought. Clearly this is so. But that contention is not dispositive of whether the funds qualify as QSFs. The court finds that two QSFs were established, as Appellant contends.
F. TAX LIABILITY DETERMINATION
The case is remanded to the bankruptcy court for calculation of the amount of the payments to Gary that were for damages claims and for determination of the Trustee's tax liability in accordance with this order. In all other respects the order of the bankruptcy court is affirmed.
SO ORDERED