(TMA International Headquarters)
Given the current state of the economy and the credit markets, it is no secret that the distressed sector is where the hot acquisition opportunities lie. Tax issues change significantly in a bankruptcy acquisition compared to a “sunny day” transaction. Although many buyers will address the federal tax implications of an acquisition, state and local tax issues that arise in a bankruptcy purchase may be overlooked. This article highlights some important issues that acquirers should consider.
There are two main types of tax issues related to acquisitions: taxes incident to the acquisition, such as real estate transfer taxes and sales taxes; and historical tax liabilities and tax attributes related to the acquired asset or entity, including net operating loss carry-forwards and tax credit recapture for early disposition of assets. In addition, an acquirer may inherit off-balance sheet liabilities, such as the debtor’s unemployment tax rating.
Acquisitions from a bankruptcy estate can be subject to a number of taxes, such as real estate transfer taxes and sales taxes, that could apply to transfers of assets. The U.S. Bankruptcy Code contains an exception for some transfer taxes, though it does not apply in all circumstances.1 Further, acquisitions could trigger change-of-control provisions in property tax statutes, which may lead to a revaluation of real estate and an increase in property tax rates.
With such concerns in mind, buyers looking to make acquisitions out of a bankruptcy should analyze the following state and local tax impacts prior to completing such a purchase:
Tax Claims. Bankruptcy claims fall into four general categories: administrative, priority, secured, and unsecured. This article focuses mainly on secured and unsecured priority claims. The Bankruptcy Code requires that secured claims be paid in an amount equal to the value of the creditor’s collateral or the full amount of the claim, whichever is less.2 If the value of the property collateral is less than the value of the claim, the difference becomes an unsecured claim.3
Secured claims include any held by a taxing authority for which a lien attaches to the debtor’s property. Tax liens can present significant problems for buyers in bankruptcy and should be reviewed in detail before an acquisition.4 Most other taxes would be classified as unsecured priority claims.
In business bankruptcies, unsecured claims for unpaid taxes have priority over most other unsecured claims, with limited exceptions. Claims for administrative expenses incurred
in administering the estate and wage and employee benefit claims would have priority over unsecured tax claims.5 Unsecured claims for unpaid taxes generally include any outstanding tax liabilities incurred within three years before the date of the bankruptcy filing, with some exceptions.6
Real Estate Transfer Taxes. State real estate transfer taxes may apply to acquisitions of real estate from a bankruptcy estate. Real estate transfer taxes are generally applicable when an interest in real property is transferred. In most states, the asset must be transferred between legal entities to trigger the liability; transfer of an ownership interest between affiliated entities does not necessarily trigger the tax.7 In some states, however, the mere transfer of an interest in an entity that owns real property is enough to trigger the tax.8
The Bankruptcy Code provides an exception to some transfer taxes.9 Specifically, if a sale occurs “under a plan confirmed” in Chapter 11, the transfer is not subject to stamp taxes or similar taxes. 10 Buyers seeking to acquire property from a bankruptcy should be aware, however, that not all transfers occur under a confirmed plan. Recently, the U.S. Supreme Court held that transfers of assets that occur before a plan is confirmed do not fall within this exception.11 Thus, states may try to pursue transfer tax assessments for transfers that occur before a plan is confirmed.
Successor-in-Interest Issues. Successor-in-interest liability may apply to the transfer of assets regardless of whether an entity is in bankruptcy. The same legal tests that apply outside of bankruptcy for determining whether a successor in interest is liable may also apply in bankruptcy.12
Taxpayers acquiring assets from a bankruptcy estate should structure those deals in the same way as other asset purchases and acquisitions to reduce successor liability. In addition, a buyer should attempt to obtain a specific finding of no successor-in-interest liability in the sale order.
Successor-in-interest liability may be further complicated by taxes for which no return had been filed and/or that have not been assessed by the state until after a bankruptcy has been completed. Because bankruptcy proceedings only apply to claims that arise prior to or during the proceeding, state taxes that have not been assessed may not be subject to administration or discharge by a Bankruptcy Court.
For example, a debtor may not have collected sales tax in a state because it did not believe that it had sales tax nexus there. The state taxing authority may not become aware that the debtor had not paid these taxes until after the discharge. If the taxing authority subsequently determined that the debtor had nexus, it may decide to assess and may try to assess the buyer of the debtor’s assets outside of the bankruptcy, or after the bankruptcy, under successor-in-interest principles. The buyer may not be able to argue that the bankruptcy order approving the sale supersedes the state law because this particular claim would not have been subject to the order.
On the other hand, a buyer could argue that the state’s assessment violates due process, as the buyer would not have had notice of the potential assessment when purchasing the assets or entities. The state taxing agency, however, may also argue that it did not have notice of the bankruptcy and thus could not have made its claim during the bankruptcy process.
There appears to be little guidance on whether a state taxing agency may pursue a successor in interest under this theory. There is guidance for an analogous situation, when plaintiffs pursue successors in interest for tort claims that were not assessed at the time of the bankruptcy.13 In cases in which there may be unknown claimants or unknown claims during a bankruptcy process, courts have held that a sale free and clear of liens would protect buyers from liability if the claimants were afforded a meaningful opportunity to participate in the bankruptcy process.14 In a case in which notice to potential class action plaintiffs was held to be insufficient, those plaintiffs were allowed to pursue claims against the buyer.15
State taxing authorities could argue that they did not have notice of the bankruptcy if a debtor made no effort to inform them of the process. Because little guidance exists on the efficacy of this argument, resolution likely would depend on what kind of notice a debtor gave to potential claimants and whether that notice was sufficient for due process purposes.
Revaluation of Property Taxes. Buyers also should be aware that newly acquired property may be reassessed for property tax purposes. For instance, in California a “change in ownership” of locally assessed real property results in the reassessment of property at its full cash value.16 The California statute provides that change in ownership generally includes the transfer of real property between legal entities. Change in ownership sometimes may also include transfers of an ownership interest in an entity.17
Federal Conformity – Discharge of Indebtedness. Under federal tax law, income is normally recognized when indebtedness is discharged.18 The discharge of indebtedness resulting from a bankruptcy discharge, however, does not result in federal taxable income.19 Unfortunately, for buyers of assets out of a bankruptcy, not every state conforms to this provision of the federal code.20 Therefore, the discharge of indebtedness from a bankruptcy may result in state taxable income in a few states.
Federal Conformity – Net Operating Losses. The federal tax code has several provisions that determine to what extent an acquiring company can use net operating losses (NOLs) from a target corporation after a merger. Internal Revenue Code (IRC) Section 381 allows a buyer to succeed to the losses held by a target company.21 Many states conform to this federal provision; however, not every state does,22 and buyers may not be able to use NOLs from a debtor to offset their state tax liabilities.
An additional provision, IRC Section 382, limits the amount of NOLs that can be carried over to other entities after there has been a change in control of an entity,23 including an entity acquired from a bankruptcy. As with IRC Section 381, many states conform to the treatment given by IRC Section 382; however, not every state does.24 Further, some states, including Illinois, conform to IRC Section 381, but not to IRC Section 382.25 Buyers should be aware of the limitations on the use of NOL carryovers for purposes of offsetting state taxable income.
Off-Balance-Sheet Liabilities. An area that may be overlooked is the impact of various state unemployment benefit laws with respect to unemployment premiums. For example, Tennessee Code Annotated (TCA) Section 50-7-403(b)(2)(B)(iii) provides that:
Commencing with the next premium rate year after an employer has transferred a distinct, severable, identifiable and segregable portion of the employer’s business, the reserve ratio and premium rate of the predecessor employer shall be based on the portion of the taxable payroll, benefit and premium experience remaining to the credit of the predecessor employer after the transfer.
As a result, the buyer of a portion of the business may inherit a premium rate that is higher than the rate it would have as a new employer. 26 In every state, including Tennessee, there are exceptions to these provisions. Thus, these provisions should be reviewed on a state-by-state basis to see what impact, if any, they will have. There is also case authority that a properly drafted order, coupled with proper notice, may negate the carryover of such items to the successor. 27
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1 See Florida Dept. of Revenue vs. Piccadilly Cafeterias, 128 S.Ct. 2326 (2008) (tax exemption does not apply to Section 363 sales that occur before plan confirmation).
2 11 U.S.C. Section 506.
3 11 U.S.C. Section 506.
4 Tax lien issues include: whether the lien is perfected and enforceable according to state law, the timing of that perfection, priority of the lien, and the effect of an undersecured lien when the liability exceeds the value of the collateral.
5 11 U.S.C. Section 507.
6 11 U.S.C. Section 507(a)(8).
7 E.g., Ga. Code Ann. Section 48-6-2(a)(11)(B).
8 E.g., N.Y. Tax Law Section 1401(e).
9 11 U.S.C. Section 1146.
10 Id.
11 Florida Dept. of Revenue vs. Piccadilly Cafeterias, 128 S.Ct. 2326 (2008).
12 Michael Solow & Harold Israel, Buying Assets in Bankruptcy: A Guide to Purchasers. 10 J. Bankr. L. & Prac. 87 (November/December 2000).
13 See George W. Kuney, “When a Defendant Goes Under,” Trial, July 2009, at note 6 (collecting authorities where post-confirmation tort claims were not considered discharged).
14 In re Fairchild Aircraft Corporation, 184 B.R. 910 (W.D.Tex. 1995).
15 In re Savage Industries, Inc. 43 F.3d 714 (1st Cir. 1994).
16 Cal. Rev. & Tax. Code Subsection 50, 110.1; Cal. Const. art. XIIIA Section 2.
17 When any corporation, partnership, or other legal entity acquires (1) control through direct or indirect ownership or control of more than 50 percent of the voting stock of any corporation that is not a member of the same affiliated group, (2) majority interest in capital and profits in a partnership or limited liability company, or (3) a majority interest in any other legal entity, including any purchase or transfer of 50 percent or less of the ownership interest whereby control or majority ownership interest is obtained, the transfer constitutes a change in ownership of all real property owned by the entity in which the controlling interest is obtained. Cal. Rev. & Tax. Code Section 64(c).
18 I.R.C. Section 61(a).
19 I.R.C. Section 108.
20 See BNA 2009 Survey of State Tax Departments, Bankruptcy, page 86-87.
21 IRC Section 381.
22 See BNA 2009 Survey of State Tax Departments, Net Operating Losses, page 106-07.
23 IRC Section 382.
24 See BNA 2009 Survey of State Tax Departments, Net Operating Losses, page 106-07.
25 See BNA 2009 Survey of State Tax Departments, Net Operating Losses, page 106-07.
26 See In re Wolverine Radio Co., 930 F.2d 1132 (6th Cir. 1991) (the court held that the Michigan Employment Security Commission could assign a debtor’s employee experience rating to a buyer, even though the sale was made free and clear of all liens, claims, and interests).
27 See In re Trans World Airlines, Inc., 322 F.3d 283 (3rd Cir. 2003); In re Eveleth Mines, LLC, 312 B.R. 634 (Bankr.D.Minn. 2004).