Chapter 11 of the United States Bankruptcy Code is intended to allow financially stressed debtors to restructure their debt obligations through a plan of reorganization. Typically, a Chapter 11 plan places different types of claims in different classes and, subject to various requirements of the Bankruptcy Code, allows the debtor to pay only portions of the claims (and in certain circumstances not to pay certain claims at all). Moreover, the Bankruptcy Code allows a debtor the flexibility to structure a plan to defer the payment of certain claims.

In an interesting twist on a run-of-themill case regarding the personal liability of a corporate officer for unremitted sales taxes, the New York State Division of Tax Appeals held an owner (“Petitioner”) personally liable for sales tax even though the corporation was in Chapter 11 bankruptcy and was being run by a bankruptcy court-approved management company. In re Eugene Dinino, Docket Nos. 822605, 822606, 822607, 822608, 822609, 822610 (N.Y.S. Div. of Tax App. June 24, 2010).

SMITH v. SIPI, LLC (July 27, 2010)

IN RE: MEYERS (August 2, 2010)

Creation of the Bankruptcy Estate  

Preservation of favorable tax attributes, such as net operating losses that might otherwise be forfeited under applicable nonbankruptcy law, is an important component of a business debtor's chapter 11 strategy. However, if the principal purpose of a chapter 11 plan is to avoid paying taxes, rather than to effect a reorganization or the orderly liquidation of the debtor, the Bankruptcy Code contains a number of tools that can be wielded to thwart confirmation of the plan.

On April 30, 2009, the Ministry of Finance and the State Administration of Taxation (the "SAT") jointly issued the Notice on Certain Issues of Corporate Income Tax Treatment of Enterprise Reorganizations (the "Notice"), Cai Shui (2009) No. 59. The Notice provides corporate income tax treatment of various types of reorganizations including debt restructurings, acquisitions of equity, acquisitions of assets, mergers, and de-mergers.

As previously discussed here, Ambac Financial Group Inc. has filed for bankruptcy for Chapter 11 bankruptcy relief with United States Bankruptcy Court for the Southern District of New York. Immediately following its bankruptcy filing, Ambac sued the United States to block the Internal Revenue Service from placing a lien on its assets in an attempt to recover an estimated $700 million in tax refunds that the agency believes it may be owed.

The current "Great Recession," which began in late 2007 with a maelstrom in the debt capital markets, has necessitated a rethinking of the federal income tax rules governing debt restructurings. The harsh rules2 promulgated by the Internal Revenue Service (IRS) in reaction to the 1991 taxpayer-favorable decision in Cottage Savings v. Commissioner,3 have been inhibiting restructurings. Instead, rules that did not trigger adverse tax results have been needed to induce lenders and borrowers to restructure obligations that can no longer be paid according to their terms.

The taxpayer was able to convince the court that the creditors who got the stock in the reorganization were not the prior owners. Because the events occurred in 1992, under a prior version of the continuity of proprietary interest rules, continuity of ownership was broken and a section 338(h)(10) election could be made and the basis in the assets inside the corporation stepped up to fair market value, with no tax liability because the seller was in bankruptcy with large net operating losses (NOLs).