Chapter 12 of the Bankruptcy Act has attracted increased attention among advisers to the farming community and their creditors. Chapter 12 filings have risen 31% in the first quarter of 2020, as compared to the first quarter of 2019. Increased utilization of Chapter 12 is partly due, in addition to economic conditions, to the August 2019 enactment of the Family Farmer Relief Act, which raised the Chapter 12 eligible debt limit for farmers to $10 million from $4.4 million.
The Chapter 12 bankruptcy provisions offer qualifying family farmers many non-tax, as well as tax advantages, when they seek to restructure their farm debt. In the Chapter 12 bankruptcy described in the 2020 case of In re DeVries, however, it was the income tax advantages that took center stage. Based upon the Chapter 12 plan confirmed by the Bankruptcy Court in DeVries and reviewed by the author for this article, if Mr. and Mrs. Devries, the debtors, successfully complete the plan, more than 98% of their otherwise applicable federal and state income taxes relating to approximately $990,000 of gain will be permanently eliminated. Further, this elimination of income tax will not trigger discharge of indebtedness income to the DeVrieses; and it is doubtful whether the DeVrieses could even be required to reduce any tax attributes under Internal Revenue Code Section 108(b) on account of the discharge.
Chapter 12
Chapter 12 offers many attractive non-tax features to qualifying farmers seeking restructuring of their farm debt. In a Chapter 12 proceeding, the farmer proposes a plan to repay the secured debt, to the extent of the value of the collateral, and to utilize the farmer’s disposable income for the period of the plan, generally three to five years from the date the plan is confirmed, towards paying unsecured creditors (including any secured debt in excess of value of the collateral). Although the secured debt cannot be reduced below the value of the collateral, the plan can reduce the interest rate on secured debt somewhat, though usually not to less than around one to three points over prime. Further, payment of principal on the secured debt can be postponed, even beyond the term of the plan. In general, secured creditors need not approve the plan, and a qualifying plan can be confirmed over the objection of creditors.
The debtor can retain assets, without the approval of the unsecured creditors, even when the unsecured creditors are projected to not be paid in full, so long as the debtor’s disposable income during the plan period goes to payments under the Chapter 12 plan, and the total payments are not less than what the unsecured creditors would receive upon a liquidation. Disposable income reflects a reduction for not only expenditures necessary to the operation of the business, but also for expenditures necessary for the support of an individual debtor and the debtor’s family.
Further, in determining what is available on a liquidation to unsecured creditors, the individual debtor can exempt certain assets, such as a homestead and retirement accounts in certain states. By claiming as many assets as exempt as possible, the Chapter 12 plan can enable the debtor to retain those assets, and yet be relieved from large unsecured debt, including, as described below, those income taxes that are treated as unsecured debt.
Deprioritizing Income Taxes
The key income tax advantage of a Chapter 12 bankruptcy is provided in 11 U.S.C. Section 1232(a). That section provides generally that unsecured federal and state income taxes imposed on the pre-petition, and on the post-petition, pre-discharge, gains of the Chapter 12 debtor, which arise from the sale, transfer, exchange or other disposition of any property used in the debtor’s farming operation, are to be treated as pre-petition unsecured claims. Such taxes are thus potentially subject to discharge without being fully paid.
The Small Business Reorganization Act of 2019 extends some of the non-tax benefits of Chapter 12 bankruptcies to Chapter 11 bankruptcies of small businesses debtors. Section 1113(a) of the 2020 CARES Act temporarily expanded the scope of the Small Business Reorganization Act eligibility to debtors with debts of up to $7.5 million. However, neither the Small Business Reorganization Act of 2019 nor the 2020 CARES Act grants non-farmers in Chapter 11 bankruptcy the deprioritization of income taxes provided to farmers in Chapter 12 bankruptcy by 11 U.S.C. Section 1232(a).
In In re Pedersen, the bankruptcy court noted that the Chapter 12 deprioritizing of income taxes has been held to apply to such items as the sale of farm real estate, the sale of equipment, the sale of slaughter hogs, the sale of the debtor’s herd of cattle, the sale of a debtor’s interest in a farm partnership, and the collection of a payout of insurance related to a decline in the market price of the farmer’s crop. Thus, although, as noted in DeVries, 11 U.S.C. Section 1232(a) was referred to by its sponsors as stripping from priority “capital gains taxes,” as Pedersen indicates, 11 U.S.C. Section 1232(a) has been applied most often to strip from priority income taxes on non-capital assets, such as farmland used in the trade or business of farming (although such non-capital-gain is often taxed at capital gains rates under IRC Section 1231), and ordinary farm machinery depreciation recapture income. Moreover, as Pederson notes, some, though not all, cases, have deprioritized the tax on gain on ordinary income assets, such as property held for sale in the ordinary course of business. Pederson itself deprioritized income taxes on ordinary income arguably not even arising from a sale or exchange, namely the collection of crop price insurance.
The DeVries Chapter 12 Plan
In DeVries, the Chapter 12 debtors were husband and wife. In furtherance of their negotiations with Farm Credit, which was the DeVrieses’ major secured creditor in 2017, the DeVrieses effected a 2017 sale of 95 acres of farmland and machinery. These sales added about $990,000 in 2017 gains to the DeVrieses’ 2017 taxable income.
The large 2017 gain in DeVries is consistent with the steady overall increase in U.S. farmland prices over the past 35 years described in the Congressional Research Service (CRS) Report R46249 “U.S. Farm Income Outlook: February 2020 Forecast,” Figure 18 (2020). The DeVrieses’ large 2017 gain is also consistent with the generous immediate expensing and depreciation rules applicable to farm machinery, which typically exceed economic depreciation. This price appreciation in farmland, faster-than-economic tax depreciation on farm machinery, and generous current deductibility of farm expenses under Treasury Regulation Sections 1.162-12(a), 1.180-1(a), and 1.263A-4(a)(2), can contribute to the existence of large taxable gains described in 11 U.S.C. Section 1232(a) when a farming operation is downsized in connection with a Chapter 12 plan.
After the 2017 farmland sale, and payment of a portion of, and refinancing the remaining portion of, the Farm Credit debt, the DeVrieses’ principal assets were the unencumbered farm on which they lived, and their unencumbered retirement plans and life insurance. In the Chapter 12 plan the DeVrieses filed in 2019 in connection with their 2019 bankruptcy petition, these assets were listed as exempt assets under Iowa law. The DeVrieses also retained some cows and some farm machinery which they planned to use for farming on land they would lease. They also retained an interest in a farming-related LLC with unknown value. The cows, farm machinery, and LLC’s assets and LLC interest were pledged to Iowa State Bank.
The fact that the DeVrieses still farmed post-petition avoided the need for the DeVrieses to rely exclusively on the decision in In re Williams in order to claim the benefits of 11 U.S.C. Section 1232(a). In re Williams, which allowed 11 U.S.C. Section 1232(a) to be available to individuals who ceased active farming two years before they filed their Chapter 12 petition, has been criticized by commentators, including the attorney who authored the DeVrieses’ Chapter 12 plan, as unduly favorable to former farmers.
The DeVrieses’ Chapter 12 plan showed that their projected W-2 income over each of the three years of the Chapter 12 plan, plus some custom hauling and similar income, would generate income approximately equal to the DeVrieses’ projected living expenses of $56,000. The presence of significant off-farm income is not atypical; pages 20-21 of the 2020 CRS report show that off-farm income is often a very substantial portion of farm household income. The DeVrieses also projected that the remaining, generally farm-related, activities would generate disposable income of approximately $100,000, which would be sufficient to service the secured Iowa State Bank debt. However, the Chapter 12 plan does contemplate that, with respect to the Bank of Iowa debt, the interest rate on a small portion of that debt will be reduced and its maturity extended. For example, one note due to Bank of Iowa in the amount of $15,000 will have its interest rate reduced from 11% to 6%, and its maturity extended for slightly more than five years.
The Chapter 12 plan showed that after the proposed payments to Iowa State Bank on the secured debt, certain other priority claims, and household expenses, there was very little disposable income projected over the three-year plan period. With respect to the deprioritized 2017 federal income taxes due to the Internal Revenue Service of $138,000 and deprioritized 2017 state income taxes due to the Iowa Department of Revenue (IDOR) of $83,000 on their 2017 gain, the DeVrieses’ analysis apparently proposed to pay IRS and IDOR about $4,000 over the three-year plan period.
To determine the amount of deprioritized 2017 claims, the DeVrieses’ Chapter 12 plan used the marginal method approved by the Eighth Circuit in In re Knudsen, 581 F.3d 696 (8th Cir.
2009). Under that method, the deprioritized tax is determined by preparing a return including the farm gain described in 11 U.S.C. Section 1232(a), a pro forma return excluding the gain described in 11 U.S.C. Section 1232(a), and then treating the excess tax as deprioritized. In DeVries, the 2017 tax with the 2017 farm gain described in 11 U.S.C. Section 1232(a) included was $221,000 due to the IRS and IDOR.
The DeVrieses’ Chapter 12 plan determined that the 2017 tax with the farm gain described in 11 U.S.C. Section 1232(a) excluded was zero due to the IRS, and zero due to the IDOR. That is, after excluding the farm gains described in 11 U.S.C. Section 1232(a), the DeVrieses determined they had enough 2017 current and carried over losses if any, itemized deductions and personal exemptions to offset Mrs. DeVries’ W-2 salary and the DeVrieses’ other off-farm income, so as to eliminate the DeVrieses’ 2017 taxable income.
Thus, in DeVries, the entire $221,000 2017 tax was deprioritized. Under the DeVrieses’ Chapter 12 plan, if the plan payments are made as scheduled, then, after three years, the DeVrieses, having paid $4,000 total to the IRS and IDOR on account of the $221,000 deprioritized taxes, will receive a discharge, thereby permanently eliminating the DeVrieses’ remaining $217,000 2017 IRS and IDOR tax liability. The DeVrieses’ $4,000 of 2017 tax payments pursuant to 11 U.S.C. Section 1232(a) would represent an effective federal and state tax rate of less than 0.5% on the 2017 $990,000 gain described in that Section.
The tax relief provided in 11 U.S.C. Section 1232(a) is conditioned upon a discharge being received by the debtors. Thus, if the DeVrieses unexpectedly do not receive a discharge through compliance with their Chapter 12 plan, and then do not receive a hardship discharge despite noncompliance, the IRS and IDOR can exercise their rights to collect the full 2017 tax, including Mrs. DeVries’ refunded 2017 wage withholding.
The DeVrieses’ Chapter 12 plan is consistent with the observation made by planning textbooks that debtors can use 11 U.S.C. Section 1232(a) in such a way as to in effect leave the debtor, after completion of the plan and discharge of its pre-petition taxes and unsecured liabilities, with unencumbered assets which are generally exempt from state law unsecured non-tax creditors. This can give discharged Chapter 12 debtors who do not subsequently mortgage their homestead, incur tax liabilities, or otherwise risk their exempt assets, peace of mind going forward. The DeVrieses’ plan shows that the DeVrieses will remain with unencumbered exempt assets of approximately $490,000, consisting mainly of their homestead and retirement plans.
By contrast, if the DeVrieses had not utilized bankruptcy to resolve their 2017 tax liability, these state-law-exempt assets could possibly have been available for levy by the IRS under IRC Section 6334. Similarly, if the DeVrieses had first considered, at the February 2019 date of their Chapter 12 petition, either Chapter 7, Chapter 11, or Chapter 13 bankruptcy, the DeVrieses’ 2017 income taxes would under such alternative not have been subject to discharge. Under 11 U.S.C. Sections 523(a)(1)(A) and 507(a)(8)(A)(i), in a Chapter 7, 11, or 13 bankruptcy (unlike a Chapter 12 bankruptcy like that in Devries, which involved only taxes governed by 11 U.S.C. Section 1232(a)), individual income taxes due for three years preceding the filing of the bankruptcy petition are generally not dischargeable.
IRS and IDOR Objections in DeVries
The IRS and IDOR objections to confirmation of the DeVrieses’ plan did not relate to the concept of the deprioritization of the vast majority of the $221,000 2017 tax liabilities. This aspect of DeVries may be viewed as consistent with the proposition that 11 U.S.C. Section 103(g), which generally makes inapplicable to Chapter 12 the prerequisites of plan confirmation contained in Chapter 11, specifically makes inapplicable to Chapter 12 the prohibition in 11 U.S.C. Section 1129(d) of confirmation of a Chapter 11 plan which has the principal purpose of tax avoidance. Alternatively, the IRS and DOR may have conceded that the deprioritization specifically allowed by 11 U.S.C. Section 1232(a) is not a prohibited principal motivation, or at least was not so in DeVries.
Rather, the IRS and IDOR in DeVries objected only to the deprioritization of the $7,000 2017 wage withholdings from Mrs. DeVries’ off-farm wages as a college administrator. The IRS held about $5,000 of her wage withholding, and the IDOR held about $2,000 of her wage withholding.
The DeVrieses contended that since their pro forma federal and state income tax, excluding the gain whose tax was deprioritized, was zero, the IRS and IDOR should be required, under 11 U.S.C. Section 1232(a), to pay over the withholding to them for use in making payments under the Chapter 12 plan. The IRS and IDOR argued that, under the general right of offset to the extent of pre-petition debts in 11 U.S.C. Section 553(a), here the $221,000 2017 tax liabilities, the IRS and IDOR should be entitled to completely offset their otherwise post-petition obligation to refund to the DeVrieses the $7,000 2017 over-withholding.
The court, however, viewed 11 U.S.C. Section 1232(a) as reflecting a Congressional intent to prevent tax liabilities from interfering with a Chapter 12 plan. The court viewed this specific Chapter 12 benefit as superseding the more general bankruptcy code offset rules. The court therefore rejected the IRS’s and IDOR’s objections. By contrast, a few weeks later, in Copley v. United States, the Fourth Circuit, without citing DeVries, did allow the IRS a right of offset in a Chapter 7 bankruptcy.
COD Income?
Although the DeVrieses’ Chapter 12 plan will result in considerably less cash outflows to the DeVrieses, the confirmation of the plan should not create cancellation of debt (COD) income to the DeVrieses. For example, upon the 2020 confirmation of the plan, under Treasury Regulations Sections 1.1001-3(c)(6)(iii), (e)(2)(ii)(A), and (e)(3)(i), the reduction in interest rate of more than 25 basis points, and more than 5%, of one of Bank of Iowa’s notes for $15,000, and the postponement of maturity of more than 50% of the original term on that note, could create a constructive reissuance of that note. Nevertheless, under Treasury Regulations Section 1.61-12(c)(2)(ii), constructive reissuance of non-publicly traded debt, with no reduction in principal, generally does not trigger cancellation of indebtedness income, so long as the constructively reissued debt bears at least the AFR, as in DeVries.
With respect to the numerically much larger issue of the prospective discharge of the IRS and IDOR tax liabilities upon successful completion of their three-year payment plan, it is likewise doubtful whether this will create COD income to the DeVrieses, even before considering the favorable application of IRC Section 108(a)(1). Academics have contended that since federal and state income tax liabilities are not incurred in connection with receipt of cash loans, goods, or services, such income tax liabilities should not be considered “indebtedness” for federal tax purposes, including for purposes of IRC Section 108(d)(1). If not considered as indebtedness, they argue there should be no COD income from their extinguishment.
Further, the discharge of IDOR tax liabilities could benefit from IRC Section 108(e)(2). That section provides COD income does not arise from a discharged liability if payment of such liability would create a deduction. Since payment of state income taxes can trigger a deduction, subject to the possible application of disallowances for state income tax deductions in the year of the discharge, IRC Section 108(e)(2) could prevent the creation of COD income.
In any event, includable COD income in the year of the discharge would be precluded by IRC Section 108(a)(1). IRC Section 108(a)(1) provides that if an item would otherwise be treated as COD income, it is excludable if the discharge occurs in a Title 11 case. In PLR 8928012, the IRS held that since the farm bankruptcy provisions are contained in Chapter 12 of Title 11, any COD income recognized under a discharge in a Chapter 12 case was excludable under IRC Section 108(a)(1).
IRC Section 108(b) Attribute Reduction?
Possible application of IRC Section 108(b) attribute reduction to taxes discharged through 11 U.S.C. Section 1232(a) is unclear. The DeVrieses’ Chapter 12 plan itself includes a provision for annual post-petition income taxes and does not address IRC Section 108(b) attribute reduction. In Non-docketed Service Advice Review (NSAR) 08741, the IRS concluded that where cancellation of a debt (e.g. deductible state income taxes) does not create COD income by reason of IRC Section 108(e)(2), there is no reduction of tax attributes under IRC Section 108(b). Although more oblique on this issue, PLR200804016 seems to reach a similar debtor-favorable conclusion.
With respect to attribute reduction under IRC Section 108(b) for federal (and non-deductible state) income tax liabilities extinguished through 11 U.S.C. Section 1232(a), arguments point in different ways. As mentioned above, many academics argue that discharge of indebtedness income described in IRC Section 108(a)(1) is not created by a reduction in federal income taxes. Some then posit that, where COD income is not created under IRC Section 108(a)(1), there is no attribute reduction under IRC Section 108(b). NSAR 08741 and PLR 200804016 are consistent with that latter point.
Moreover, the broad pro-farmer interpretation of 11 U.S.C. Section 1232(a) in DeVries might support an argument that the discharged federal tax liabilities should not reduce tax attributes at all. On the other hand, even some academics who argue that discharged federal income tax liabilities (e.g. income tax liabilities forgiven pursuant to an offer in compromise) should not create COD income, have argued that the IRS, as a policy matter, should be entitled to reduce NOL carryforwards not only by the amount of the forgiven liabilities, as IRC Section 108(b)(2)(A) would ordinarily dictate, but rather, in the case of individuals, by those forgiven federal income tax liabilities divided by a federal individual income tax rate—i.e., by about three times as much—to avoid the taxpayer reaping a windfall.
In some cases, involving offers in compromise, such as Yale Avenue Corp. v. Commissioner, the IRS has argued for a position that would reduce NOL carryforwards after a discharge of federal income tax liabilities, but only for the amount of the forgiven federal tax liabilities. Even such a dollar-for-dollar reduction in tax attributes for the federal tax liabilities extinguished through 11 U.S.C. Section 1232(a) at the successful conclusion of the payment plan would still leave the debtors with a large net benefit. Complicating the NOL analysis are other uncertainties concerning the application of NOL carryforwards and carrybacks to situations involving 11 U.S.C. Section 1232(a).
Conclusion
As DeVries shows, in some cases 11 U.S.C. Section 1232(a) offers a way for a farmer to reduce, sometimes to a nominal amount, income tax liabilities associated with downsizing a farming operation. The significant long-term appreciation in farmland values documented in the 2020 CRS Report, and immediate expensing in farm machinery, cause the percentage of selling price recognized as taxable gain by farmers selling their farms and farm machinery, as part of a Chapter 12 proceeding or otherwise, to be relatively high. This, coupled with the increase in Chapter 12 farm debt limits to $10 million, suggests that use of 11 U.S.C. Section 1232(a) will become an increasingly important aspect of Chapter 12 reorganizations.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Author Information
Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, Fla.