Key Issues and Considerations
Introduction
The U.S. Constitution empowers Congress to enact bankruptcy laws. Our modern federal bankruptcy system provides bankruptcy judges in each federal judicial district. These judges serve for terms of 14 years and are considered to be “units” of federal district courts. Decisions of the bankruptcy judges are generally appealable to a district court and then to a federal circuit court of appeals.
But receivership is different—it’s a creature of state law (coming from English courts sitting in equity) and so receivership rules can vary significantly from state to state. A receiver is a neutral party appointed by a court to manage, administer, and sometimes sell, the assets held in receivership. Under certain circumstances, a receiver ultimately can move to dissolve a corporation in receivership after its affairs have been resolved.
One commonly heard generalization is that bankruptcy is entered into voluntarily by the debtor and a receivership is the result of legal action by creditors to recover debt. That can be true, but not always. For example, the Uniform Commercial Real Estate Receivership Act makes receivership an attractive option in those states that have enacted it. A current notable example of the use of receivership instead of bankruptcy is the troubled cannabis industry. Cannabis enterprises are not allowed access to federal bankruptcy courts because their activities are federally illegal.
Personal Liability for Receivers
Startingly, receivers can be liable for unpaid tax obligations under a number of circumstances. On the federal level, the Federal Priority Statute (31 U.S.C. § 3713) is designed to make sure that the federal government gets paid first in the case of insolvent debtors who make a “voluntary assignment or property” or there is an “act of bankruptcy.” The law (in effect since 1797) establishes a priority claim but does not establish a lien. An “act of bankruptcy” includes the appointment of a receiver with control over all the assets of an entity.
Personal liability can arise to the extent that a receiver knew (or should have known) of federal claims and makes a payment to another creditor. The liability would be for the amount of that payment. The unpaid federal claim can also include future claims that are known (or knowable) by the receiver. Although there are various defenses that can be asserted by a receiver, the significant number of court cases imposing personal liability on a receiver underline the care with which a receiver should consider paying creditors over tax obligations.
An important 2002 Second Circuit decision, SEC v. Credit Bancorp., went so far as to hold that a receiver can be personally liable for unpaid federal obligations even if the payments made before satisfying them are pursuant to a court order. A receiver can also be held personally liable for unpaid federal payroll withholding taxes.
On the state and local level, a receiver can be personally liable for unpaid state and local taxes that are supposed to be collected at the point of sale and then held in trust to be turned over to the authorities periodically. The taxes that are typically held in trust are sales and excise taxes.
Tax Liens
A critical issue for receivers is whether a federal tax lien has attached to assets being disposed of by the receivership. Receivers want to make certain that the assets are free of tax liens and receiver asset sales are commonly advertised as coming without any tax obligations.
A federal tax lien arises when there has been a tax assessment and notice (specifying the amount demanded) sent to the taxpayer. The notice and demand must be sent within 60 days of the assessment. If the taxpayer does not pay, a lien arises with respect to all property owned by the taxpayer. Since these liens arises without public notice, they are sometimes referred to as “secret liens.” However, federal tax law provides that a secret lien is subordinate to holders of certain prior security interests. Moreover, federal tax liens require formal notice by the IRS in an appropriate location to be effective with respect to subsequent security interest holders.
Furthermore, the primacy of claims under the Federal Priority Statute (discussed above) is separate and distinct from federal tax liens. Tax Code Sections 6321-6323 (the Federal Tax Lien Act) provide an ordering system for non-tax claims relative to federal tax liens. Claims controlled by these provisions are generally not subject to the Federal Priority Statute and thus do not give rise to personal liability for the receiver.
Paying an unsecured creditor over satisfying a federal tax lien may result in personal liability. In contrast, under certain circumstances, creditor security interests that arose and were perfected before a tax lien arises can be used to convey the assets to the creditors even though the debtor entity has liens for federal taxes. In the case of significant unpaid federal tax liabilities (a common circumstance, for example, in the cannabis industry) the existence of a prior perfected security interest can result in the assets being conveyed out of the receivership and the receiver being left to unwind a hollowed-out entity owing taxes that will never be paid to federal, state, and local authorities.
The interaction between the Federal Priority Statute and federal tax liens is complex and highly dependent on the specific facts of each situation, so receivers need to take special care to understand the potential applicability of these laws.
Communications with Taxing Authorities
Typically, when appointed, a receiver must file a Form 56: Notice of Fiduciary Relationship with the Internal Revenue Service. It is also advisable that a receiver not only file a Form 56 with the IRS but also file Form 56 (or its equivalent) with every potential state and local taxing and governmental agency that governs the receivership estate. Putting taxing agencies on notice of the receivership is prudent and provides the receiver with protection if, at some time in the future, an agency claims it was not aware of such receivership appointment.
Additionally, a receiver should formally serve all critical pleadings such as his or her appointment order, monthly reports, asset disposition motions and disbursement motions on all the very same agencies provided with that Form 56 (or equivalent). This is because if assets are being harbored, sold, disbursed or abandoned, these agencies should be provided notice. However, while a state court may have jurisdiction over local and state government agencies in the state where the court sits, that court does not have jurisdiction over the IRS or any other Federal agency nor does it have jurisdiction over out-of-state taxing agencies. So, it makes sense to ensure that federal tax filings are current (even if unpaid) and that, if needed, ancillary state proceedings are initiated to gain jurisdiction over the out-of-state agencies. Notice to agencies is critical and, the agencies should be kept informed by serving pleadings that are substantive on these multiple agencies.
Filing Tax Returns
Sometimes receivers are instructed in their appointment orders that they do not need to file tax returns. In many cases, the receiver needs to do so anyway, especially when the receiver is in charge of all or substantially all of the debtor’s assets (given the ever-looming specter of personal liability).
In many cases the receivers find the books and records are not in good enough shape to support the filing of an accurate tax return. Receivers should still file a “noticed return” or a “zero return” so that the tax filing requirement is met. Under these circumstances, the receiver should submit an accompanying letter explaining the facts and requesting immediate review by the IRS. Sometimes a return review can be expedited by the IRS and the receiver can seek a “clearance” form from the reviewing agent absolving the receiver of further obligations.
Paying Tax Obligations
If the receiver is in possession of all or substantially all of a corporation’s assets, it is obligated under Section 6012 to file federal tax returns. The receiver is also obligated to pay those taxes to the extent funds are available. However, if funds are not available, the receiver should still file the returns and, if possible, notify the IRS of the circumstances. It may be advisable for a receiver to ask for a closing agreement with the IRS (under Section 7121) to clarify federal tax claims and relieve the receiver of potential personal liability.
The IRS Cannot Levy on Property Subject to a Receivership
A court-appointed receiver takes property placed in receivership subject to the liens, equities, and rights of existing creditors. While a debtor’s assets are in receivership, creditors may not take any action that would interfere with a receiver’s possession or control of assets, but creditors are permitted to take action that does not interfere with the receiver’s possession or control of the receivership property.
This general principle of receivership also applies to the IRS as a creditor. A 1953 Eighth Circuit case, Hart v. United States, held that once property is under the jurisdiction of a receivership in state court, the IRS may not intervene to seek the distribution of those assets. While the IRS is free to assert in federal court its claim to those assets over other parties, it may not levy on those assets.
The Tax Court, agreeing with Hart, held in a 2010 case, Appleton v. Comm’r, that the IRS may not levy on assets in receivership. As the Tax Court pointed out, there are also two federal regulations prohibiting tax levies during a bankruptcy or state court receivership proceeding.
Even though the rule is clear, there are cases in which the IRS has in fact levied on receivership assets, imposing liens and seizing bank accounts, and the only recourse is to pursue immediate judicial relief.
Sale of Assets and Discharge of Indebtedness Income
Taxable income arises when any amount of debt of the taxpayer is forgiven. Such income is commonly referred to as cancellation-of-debt income, or CODI. There is a CODI exclusion for taxpayers in federal bankruptcy court but not receivership proceedings. However, there is an insolvency exclusion under the tax code to discharge of indebtedness income, but that exclusion is limited to the amount by which the taxpayer is insolvent (raising obvious measurement and timing issues).
Conclusion
There are areas of ambiguity and controversy regarding federal bankruptcy questions, including tax questions, but they pale by comparison to the complex tax issues that can arise in connection with state receivership proceedings. The lack of uniformity from state to state in receivership rules is not necessarily a bad thing (unless the debtor has operations in different states), but it impedes the development of a broadly disseminated body of knowledge of how to deal with the tax implications of the various forms of receivership.
