Bankruptcy Court Expands Concept of Collected Tax for Purpose of Determining Priority Claim

At the time Mr. Peatross discovered his brother’s theft, the estates’ assets were woefully inadequate to pay the taxes. The estates had a combined $70,000 in cash and the tax liabilities exceeded more than $1,250,000. While the estates did not have money, Mr. McCormick’s bankruptcy estate did, albeit subject to the claims of various creditors. The bankruptcy estate had more than enough to pay all the taxes, provided the taxing agencies did not have to share in the distributions from the bankruptcy estate with the bankruptcy estate’s other unsecured creditors. Moreover, it made sense that Mr. McCormick’s bankruptcy estate should pay the taxes as it was Mr. McCormick who stole the money that the estates had earmarked to pay the estate taxes in the first place. The problem was figuring out how to get the tax claims paid by Mr. McCormick’s bankruptcy ahead of the other creditors.

While typically general unsecured creditors are paid in bankruptcy pro rata based on the ratio that each general unsecured creditor’s claim bears to the total of all general unsecured creditor claims, certain “priority” unsecured claims are paid in full prior to any payment to the general unsecured creditors. These “priority claims” enjoy their preferred status based on public policy considerations which dictate that some unsecured claims are more deserving of payment than others and are therefore paid in advance. Unfortunately for the estates, there is not priority under the bankruptcy code for claiming monies stolen by an executor from an estate. There are, however, several types of tax claims that are entitled to priority payment under the bankruptcy code.

At first blush, it appears that the estate tax liabilities would fall under the ambit of Section 507(a)(8)(E) as that section is the only section expressly conferring priority status to excise taxes (like estate taxes). Unfortunately that section only applies to excise taxes if the estates’ tax returns were due within the three years before the filing of Mr. McCormick’s bankruptcy. Because the estate tax returns were due more than three years before Mr. McCormick’s bankruptcy proceeding, Section 507(a)(8)(E) did not apply.

Instead, lawyers for the parents’ estates considered Section 507(a)(8)(C) as an alternate option. Section 507(a)(8)(C) affords priority status to any “tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” Here, the estate taxes were required to be collected from the assets of the estates and paid over by the executor to the taxing agencies. Moreover, the executor was a fiduciary under local law and owed to the taxing authority both a statutory and a fiduciary duty to collect the taxes from the estates’ assets and pay them over to the taxing agencies. Failure to do so rendered the executor personally liable to the taxing authorities for the unpaid taxes. Prior to this case no federal court had ever applied Section 507(a)(8)(C) to estate taxes. Instead, virtually all of the Section 507(a)(8)(C) cases involve employment “trust fund” taxes and state and local sales taxes. Nevertheless, counsel for the estates was able to persuade the taxing agencies to assert that the unpaid estate taxes were entitled to priority treatment under Section 507(a)(8)(C) and fortunately for the estates (and the taxing authorities) the bankruptcy court agreed.

The Bankruptcy Court discussed at length the interplay between Section 507(a)(8)(C) and Section 507(a)(8)(E). Specifically, the Court noted applying Section 507(a)(8)(C) to “stale” excise taxes (i.e., excise taxes with respect to which a return was due more than 3 years prior to the filing of the debtor’s bankruptcy action) arguably conflicted with 507(a)(8)(E) which specifically provides that only those excise taxes with respect to which a return was due within 3 years prior of the debtor’s bankruptcy filing are afforded priority status. The Court, however, noted that many other courts had resolved this conflict in the context of sales taxes, which are also a form of excise taxes, by limiting the application of Section 507(a)(8)(C) to only those excise taxes which the debtor is required to “collect or withhold” from a third party. Slip opinion at p. 11. By doing so, the Court effectively harmonized the two sections which otherwise arguably conflict.

Having resolved the tension between Section 507(a)(8)(C) and Section 507(a)(8)(E), the Court next examined whether the estate taxes fell within the language of Section 507(a)(8)(C). The Court concluded that estate taxes did meet the requirements of Section 507(a)(8)(C). Specifically, the Court held that the estate tax was imposed on the estate and that the personal representative was charged with the responsibility of collecting the tax from the estate and holding the funds so collected “in trust” for the taxing authorities. If the personal representative fails to fulfil his or her statutory duty to collect the taxes from the estate and pay it over to the taxing authority, the personal representative can be held personally liable for the tax. In that sense, the Court noted, the estate taxes “are similar to sales and employer [sic] taxes” which are also afforded priority status under Section 507(a)(8)(C). Slip op. at p. 13.

The Court also reviewed the public policy behind Section 507(a)(8)(C) and Section 507(a)(8)(E) and noted that its decision was consistent with public policy. Specifically the Court noted that Congress provided a “stale date” for excise taxes but not trust fund taxes because the bankruptcy code “is not designed to unjustly enrich a company that converted consumers’ tax dollars to its own use, but is designed to allow forgiveness of debts that a company accrued for itself.” Slip Op. at p. 4, quoting Ill. Dep’t of Revenue v. Hayslett/Judy Oil. Inc., 426 F.3d 899, 904 (7th Cir. 2005). (Generally speaking priority taxes are not dischargeable in bankruptcy.  By holding that the estate taxes are not entitled to priority, the Court would also effectively rule that the tax claims are dischargeable, thus effectively  benefiting the debtor.)  In this case, excluding excise taxes that fall within the ambit of Section 507(a)(8)(C) and Section 507(a)(8)(E) would thwart that policy by allowing the debtor to unjustly enrich himself by retaining the benefit of the tax dollars that he held in trust for the taxing authorities for his own purposes.

While the conclusion in In re John G. McCormick, et. al. may seem self-evident, it is nevertheless a case of first impression insofar as it represents the first time a court has applied Section 507(a)(8)(C) to estate taxes. The better lesson, however, may be to always think “outside the box” when assisting clients with their tax matters. In this case the approach taken by counsel for Mr. Peatross was unorthodox. Applying bankruptcy law to this unusual fact pattern, the estates were able to pay taxes that they otherwise lacked the asset to pay. By doing so, Mr. Peatross both honored his fiduciary duty to the taxing agencies and ensured that the taxes were paid by the party who took the money earmarked to pay the taxes in the first place.