Nature of Bankruptcy & Insolvency Proceedings
(a) Introduction
The income tax effect of certain transactions during the administration period and of tax assessments related to pre-bankruptcy periods can impose undue hardship on the bankrupt, who is already in a tenuous financial position. It is not uncommon for a bankrupt to realize substantial taxable income during the administration period from the sale of all or part of the assets or from taxable recoveries. Net operating loss carryovers and other offsetting tax deductions are often unable to minimize the income tax effect. Therefore, in addition to ensuring that all statutory tax reporting and filing requirements are satisfied at the due dates, the accountant must be aware of those tax aspects that will permit the preservation and enlargement of the bankrupt’s estate. During the closing days of the 96th Congress, the Bankruptcy Tax Act of 1980 was passed as Public Law 96-589 and signed by President Carter on December 24, 1980. This bill eliminated a great deal of the uncertainty about handling debt forgiveness and other tax matters, as the Bankruptcy Code superseded the sections of the Bankruptcy Act that contained provisions for nonrecognition of gain from debt forgiveness along with other related tax items. The Bankruptcy Code contains state and local tax law but no federal tax provisions. The new Bankruptcy Tax Act was passed after some last-minute compromises. Included was an amendment that delayed until January 1, 1982, the requirement that net operating losses be reduced by the amount of debt that is forgiven. This was designed to allow one year for Congress to consider comments from the public regarding the handling of debt forgiveness. Sections of the Bankruptcy Tax Act and other sections of the Bankruptcy Code relating to the tax issues of troubled businesses were changed by the several tax reform acts since it was passed. The purpose of this book is to analyze in detail the tax ramifications of bankruptcy and insolvency proceedings and to provide a practical guide that will assist financial advisors, accountants, attorneys, and other related professionals in rendering tax services in the liquidation and rehabilitation of financially troubled debtors in and out of bankruptcy court. The book should be of interest to debtors, business turnaround professionals, trustees, appraisers, and other professionals who assist debtors or creditors of debtors that are experiencing financial difficulty. While these professionals may not be directly involved in rendering professional tax services, they must be aware of the tax consequences of many decisions they make or recommend in bankruptcy cases or out-of-court settlements.
(b) Scope of Coverage
This book describes the tax aspects of a separate estate created for individuals in a chapter 7 or 11 case. The tax ramifications of discharge of debt in and out of bankruptcy court are discussed for both the debtor and creditors. A full chapter is devoted to a discussion of the use of net operating losses by corporations. Tax priorities, assessments, discharges, and authority in bankruptcy are described in the last three chapters. The Bankruptcy Tax Act significantly changed the ways in which a corporation can be reorganized in a bankruptcy proceeding. The new type “G” reorganization created under the Act is analyzed, along with the other aspects of tax reorganization. Other special tax problems are described, such as impact of debt forgiveness on the earnings and profit account and tax issues related to partnerships and S corporations. The balance of this chapter describes briefly the nature of out-of-court settlements and reorganization or liquidation in a title 11 bankruptcy case. This discussion is intended only to provide the reader with a basic introduction to out-of-court and bankruptcy proceedings. For a more detailed discussion of the legal aspects of and the accounting for out-of-court settlements and bankruptcy cases, see Newton’s Bankruptcy and Insolvency Accounting: Practice and Procedure (Wiley; updated annually).
§ 1.2 ALTERNATIVES AVAILABLE TO A FINANCIALLY TROUBLED BUSINESS A debtor’s first alternatives are to locate new financing, to merge with another company, or to find some other basic solution to its situation in order to avoid the necessity of discussing its problem with representatives of creditors. If none of these alternatives is possible, the debtor may be required to seek a remedy from creditors, either informally (out of court) or with the help of judicial proceedings. (a) Out-of-Court Settlements An out-of-court settlement is an informal agreement that usually consists of an extension of time (stretch-out), a pro rata cash payment for full settlement of claims (composition), an issue of stock for debt, or some combination of these methods. The debtor, through a counselor credit association, calls an informal meeting of the creditors for the purpose of discussing its financial problems. In many cases, the credit association makes a significant contribution to the out-ofcourt settlement by arranging a meeting of creditors, providing advice, and serving as secretary for the creditors’ committee. A credit association is composed of credit managers of various businesses in a given region. Its functions are to provide credit and other business information to member companies concerning their debtors, to help make commercial credit collections, to support legislation favorable to business creditors, and to provide courses in credit management for members of the credit community. At the creditors’ meeting, the debtor will describe the causes of failure, discuss the value of assets (especially those unpledged) and unsecured liabilities, and answer any questions the creditors may ask. The main objective of this meeting is to convince the creditors that they would receive more if the business were allowed to operate than if it were forced to liquidate and that all parties would be better off if a settlement could be worked out.
(i) Creditors’ Committee To make it easier for the debtor to work with the creditors, a committee of creditors may be appointed during the initial meeting of the debtor and its creditors, providing, of course, the case is judged to warrant some cooperation by the creditors. The creditors are often as interested in working out a settlement as is the debtor. There is no set procedure for the formation of a committee. Ideally, the committee should consist of four or five of the largest creditors and one or two representatives from the smaller creditors. A lot of time wasted on deciding the size and composition of the committee would be saved at creditors’ meetings if the committees were organized routinely in this manner. However, there are no legal or rigid rules defining the manner in which a committee may be formed. Although a smaller creditor may often serve on a committee, there are committees on which only the larger creditors serve, either because of lack of interest on the part of the smaller creditors or because the larger creditors override the wishes of others. The debtor’s job of running the business while under the limited direction of the creditors’ committee can be made easier if the creditors selected are those most friendly to the debtor.
(A) Duties of Committee The creditors’ committee serves as the bargaining agent for the creditors, supervises the operation of the debtor during the development of a plan, and solicits acceptance of a plan once it has been approved by the committee. Generally, the creditors’ committee will meet as soon as it has been appointed, for the purpose of electing a presiding officer and counsel. The committee will also engage a financial advisor to help the members understand the nature of the debtor’s problems and evaluate the debtor’s business plan. At the completion of the audit, the creditors’ committee will meet to discuss the results. If the audit reveals that the creditors are dealing with a dishonest debtor, the amount of settlement that will be acceptable to the creditors will be increased significantly. It becomes very difficult for a debtor to avoid a bankruptcy court proceeding under these conditions. However, if the debtor is honest and demonstrates the ability to reverse the unprofitable operations trend and reestablish the business, some type of plan may eventually be approved.
(ii) Plan of Settlement It is often advisable, provided there is enough time, for the financial advisor and the attorney to assist the debtor in preparing a suggested plan of settlement so it can be presented and discussed at the first meeting with creditors. Typically, only the largest creditors and a few representatives of the smaller creditors are invited in order to avoid having a group so large that little can be accomplished. There is no set form that a plan of settlement proposed by the debtor must take. It may call for 100 percent payment over an extended period of time, payments on a pro rata basis in cash for full settlement of creditors’ claims, satisfaction of debt obligations with stock, or some combination. A carefully developed forecast of projected operations, based on realistic assumptions developed by the debtor with the aid of its accountant, can help creditors determine whether the debtor can perform under the terms of the plan and operate successfully in the future. Generally, for creditors to accept a plan, the amount they will receive must be at least equal to the dividend they would receive if the estate were liquidated. This dividend, expressed as a percentage, is equal to the sum of a forced-sale value of assets, accounts receivable, cash, and prepaid items minus priority claims, secured claims, and expenses of administration divided by the total amount of unsecured claims. The plan should provide that all costs of administration, secured claims, and priority claims, including wages and taxes, are adequately disposed of for the eventual protection of the unsecured creditors. If the debtor’s plan includes a cash down payment in full or partial settlement, the payment should at least equal the probable dividend the creditors would receive in bankruptcy.
(iii) Acceptance of Plan After the creditors’ committee approves a plan, it will notify all the other creditors and recommend to them that they accept the plan. Even if a few creditors do not agree, the debtor should continue with the plan. The dissenting creditors will eventually have to be paid in full. Some plans even provide for full payment to small creditors, thus destroying the nuisance value of the small claims. In an informal agreement, there is no provision binding the minority of creditors to accept the will of the majority. Thus, it is necessary to obtain the approval of almost all of the creditors in order for an out-of-court settlement to be successful.
(iv) Advantages and Disadvantages Summarized below are a few of the reasons why the informal settlement is used in today’s environment:
The out-of-court settlement is less disruptive to a business that continues operating.
The debtor can receive considerable benefits from the advice of a committee, especially if some of the committee members have extensive business experience, preferably but not necessarily in the same line of business.
The informal settlement avoids invoking the provisions of the Bankruptcy Code and, as a result, more businesslike solutions can be adopted.
Frustrations and delays are minimized because problems can be resolved properly and informally without the need for court hearings.
An agreement can usually be reached much faster informally than in court proceedings.
The costs of administration are usually less in an out-of-court settlement than in a formal reorganization. The weaknesses of informal composition settlements are:
A successful plan of settlement requires the approval of substantially all creditors, and it may be difficult to persuade distant creditors to accept a settlement that calls for payment of less than 100 percent.
The assets of the debtor are subject to attack while a settlement is pending. (The debtor can, of course, point out to the creditors that if legal action is taken, a petition in bankruptcy court will have to be filed.)
The informal composition settlement does not provide a method to resolve individual disputes between the debtor and the creditors.
Executory contracts, especially leases, may be difficult to avoid.
Certain tax law provisions make it more advantageous to file a bankruptcy court petition.
Priority debts owed to the United States under Rev. Stat. section 3466 must be paid first.
(b) Assignment for Benefit of Creditors A remedy available under state law to a corporation in serious financial difficulties is an assignment for the benefit of creditors. In this instance, the debtor voluntarily transfers title to its assets to an assignee, which then liquidates them and distributes the proceeds among the creditors. Assignment for the benefit of creditors is an extreme remedy because it results in the cessation of the business. This informal liquidation device (although court-supervised in many states) is like the out-of-court settlement devised to rehabilitate the debtor, in that it requires the consent of all creditors or at least their agreement to refrain from taking action. The appointment of a custodian over the assets of the debtor gives creditors the right to file an involuntary bankruptcy court petition. Proceedings brought in the federal courts are governed by the Bankruptcy Code. Normally, it will be necessary to resort to such formality when suits have been filed against the debtor and its property is under garnishment or attachment or is threatened by foreclosure or eviction.
(c) Bankruptcy Court Proceedings Bankruptcy court proceedings are generally the last resort for a debtor whose financial condition has deteriorated to the point where it is impossible to acquire additional funds. When the debtor finally agrees that bankruptcy court proceedings are necessary, the liquidation value of the assets often represents only a small fraction of the debtor’s total liabilities. If the business is liquidated, the creditors get only a small percentage of their claims. The debtor is discharged of its debts and is free to start over; however, the business is lost and so are all the assets. Normally, liquidation proceedings result in large losses to the debtor, to the creditor, and to the business community in general.Chapter 7 of the Bankruptcy Code covers the proceedings related to liquidation. Another alternative under the Bankruptcy Code is to seek some type of relief so that the debtor will have enough time to work out agreements with creditors with the help of the bankruptcy court and be able to continue operations. Chapters 11, 12, and 13 of the Bankruptcy Code provide for this type of operation Title 1111 of the U.S. Code contains the bankruptcy law. The code is divided into eight chapters: Chapter 1: General Provisions Chapter 3: Case Administration Chapter 5: Creditors, the Debtor, and the Estate 1 The Bankruptcy Code as originally passed consisted of only odd-numbered chapters. In 1986, Congress added chapter 12. Chapter 7: Liquidation Chapter 9: Adjustment of Debts of a Municipality Chapter 11: Reorganization Chapter 12: Adjustment of Debts of a Family Farmer with Regular Income Chapter 13: Adjustment of Debts of an Individual with Regular Income Chapters 1, 3, and 5 apply to all proceedings under the code, except in chapter 9, where only those sections of chapters 1, 3, and 5 specified apply. A case commenced under the Bankruptcy Code’s chapters 7, 9, 11, 12, or 13 is referred to as a title 11 case.
(d) Provisions Common to All Bankruptcy Proceedings A voluntary case is commenced by the filing of a bankruptcy petition under the appropriate chapter by the debtor. An involuntary petition can be filed by creditors with aggregate unsecured claims of at least $12,3002 and can be initiated only under chapter 7 or 11. If there are 12 or more creditors with unsecured claims, at least three creditors must sign the petition; if the number of unsecured creditors is less than 12, a single creditor can force the debtor into bankruptcy.
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