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Prepared Floor Statement of Senator Chuck Grassley
Ranking Member, Senate Committee on the Judiciary
Hall v. United States and Chapter 12 of the Bankruptcy Code
Friday, December 16, 2012
Mr. President, I'd like to take a few minutes to discuss a case that was argued a few weeks ago before the Supreme Court, Hall v. United States. This case involves a specific provision I authored, which is contained in 2005 Bankruptcy Reform law. Throughout the litigation in this case, my statements supporting the provision were discussed at length. I want to take a few minutes and walk through the history and intent of this provision, so people hear it straight from the author's mouth.
At its core, Hall v. United States is about statutory interpretation. The statute at issue is 11 U.S.C. section 1222(a)(2)(A), which was a farm bankruptcy provision added to the Bankruptcy Code in 2005. Before I get into a discussion about the case, let me explain what this particular provision does and why it was needed.
Congress enacted Chapter 12 of the Bankruptcy Code in 1986, which was subsequently made permanent in 2005. Chapter 12 allows family farmers to use the bankruptcy process to reorganize their finances and operations. It's a proven success as a leverage tool for farmers and their lenders. It helps the farmer and the banker sit down and work out alternatives for debt repayment. Not long after it became law in 1986, we began to hear about what worked and what didn't work for farmers who were reorganizing in bankruptcy.
One problem we learned about arose when a debtor farmer needed to sell assets in order to generate cash for reorganization. A farmer may need to sell portions of the farm to raise cash to fund a plan and pay off his creditors. However, in this situation we're usually dealing with land that's been in a family's hands for a long time. This means that the cost basis is usually very low. So, once a farmer filed bankruptcy and then tried to sell a portion or all of the land, he would be hit with a substantial capital gains tax.
This created problems because, as originally drafted, Chapter 12 required full payment of all priority claims under Section 507 of the Bankruptcy Code. The only way to avoid this requirement was if the holder of the claim agreed that its claim could be treated differently. Thus, when a farmer sold his land, which resulted in large capital gains, the IRS would have a priority claim against the bankruptcy estate.
Now, let me take a moment to explain the concept of a bankruptcy estate, which may be a bit confusing. When an individual or a corporation files for bankruptcy, an estate is created. The estate consists of property that is liquidated for the purpose of paying creditors. So, in the case of farmers filing a bankruptcy petition under Chapter 12, the farm assets are property of the estate. And according to Section 541(a)(6) of the Bankruptcy Code, the proceeds from the sales of those assets are also property of the estate.
So, the situation farmers faced was where the IRS held a large priority claim against the bankruptcy estate. Let's talk a minute about claims against the estate, because this helps to understand how we got to where we are today. In the situation I'm discussing, we're dealing with a claim that is based on taxes owed. The Bankruptcy Code says that taxes incurred by the estate are administrative expenses. An administrative expense essentially receives top priority when determining who gets paid what.
Thus, the effect this had was that the IRS, with its priority claim, could object to any reorganization plan that didn't provide for full payment of its tax claim. The IRS essentially held veto authority over the farmer's plan confirmation. In some instances, then, a farmer who sought to sell a portion of his farm to reorganize, pay creditors and become profitable again was prohibited completely from doing so.
After learning of this problem, I started working on a way to fix it. Simply put, I wanted to make sure that family farmers in a Chapter 12 case could, in fact, sell portions of their farms to effectively reorganize, without the capital gains taxes jeopardizing the reorganization. The very purpose of Chapter 12 and bankruptcy in general is to allow for a fresh start. Unfortunately, this wasn't happening.
In 1999 I introduced the "Safeguarding America's Farms Entering the Year 2000 Act." This bill, among other things, sought to fix the capital gains tax issue. When I introduced this bill, I said that it would "help farmers to reorganize by keeping tax collectors at bay." I also explained that:
"Under current law, farmers often face a crushing tax liability if they need to sell livestock or land in order to reorganize their business affairs. . . High taxes have caused farmers to lose their farms. Under the Bankruptcy Code, the IRS must be paid in full for any tax liabilities generated during a bankruptcy reorganization. If the farmer can't pay the IRS in full, then he can't keep his farm. This isn't sound policy. Why should the IRS be allowed to veto a farmer's reorganization plan?"
The language I proposed ultimately was enacted in the 2005 Bankruptcy Reform law. Since the Bankruptcy Code, courts and the IRS treated the tax liability as an administrative expense, the new provision created a very narrow exception. Basically, only in a Chapter 12 case, if a farmer sold farm land that resulted in a capitals gain liability, then the IRS's claim would not receive priority status.
Instead, the government would have an unsecured claim, which means they may get paid something, but not necessarily the entire amount. Also, the IRS would no longer be able to veto a plan's confirmation. Thus, the farmer debtor would be allowed to try and reorganize.
Now, from a bankruptcy point of view, this approach makes complete sense. As I've discussed already, filing a petition creates a bankruptcy estate. The bankruptcy estate then sells the land, post-petition, and that results in capital gains that are owed to the IRS. These taxes, incurred by the estate post-petition, are administrative expenses, which receive priority status. So, my language, enacted into law in 2005, stripped the priority claims owed to the government, in this very specific instance, and made them general unsecured claims.
However, since passage of this provision, the IRS has made an about face. The government now argues, despite the way it treated this situation for all these years, that the tax liability created is the responsibility of the individual and not the bankruptcy estate. Yet, the entire reason we created this new provision was because of the way the IRS treated the tax liability.
The IRS's new position has been argued in federal court and has received mixed results. So now there's a dispute whether my provision accomplishes what it was designed to do. A 2009 Eighth Circuit case, Knudsen v. Internal Revenue Service, held the provision applies to the post-petition sale of farm assets, which is what we're discussing here. Specifically, the Eighth Circuit rejected the IRS's position that the Internal Revenue Code does not recognize a separate taxable entity being created when a debtor files a Chapter 12 petition.
Put another way, the IRS is claiming the individual debtor is responsible for the tax liability that arises out of the bankruptcy estate's actions. The Eighth Circuit disagreed and said there's now an exception preventing the IRS from having a priority claim for the capital gains.
But in a Ninth Circuit case, the court there held that there was no exception for post-petition capital gains. In Hall v. United States, now before the Supreme Court, the Ninth Circuit said the Halls were responsible for the capital gains taxes from selling part of their farm during bankruptcy. This holding means that my provision didn't create a narrow exception, even though that's what was intended.
Unfortunately, the IRS, under the Obama administration, is taking a position today that is anti-farmer and the exact opposite of what it said six years ago.
This about-face came only after we made the change in the law, and it became clear that in very narrow circumstances the IRS would lose its priority position. I respect the IRS's interest in pursuing tax dollars, but it exhibited a lot of chutzpah in taking this position. Our policy reasons for this new exception were simple. The farmers didn't have enough money to pay everyone. We decided that it would be better to let them sell some assets, which would generate cash and help them to reorganize and pay their creditors. In making this decision, we realized that someone would have to make a sacrifice. We decided to give the farmers a break from government taxes in a very narrow set of circumstances. Now, though, the government is trying to figure out a way to jump back ahead of other creditors and get more money.
And these creditors that the IRS is trying to break in front of are small businesses, suppliers and small, local banks that extend credit and supplies to farmers. This is not what we expected would happen when we passed the 2005 Bankruptcy law.
This is an important issue and an important case that the Supreme Court will decide in the coming months. The Supreme Court will decide whether this provision accomplishes my goal, which I've stated. I look forward to seeing how the case is resolved. Rest assured that I'll work to ensure that this policy of protecting family farmers is followed as that was our clear intent in having this law enacted. Chapter 12 has proven successful as a leverage tool for farmers and their lenders. It helps the farmer and the banker sit down and work out alternatives for debt repayment.
Should the Court rule that the Internal Revenue Code is inconsistent with the Bankruptcy Code, and rule against my intent as the author, I will work to remedy this inconsistency.