UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
_____________________
No. 94-10089
_____________________
IN THE MATTER OF: WEST TEXAS MARKETING CORPORATION,
Debtor.
WALTER C. KELLOGG, Trustee,
West Texas Marketing Corporation,
Appellant,
VERSUS
UNITED STATES OF AMERICA,
(Internal Revenue Service),
Appellee.
____________________________________________________
Appeal from the United States District Court
for the Northern District of Texas
_____________________________________________________
(May 31, 1995)
Before SMITH, and BARKSDALE, Circuit Judges, and FITZWATER,1
District Judge.
RHESA HAWKINS BARKSDALE, Circuit Judge:
At issue in this Chapter 7 liquidation is whether the district
court erred in holding that the estate of West Texas Marketing
Corporation (WTMC), the debtor, (1) could not, for federal income
tax purposes, accrue and deduct post-petition interest on
undisputed and resolved general unsecured claims; and (2) was
liable for a tax penalty, even though the Internal Revenue Service
1
District Judge of the Northern District of Texas, sitting by
designation.
assessed it outside the period allowed by § 505(b) of the
Bankruptcy Code. We AFFIRM.
I.
This case was tried on stipulated facts, which are developed
more fully in In re West Texas Mktg. Corp., 155 B.R. 399 (Bankr.
N.D. Tex. 1993), and are restated here only as necessary. In 1982,
WTMC filed a voluntary bankruptcy petition under Chapter 11 of the
Bankruptcy Code; but, the bankruptcy court converted the case to a
Chapter 7 liquidation in 1983.
In 1991, Kellogg, as trustee for the estate, filed amended tax
returns for 1988 and 1989, on the basis that the estate (1) failed
previously to deduct post-petition interest on undisputed and
resolved general unsecured claims for 1988 and 1989; and, (2) could
deduct net operating loss carryforwards based, in part, on post-
petition interest for such claims for 1982 through 1987.2 On
WTMC's 1991 return, Kellogg sought also to deduct post-petition
interest for such unsecured claims. The total interest expense was
approximately $12.6 million, with a total refund claim of
approximately $1.1 million. The IRS disallowed the refunds.
In addition, prior to the attempt to deduct post-petition
interest, the IRS had assessed a penalty of approximately $23,000
against WTMC for 1989, because it failed to make estimated tax
payments. Eventually, the IRS set off this penalty against a
refund due WTMC for 1988.
2
WTMC's accounting period runs from October 1 to September 30.
For example, taxable year 1988 represents October 1, 1987, to
September 30, 1988.
- 2 -
As a result of, inter alia, both actions by the IRS, Kellogg
filed this adversary proceeding. The bankruptcy court denied
relief; the district court affirmed.
II.
A.
It goes without saying that, generally, pursuant to I.R.C. §
163, a corporation may deduct all interest paid or accrued within
the taxable year on indebtedness. Kellogg maintains that WTMC's
liability vel non for post-petition interest is a question of state
law: that, because the unsecured claims constitute a fixed
liability when the petition was filed, the Texas statutory rate of
6% establishes a present and unconditional liability for interest
on those claims; and that federal law determines only the priority
of how assets of the estate are to be distributed in satisfaction
of the claims against it.
In Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156
(1946), the Court recognized that "[w]hat claims of creditors are
valid and subsisting obligations against the bankrupt at the time
a petition in bankruptcy is filed, is a question which, in the
absence of overruling federal law, is to be determined by reference
to state law." Id. at 161 (emphasis added). Thus, the validity of
any interest that may have accrued prior to the filing of the
petition is resolved generally by state law. But, once the
petition is filed, federal law controls. Id. at 163 ("[w]hen and
under what circumstances federal courts will allow interest on
- 3 -
claims against debtors' estates being administered by them has long
been decided by federal law").
Sections 446(a) and 461(a) of the Internal Revenue Code
provide that taxable income is computed, and deductions taken,
under the accounting method that the taxpayer normally uses for his
books. I.R.C. §§ 446(a), 461(a).3 WTMC maintained its books, and
calculated its federal income tax liability, utilizing the accrual
method. Under that method, the standard for determining when an
expense has been incurred for federal income tax purposes has been
the "all events" test. During the years at issue, the test
required that two elements be met before accrual of an expense
would be allowed: first, all the events must have occurred that
establish the fact of the liability; and, second, the amount of the
liability must be capable of being determined with reasonable
accuracy.4 Only the first element is at issue.
3
I.R.C. § 446(a) provides: "Taxable income shall be computed
under the method of accounting on the basis of which the taxpayer
regularly computes his income in keeping his books".
I.R.C. § 461(a) provides: "The amount of any deduction or
credit allowed by this subtitle shall be taken for the taxable year
which is the proper taxable year under the method of accounting
used in computing taxable income".
4
The Treasury Regulation in force from 1982 to 1991 provided
that "an expense is deductible for the taxable year in which all
the events have occurred which determine the fact of the liability
and the amount thereof can be determined with reasonable accuracy".
Treas. Reg. § 1.461-1(a)(2) (1991). In 1992, the Regulation was
modified to provide for the deduction of expenses "in the taxable
year in which all the events have occurred that establish the fact
of the liability, the amount of the liability can be determined
with reasonable accuracy, and economic performance has occurred
with respect to the liability". Treas. Reg. § 1.461-1(a)(2)(i)
(1992).
- 4 -
"[A]lthough expenses may be deductible before they have become
due and payable, liability must first be firmly established....
[A] taxpayer may not deduct a liability that is contingent...."
United States v. General Dynamics Corp., 481 U.S. 239, 243 (1987);
accord United States v. Hughes Properties, Inc., 476 U.S. 593, 600-
01 (1986). In describing this noncontingent requirement, the
Supreme Court has required also that the liability be "fixed and
absolute", Hughes, 476 U.S. at 600 (quoting Brown v. Helvering, 291
U.S. 193, 201 (1934)), and "unconditional", id. (quoting Lucas v.
North Tex. Lumber Co., 281 U.S. 11, 13 (1930)).
The issue is not the ability vel non of WTMC to pay post-
petition interest on the unsecured claims. See Fahs v. Martin, 224
F.2d 387 (5th Cir. 1955) (interest for which an accrual basis
taxpayer is presently and unconditionally liable, but which is
unlikely to be paid by reason of his insolvency, is still
deductible).5 Rather, we must determine whether WTMC's liability
for post-petition interest is fixed, absolute, unconditional, or
not subject to any contingency. See 2 MERTENS LAW OF FED INCOME TAX §
12A.139 (1993) ("[w]hile cases have held interest is deductible
when there is improbability of payment it is well to note that in
none was there any uncertainty (substantial contingency) of the
liability itself").
5
For all but one of the years at issue, the total undisputed
and resolved claims against WTMC exceeded WTMC's assets. Thus, it
was extremely unlikely that WTMC would be able to pay such claims.
As noted, however, this fact is not dispositive of the issue before
us.
- 5 -
Section 502 of the Bankruptcy Code sets forth a general rule
that claims for post-petition interest are not allowed against the
estate. 11 U.S.C. § 502(b)(2).6 One of the principles underlying
this provision is that "interest stops accruing at the date of the
filing of the petition." H.R. REP. NO. 595, 95th Cong., 1st Sess.
353 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6309; S.R. REP.
NO. 989, 95th Cong., 2d Sess. 63 (1978), reprinted in 1978
U.S.C.C.A.N. 5787, 5849; see In re Brints Cotton Mktg., Inc., 737
F.2d 1338, 1341 (5th Cir. 1984) ("post-petition accumulation of
interest (allowable by state law) on claims against a bankrupt's
estate are suspended").
The Code provides, however, for several exceptions to this
general rule. Section 726(a) establishes hierarchial priorities
when distributing a debtor's estate in a Chapter 7 liquidation.
Included within the priorities is the payment of post-petition
interest on claims against the estate if any assets remain after
6
Section 502 of the Bankruptcy Code provides, in pertinent
part:
(a) A claim or interest, proof of which is
filed under section 501 of this title, is deemed
allowed, unless a party in interest ... objects.
(b) ... if such an objection to a claim is
made, the court, after notice and a hearing, shall
determine the amount of such claim ... and shall
allow such claim in such amount, except to the
extent that --
....
(2) such claim is for unmatured interest.
11 U.S.C. § 502.
- 6 -
distributions for prioritized claims, unsecured claims, and
penalties, fines, and nonpecuniary damages. 11 U.S.C. § 726(a)(5).
The only distribution occupying a lower position on the hierarchy
is the return of any remaining assets to the debtor.7
7
Section 726 of the Bankruptcy Code provides that:
(a) ... property of the estate shall be
distributed --
(1) first, in payment of claims of the
kind specified in, and in the order specified
in, section 507 of this title [(prioritized
claims)];
(2) second, in payment of any allowed
unsecured claim, other than a claim of a kind
specified in paragraph (1), (3), or (4) of
this subsection ...;
(3) third, in payment of any
allowed unsecured claim proof of which is
tardily filed under section 501(a) of
this title, other than a claim of the
kind specified in paragraph 2(C) of this
subsection;
(4) fourth, in payment of any
allowed claim, whether secured or
unsecured, for any fine, penalty, or
forfeiture, or for multiple, exemplary,
or punitive damages, arising before the
earlier of the order for relief or the
appointment of a trustee, to the extent
that such fine, penalty, forfeiture, or
damages are not compensation for actual
pecuniary loss suffered by the holder of
such claim;
(5) fifth, in payment of interest
at the legal rate from the date of the
filing of the petition, on any claim paid
under paragraph (1), (2), (3), or (4) of
this subsection; and
(6) sixth, to the debtor.
- 7 -
In Guardian Investment Corp. v. Phinney, 253 F.2d 326 (5th
Cir. 1958), a taxpayer sought to deduct interest on a second
mortgage, even though no payments of principal or interest would be
due until payment of the first mortgage. Additionally, according
to the terms of the second mortgage, payments on it could be made
only from the net proceeds of any sale of the mortgaged property.
Thus, the potential existed that no payments on the second mortgage
would ever be made.
Although Guardian Investment addressed whether the principal
due on the second mortgage was contingent, it still provides a
framework to consider the contingent nature of an obligation for
income tax purposes.8 In finding the indebtedness to be
contingent, the Guardian Investment court examined five aspects of
the obligation: (1) is there a fixed or determinable date of
maturity; (2) is the obligation owed only upon the happening of a
condition; (3) is the happening of that condition uncertain; (4) is
that condition to occur in futuro; and, (5) is there a fixed or
determinable liability? Id. at 331. Considering the aggregate of
these factors, our court held that the liability on the second
mortgage was not "a fixed, definite, existing obligation". Id.
Implicit in the obligation under § 726 to pay post-petition
interest on unsecured claims is the necessary condition that
8
We rely upon Guardian Investment to provide structure for our
analysis of the contingent nature of WTMC's liability for post-
petition interest, not to command of itself the result we reach on
the basis of §§ 502(b) and 726(a). We need not, therefore, concern
ourselves with factual distinctions between Guardian Investment and
the present case.
- 8 -
sufficient assets remain following distributions under § 726(a)(1)-
(4). These distributions could not occur during the taxable years
at issue, and there is no fixed or determinable date when these
distributions will occur; the condition is in futuro. Because
Kellogg seeks to deduct post-petition interest on undisputed
claims, the amount of such liability can easily be determined.
When taken in the aggregate, and based upon the principles of
accrual accounting, we conclude that, under the all events tests,
WTMC's liability for post-petition interest has not been
established. Our court recognized in Guardian Investment that, "if
the proceeds from the sale of the mortgaged property [were] not
sufficient to pay off the first mortgage, the taxpayer [would] not
[be] under any obligation to pay any interest or principal of the
second mortgage". Id. at 331. Similarly, if, in the distribution
of WTMC's assets in accordance with § 726(a)(1)-(4), all assets are
depleted, then the estate will not have incurred any obligation to
pay interest on unsecured claims. This is not due to the fact that
payment became impossible, but because the condition necessary to
create the liability for the post-petition interest failed to
occur.
Accordingly, Kellogg may not now deduct post-petition interest
on undisputed and resolved, general unsecured claims against the
estate.9
9
Of course, if assets remain after distributions are made
pursuant to § 726(a)(1)-(4), then liability for post-petition
interest will be established.
- 9 -
B.
The other issue is whether the IRS violated the tax liability
discharge provision of 11 U.S.C. § 505(b) when it assessed the
estimated tax penalty for 1989 and used it as a setoff against a
refund due for 1988.10 Section 505(b) allows trustees to request
10
As a preliminary matter, the IRS contends, erroneously, that,
because the United States did not waive sovereign immunity, the
district court lacked jurisdiction to consider whether WTMC was
entitled to a refund for the penalty. It maintains that, as a
statutory condition precedent to a refund suit, the taxpayer must
file a claim for the refund.
Section 7422 of the Internal Revenue Code provides that "[n]o
suit or proceeding shall be maintained in any court for the
recovery of any internal revenue tax ... until a claim for refund
or credit has been duly filed with the Secretary, according to the
provisions of law in that regard, and the regulations of the
Secretary established in pursuance thereof". I.R.C. § 7422(a).
Furthermore, Bankruptcy Code § 505(a)(2)(B) provides that a
bankruptcy court may not determine
any right of the estate to a tax refund, before the
earlier of --
(i) 120 days after the trustee properly
requests such refund from the governmental unit
from which such refund is claimed; or
(ii) a determination by such governmental unit
of such request.
11 U.S.C. § 505(a)(2)(B).
Between submission of briefs and oral argument, however,
Congress enacted the Bankruptcy Reform Act of 1994 by which it,
inter alia, abrogated expressly, and retrospectively, a claim of
sovereign immunity with respect to § 505. Pub. L. No. 103-394, §
113, 108 Stat. 4106, 4117. Section 113 of the Act provides in
pertinent part:
Section 106 of title 11, United States Code,
is amended to read as follows:
"§ 106. Waiver of sovereign immunity
"(a) Notwithstanding an assertion of
- 10 -
a determination of any unpaid tax liability from the appropriate
governmental unit, and provides that, unless that entity notifies
the trustee within 60 days that the return has been selected for
examination, "the trustee, the debtor, and any successor to the
debtor are discharged from any liability for such tax" unless the
return is fraudulent or contains a material misrepresentation. 11
U.S.C. § 505(b) (emphasis added).11 Kellogg made a § 505(b)
sovereign immunity, sovereign immunity is
abrogated as to a governmental unit to the
extent set forth in this section with respect
to the following:
"(1) Section[] ... 505 ... of this
title.
"(2) The Court may hear and
determine any issue arising with respect
to the application of such sections to
governmental units.
...."
108 Stat. 4106, 4117-18. And, pursuant to § 702(b)(2)(B) of the
Act, this amendment is made applicable to all pending cases:
The amendments made by sections 113 and 117 shall
apply with respect to cases commenced under title
11 of the United States Code before, on, and after
the date of the enactment of this Act.
108 Stat. 4106, 4150.
Although, in his rebuttal at oral argument, counsel for
Kellogg noted the recent Act, neither side filed a letter citing
supplemental authority as permitted by FED. R. APP. P. 28(j). We
note that the Government is obviously cognizant of Rule 28(j), in
that it filed a 28(j) letter on a different issue in this case.
Needless to say, supplemental briefs should have been filed.
11
Section 505(b) of the Bankruptcy Code provides:
A trustee may request a determination of any
unpaid liability of the estate for any tax incurred
during the administration of the case by submitting
- 11 -
request, but the IRS did not assess the penalty within the 60 day
limit. We must determine, therefore, whether § 505(b) bars the
subsequent assessment and collection of the penalty against the
estate.12
1.
The IRS contends that Kellogg's reliance on § 505(b) is
misplaced because this issue does not involve the IRS seeking to
a tax return for such tax and a request for such a
determination to the governmental unit charged with
responsibility for collection or determination of
such tax. Unless such return is fraudulent, or
contains a material misrepresentation, the trustee,
the debtor, and any successor to the debtor are
discharged from any liability for such tax --
(1) upon payment of the tax shown on such
return, if --
(A) such governmental unit does not
notify the trustee, within 60 days after such
request, that such return has been selected
for examination; or
(B) such governmental unit does not
complete such an examination and notify the
trustee of any tax due, within 180 days after
such request or within such additional time as
the court, for cause, permits;
(2) upon payment of the tax determined by the
court, after notice and a hearing, after completion
by such governmental unit of such examination; or
(3) upon payment of the tax determined by
such governmental unit to be due.
11 U.S.C. § 505(b).
12
Kellogg challenges the underlying merits of the penalty. The
only time Kellogg previously raised this issue was in a reply brief
to the bankruptcy court. (It was not in the pretrial order.) It
appears that the issue was not raised in, or considered by, the
district court. In any event, we consider it waived.
- 12 -
assess or collect taxes; rather, any tax liability for the penalty
has been extinguished because it was used as a setoff against the
refund due for 1988. Thus, the IRS maintains, this claim is
instead for a refund, governed by § 505(a).13
As noted, Kellogg filed a timely return for 1989, and
requested a prompt determination pursuant to § 505(b). A month
later, the IRS notified Kellogg that the return had been accepted
as filed and issued a refund check. But, over three months after
the 1989 return was filed, the IRS notified Kellogg of the penalty
and, subsequently, used it as a setoff against the refund due for
1988. If WTMC had not had that refund due, the IRS would not have
been able to collect the penalty as it did. Only because the IRS
found WTMC in the fortuitous position of being entitled to a refund
for the prior tax year was it able to offset. Claiming that these
events mandate that Kellogg is not entitled to raise a § 505(b)
timeliness issue places form over substance.
2.
Under 505(b), the failure of the IRS to act in a timely manner
discharges potential tax liability of, inter alia, the debtor and
the trustee. At issue is whether this failure discharges the
13
Section 505(a)(1) of the Bankruptcy Code provides that
the court may determine the amount or legality of
any tax, any fine or penalty relating to a tax, or
any addition to tax, whether or not previously
assessed, whether or not paid, and whether or not
contested before and adjudicated by a judicial or
administrative tribunal of competent jurisdiction.
11 U.S.C. § 505(a)(1).
- 13 -
estate as well, under the section's nomenclature of "any successor
to the debtor". This is an issue of first impression for any
circuit court. Of the two lower courts to have considered directly
this issue, both have held that the estate does not enjoy the
discharge given to "any successor to the debtor". In re Fondiller,
125 B.R. 805 (N.D. Cal. 1991); In re Rode, 119 B.R. 697 (Bankr.
E.D. Mo. 1990); but see In re Flaherty, 169 B.R. 267, 270 n.4
(Bankr. D.N.H. 1994) (declaring, in dictum, that "[a]lthough the
actual wording of subsection (b) of the statute is `the trustee,
the debtor, or any successor to the debtor are discharged from any
liability for such tax,' ... this language effectively discharges
the estate of the tax, as well").
It goes without saying that our interpretation of a statute
begins with its language. The Bankruptcy Code defines a debtor as
a "person or municipality concerning which a case under this title
has been commenced", 11 U.S.C. § 101(13); and a "person" includes
an "individual, partnership, and corporation". 11 U.S.C. §
101(41). Thus, a "debtor" must be an individual, partnership or
corporation, and it follows that any "successor to the debtor" must
also be an individual, partnership or corporation. It becomes more
obvious that the estate cannot be a "successor" when we consider
what is an "estate". An "estate" is created at the commencement of
the bankruptcy case, and is "comprised" of, inter alia, "all legal
and equitable interests of the debtor in property as of the
commencement of the case". 11 U.S.C. § 541(a), (a)(1).
- 14 -
Furthermore, § 505(c) uses the term "estate" as distinct from
the terms "debtor" and "successor to the debtor". Section 505(c)
provides that, after the court makes a determination of tax under
§ 505, "the governmental unit charged with responsibility for
collection of such tax may assess such tax against the estate, the
debtor, or a successor to the debtor ...." Thus, the clear
distinction between the "estate" and "successor to the debtor"
demonstrates that Congress did not intend for the discharge of tax
liability under § 505(b) to apply to the estate.
In addition to the Code's plain language, the situation faced
by trustees prior to the enactment of the Bankruptcy Code illumines
the purpose to be served by § 505. Prior to the Code, trustees
lacked a mechanism for obtaining a prompt determination of the tax
liability of the estate. Therefore, a trustee wishing to have the
case closed was confronted with the choice of leaving the estate
open until the IRS's opportunity to review the estate's tax
expired, or proceed to have the case closed and face the potential
of personal liability for additional taxes that the IRS might
determine subsequently were due. Section 505(b) provided the
solution to this dilemma. 1A Collier on Bankr. (MB) ¶ 12.04[3].
Although [§ 505(b)] was envisioned as a mechanism
to permit a determination of tax liability at the
conclusion of the administration of an estate,
i.e., a single request for a prompt determination
of all the relevant tax periods, there is nothing
in its language to prevent successive requests as
each tax period is completed and a return filed
apart from the obligation to pay the taxes shown on
such returns.
Id.
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III.
For the foregoing reasons, the judgment is
AFFIRMED.
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JERRY E. SMITH, Circuit Judge, dissenting:
Ever since this circuit decided Fahs v. Martin, 224 F.2d 387
(5th Cir. 1955), the settled rule has been that an accrual basis
taxpayer immediately may deduct, under the Internal Revenue Code,
an expense such as interest legally owed, notwithstanding the
improbability of payment. Id. at 393. No distinction is made
between a debt backed by the full faith and credit of the United
States and one owed by a creditor who has not only tottered at the
brink of bankruptcy but has fallen into the chasm. The majority
today would retreat from our rule in the case of interest imposed
by state law during the pendency of bankruptcy ("pendency inter-
est"). As I believe the majority misinterprets the Bankruptcy
Code, extinguishes a state property right and creates a federal
one, and confuses the distinction between improbable and contingent
payment, I respectfully dissent.
A.
I begin by examining the source of the interest at issue. The
obligation to pay interest for debts owed on contracts and accounts
is a creation of the law of contract. Generally, contract law
among private parties in our federalist system is state law. Under
the state law of contract here, Texas law, the background rule for
debts owed on accounts and contracts is that interest at six
percent will be imposed thirty days after the debt was due, unless
the parties agree otherwise. TEX. REV. CIV. STAT. ANN. art. 5069-1.03
(West 1987). The majority does not doubt that such a property
-17-
right and its obligations existed prior to the imposition of
bankruptcy.
The majority, however, believes that, post-petition, federal
law controls. See Vanston Bondholders Protective Comm. v. Green,
329 U.S. 156, 163 (1946) ("When and under what circumstances
federal courts will allow interest on claims against debtors'
estates being administered by them has long been decided by federal
law."). The majority does not specify what it means by "controls."
Presumably, however, the majority means that federal law defines
which debts are valid, as that was the position taken here by the
government and bankruptcy court below. See Kellogg v. United
States (In re West Texas Mktg. Corp.), 155 B.R. 399, 402 (Bankr.
N.D. Tex. 1993) (positing that both state and federal law are
"sources of liability for postpetition interest on general
unsecured claims"). This view is only half right.
The federal law of bankruptcy is not designed to create debts
among parties but to determine how existing debts should be
distributed to creditors fairly. Justice Frankfurter's concurrence
in Vanston explains as much:
The business of bankruptcy administration is to determine
how existing debts should be satisfied out of the
bankrupt's estate so as to deal fairly with the various
creditors. The existence of a debt bewteen the parties
to an alleged creditor-debtor relation is independent of
bankruptcy and precedes it. Parties are in a bankruptcy
court with their rights and duties already established,
except insofar as they subsequently arise during the
course of bankruptcy administration or as part of its
conduct. Obligations to be satisfied out of the bank-
rupt's estate thus arise, if at all, out of tort or
contract or other relationship created under applicable
law. And the law that fixes legal consequences to
transactions is the law of the several States.
-18-
Vanston, 329 U.S. at 169 (Frankfurter, J., concurring); see also
id. at 161 ("What claims of creditors are valid and subsisting
obligations against the bankrupt at the time a petition in
bankruptcy is filed is a question which, in the absence of
overruling federal law, is to be determined by reference to state
law.") (Black, J.) (majority opinion); Grogan v. Garner, 498 U.S.
279, 283 (1991) ("The validity of a creditor's claim is determined
by rules of state law.").
This point bears stressing. Nothing in the Bankruptcy Code
awards damages for failure to deliver goods or injury from the
negligent operation of a vehicle. Nor does it create the right to
collect interest from an unpaid debt.
Bankruptcy law does control in the sense that courts ulti-
mately may not enforce such rights in carrying out their constitu-
tional and statutory obligations. As Justice Frankfurter contin-
ued:
Of course a State may affix to a transaction an obliga-
tion which the courts of other States or the federal
courts need not enforce because of overriding consider-
ations of policy. And so, in the proper adjustment of
the rights of creditors and the desire to rehabilitate
the debtor, Congress under its bankruptcy power may
authorize its courts to refuse to allow existing debts to
be proven.
Vanston, 329 U.S. at 169. Thus, a state-law debt may enter the
controls of the Bankruptcy Code as valid, but ultimately may not be
enforced if the bankruptcy court, through its congressionally
granted equitable powers, determines otherwise. See Fahs, 224 F.2d
at 395 ("[W]e interpret [Vanston] only as establishing the
-19-
equitable power and duty of bankruptcy courts to subordinate such
a claim.").14
B.
I have stressed the distinction between state property law and
federal bankruptcy law in some detail, as that distinction is
critical in understanding how federal bankruptcy law "controls"
here. Kellogg's state law obligation to pay interest on its over-
due debts pre-dates the imposition of bankruptcy. Now, the
question we must answer is when, in the bankruptcy proceedings,
such a state law right is extinguished.
Turning to the Bankruptcy Code, I note that section 502(a),
11 U.S.C. § 502(a), provides, in pertinent part, that a claim is
allowed unless a party in interest objects. Upon objection,
section 502(b) provides, in relevant part, that "the court, after
notice and a hearing, shall determine the amount of such a claim
. . . and shall allow such a claim in such amount except to the
14
In Fahs, we further explained our position, stating:
The majority opinion [in Vanston] may be reconciled with [the
concurrence's] unquestionably correct principles only if it is
regarded, as we regard it, as not declaring the obligation
(regardless of validity under state law) void, but merely as
subordinating it.
224 F.2d at 395 n.5. See also Pepper v. Litton, 308 U.S. 295, 310-12 (1939)
(holding that bankruptcy court has equitable power to disallow or subordinate
state judgment); Addison v. Langston (In re Brints Cotton Mktg., Inc.), 737 F.2d
1338, 1341-42 (5th Cir. 1984) ("[W]hile state law ordinarily determines what
claims of creditors are valid and subsisting obligations, a bankruptcy court is
entitled (if authorized by the federal bankruptcy statute) to determine how and
what claims are allowable for bankruptcy purposes, in order to accomplish the
statutory purpose of advancing a ratable distribution of assets among the
creditors."); see generally 3 DANIEL R. COWANS, COWAN'S BANKRUPTCY LAW AND PRACTICE § 12.7,
at 39-40 (1994) (examining interrelationship of state law claims and
"allowability" under the Bankruptcy Code).
-20-
extent that)) . . . (2) such a claim is for unmatured interest."
This section is a codification of the pre-Code rule that courts
need not recognize the accrual of interest during the pendency of
bankruptcy.15 When read in isolation, the plain language of
§ 502(b)(2) appears to extinguish a creditor's right to earn
interest and a debtor's obligation to pay it.
A court's duty in interpreting the Bankruptcy Code, however,
is to read the statute holistically. United Sav. Ass'n v. Timbers
of Inwood Forest Assocs., Ltd., 484 U.S. 365, 371 (1988). As the
majority recognizes, Congress has codified an exception to the
general rule.16 Section 726(a) of the Bankruptcy Code, which
controls the order of distribution in chapter 7 cases, mandates to
the court that the
property of the estate shall be distributed))
(5) fifth, in payment of interest at the legal rate from
the date of the filing of the petition, on any claim paid
under paragraph (1), (2), (3), or (4) of this subsection
. . . .
15
See Sexton v. Dreyfus, 219 U.S. 339, 344-46 (1911) (examining origins
of American rule derived from English bankruptcy system); see also Thomas v.
Western Car Co., 149 U.S. 95, 116-17 (1893) (recognizing rule); American Iron
& Steel Mfg. Co. v. Seaboard Air Line Ry., 233 U.S. 261, 266-67 (1914)
(recognizing rule and exceptions); City of New York v. Saper, 336 U.S. 328, 330
& n.7 (1949) (same).
16
In fact, the Code provides at least three exceptions. Section
726(a)(5) is discussed in the text. Section 506(b) allows interest to a secured
creditor to the extent the secured property is greater than the amount of the
claim. See United States v. Ron Pair Enters., Inc., 489 U.S. 235, 245-46 (1989)
(interpreting § 506(b)). Section 1124 specifically permits reinstatement of a
debt according to its original contractual terms if the debtor brings current the
payments of principal and interest accrued during bankruptcy. See United Sav.
Ass'n v. Timbers of Inwood Forest Assocs., Ltd. (In re Timbers of Inwood Forest
Assocs., Ltd.), 808 F.2d 363, 380 (5th Cir. 1987) (en banc) (Jones, J.,
dissenting), aff'd, 484 U.S. 365, 371 (1988).
-21-
This rule, like that codified in § 502(b)(2), claims an impressive
pedigree from a long line of pre-Code decisions. See, e.g.,
2 WILLIAM BLACKSTONE, COMMENTARIES *488 ("[T]hough the usual rule is,
that all interest on debts carrying interest shall cease from the
time of issuing the commission, yet, in the case of a surplus left
after payment of every debt, such interest shall revive, and be
chargeable to the bankrupt or his representatives.").17 Its effect
is that when sufficient assets remain in the estate after prior
distributions, the bankruptcy court is required to pay the
creditors interest.18 The only lower distribution returns the
remaining assets to the debtor. § 726(a)(6).
Accordingly, throughout bankruptcy, the debtor retains the
obligation to pay its creditors interest. When sufficient assets
remain upon distribution, the court must provide for the payment of
interest. No doubt the creditors would insist on as much. And,
while actual payment may be unlikely, the obligation to pay is not.
Such an obligation, therefore, is not extinguished, but, for
purposes of the bankruptcy proceedings, is ignored until the time
17
Thus, while pre-Code precedent supports the argument that interest
stops running when a bankruptcy petition is filed, Sexton, 219 U.S. at 344, this
practice was not absolute. Two, if not three, exceptions were recognized. See
Ron Pair, 489 U.S. at 246. The two well-recognized rules were: If the alleged
bankrupt proved solvent, creditors received post-bankruptcy interest before any
surplus was returned to the bankrupt; and if securities of the bankrupt produced
interest or dividends during bankruptcy, such amounts were supplied to post-
bankruptcy interest. Saper, 336 U.S. at 330 n.7. Of more doubtful origin, under
pre-Code precedent, was an exception for oversecured claims. Ron Pair, 489 U.S.
at 246.
18
Because § 726(a)(5) states that the interest should be set "at the
legal rate," Texas state law determines the existence and amount of interest.
See generally Chaim J. Fortgang & Lawrence P. King, The 1978 Bankruptcy Code:
Some Wrong Policy Decisions, 56 N.Y.U.L. Rev. 1148, 1151-52 (1981) (discussing
whether "legal rate" means statutory rate or rate set by contracts). As no rate
was set by the contracts here, this problem is not presented.
-22-
the court determines whether the debtor's assets can meet the
obligation.19 Only upon discharge, see § 727, is the state law
obligation to pay extinguished.
This result occurs because § 502(b)(2) is a matter of
convenience, not substantive law.20 That section is premised upon
the idea of making bankruptcy proceedings easier and fairer to
administer, not replacing state property law with federal. The
Supreme Court explained the pre-Code justification of the rule
thus:
19
Courts in applying the general rule of 502(b)(2) have used various
terms to describe its effect: Interest is "suspended," Nicholas v. United
States, 384 U.S. 678, 682 & n.9 (1966), ceases to run, Ron Pair, 489 U.S. at 246,
stops, Saper, 336 U.S. at 330, is "not computed," Sexton, 219 U.S. at 344, and
is not allowed, Vanston, 329 U.S. at 163. The exact terminology, while
important, does not overcome the requirements of the Bankruptcy Code, however.
As discussed below, where the Code provides an exception to the general rule, the
right to the interest continues to exist.
20
The leading commentary on bankruptcy has recognized as much:
[C]are must be taken not to confuse tax accrual concepts and payment
in a title 11 context. Section 502(b)(2) of the Bankruptcy Code
prescribes the grounds for objecting to claims in a title 11 case.
By itself, it does not change the legal rights of the holder of an
obligation against the debtor. Put another way, the general rule in
title 11 cases that there is no accrual of postpetition interest is
a rule of convenience governing distributions to creditors. It is
not a rule of substantive law that converts an interest-bearing
indebtedness to a nonenforceable, non-interest-bearing indebtedness.
Even In re Continental Vending Mach. Corp., [77-1 U.S. Tax Cas.
(CCH) ¶ 9,121, at 86,093 (E.D.N.Y. 1976)], which is often cited for
the opposite position against tax accrual of post-petition interest,
state unequivocally:
A bankruptcy petition, whether straight or a corporate
reorganization, . . . suspends or postpones the accrual of interest
even though the "claim has not lost its interest-bearing quality."
Id. at 86,097-98 (citing 6A COLLIERS ON BANKRUPTCY ¶ 9.08, at 194 (14th
ed.)).
1A ELIOT G. FREIER ET AL., COLLIERS ON BANKRUPTCY ¶ 22.05, at 22-40 (Lawrence P. King ed., 15th
ed. 1988) [hereinafter COLLIERS ON BANKRUPTCY]; see also 3 COLLIERS ON BANKRUPTCY, supra,
¶ 502.02[2] (discussing general principles of bankruptcy as applied to unmatured
interest).
-23-
Accrual of simple interest on unsecured claims in
bankruptcy was prohibited in order that the
administrative inconvenience of continuous recomputation
of interest causing recomputation of claims could be
avoided. Moreover, different creditors whose claims bore
diverse interest rates or were paid by the bankruptcy
court on different dates would suffer neither gain nor
loss caused solely by delay.
Vanston, 329 U.S. at 164. Nothing in the text or the legislative
history of this section of the Bankruptcy Code, which admits to
codifying much of the pre-Code practice, suggests that Congress
adopted this rule for any other purpose. See John C. McCoid, II,
Pendency Interest in Bankruptcy, 68 Am. Bankr. L.J. 1, 9 (1994)
("Though Congress said more this time, there is nothing in the
legislative history that indicates any intention to effect any
change in the law on the subject of pendency interest by virtue of
these sections.").21
21
Indeed, the legislative history in the Senate and House reports
accompanying the Bankruptcy Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549, shows
that the current Bankruptcy Code enacted much of the pre-Code rules regarding
pendency interest. See S. Rep. No. 989, 95th Cong., 2d Sess. 62-63 (1978),
reprinted in 1978 U.S.C.C.A.N. 5787, 5848-89 (stating that § 502(b)(2) contains
"two principles of current law," including rule that unmatured interest is
disallowed); H. Rep. No. 595, 95th Cong., 1st Sess., 352-53 (1977), reprinted in
1978 U.S.C.C.A.N. 5963, 6308 (same); S. Rep. No. 989, 95th Cong., 2d Sess. 97
(1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5883 (stating that §726(a)(4)
provides that punitive penalties are subrogated to all other claims, "except
interest accruing during the case"; § 726(a)(5) provides for post-petition
interest where assets remain); H. Rep. No. 595, 95th Cong., 1st Sess. 383
(1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6339 (same); see also Report of the
Committee of Finance, S. Rep. No. 95-1106, 95th Cong., 2d Sess. 22-23 (1978),
reprinted in 3 app. COLLIERS ON BANKRUPTCY, supra, at Tab VI (recognizing "subordination
rule" for post-petition interest and recommending that tax liens and interest be
"non-dischargeable"). A search of the Congressional Record reveals no discussion
or even language suggesting that the pre-Code rules should be discarded or
Vanston legislatively overturned. See 124 Cong. Rec. 1783 (1978); 124 Cong.
Rec. 32,383 (1978); 124 Cong. Rec. 34,143 (1978); 124 Cong. Rec. 28,257 (1978).
Finally, the suggested bill contained in the report of the Commission of the
Bankruptcy Laws of the United States, which provided much of the legislative
impetus for the 1978 Act, provided an explicit provision for the payment of
interest. McCoid, supra, at 8-9 (citing Report of the Commission on the
Bankruptcy Laws of the United States § 4-405(a)(8), H.R. Doc. No. 137, 93d Cong.
1st Sess., Part II, at 110 (1973)).
(continued...)
-24-
Moreover, our precedent and Supreme Court caselaw conclude
that § 502(b) does not void the state property interests, but only
ignores it until distribution as a matter of policy. In Fahs, we
stated that
[t]he Vanston case seems to us to establish a rule only
for the distribution of a bankrupt's assets. It did not
hold that such a claim was void, but only that the
claimant should not participate in the distribution of
assets until all claims superior in conscience and
fairness were paid.
224 F.2d at 394. We have followed this reasoning in applying the
current Bankruptcy Code. See United Sav. Ass'n v. Timbers of
Inwood Forest Assocs., Ltd. (In re Timbers of Inwood Forest
Assocs., Ltd., 793 F.2d 1380, 1386 n.5 (5th Cir. 1986) ("Put
differently, the petition suspended the contract right to accrue
interest; it did not extinguish the right."), reinstated, 808 F.2d
363 (5th Cir.), (en banc), aff'd, 481 U.S. 1068 (1987).
Likewise, the Supreme Court has continued to adhere to
Vanston.22 In sum, § 502(b)(2), as a non-substantive rule, does not
(...continued)
I have examined the legislative history to show that the majority's
reliance upon the Senate and House reports discussing § 502(b)(2) is incomplete.
That section must be read in context with the other sections of the Code, their
legislative history, and the pre-Code practice that the Code adopted.
22
See Nicholas v. United States, 384 U.S. 678, 689 (1966) (quoting
Vanston passage with approval); Bruning v. United States, 376 U.S. 362, 362 n.4
(1964) (same); American Iron, 233 U.S. at 266 (explaining that the pre-Code rule
applies, "not because the claims had lost their interest-bearing quality during
[receivership], but [because it] is a necessary and enforced rule of
distribution, due to the fact that in case of receiverships the assets are
generally insufficient to pay debts in full."); 3 COLLIER ON BANKRUPTCY, supra,
¶ 502.2[2], at 34-34.1 (noting that § 502(b)(2)'s "disallowance of claims for
unmatured interest or claims accruing after the date of the filing of the
petition is one of policy and convenience rather than a statement of substantive
law").
-25-
void the state right to interest, but merely limits its eventual
distribution.
While the majority does not say so explicitly, it treats
section 502(b) as a substantive rule. According to the majority,
the non-contingent, state-law obligation to pay pendency interest
becomes "contingent" upon the filing of the bankruptcy petition.
The majority does not mean that payment is contingent, as
sufficient funds must remain in order for the debt to be paid.
Rather, reasoning that the ultimate distribution of any interest is
contingent upon there being assets remaining in the estate to pay
it, the majority holds that "the condition necessary to create the
liability for the post-petition interest failed to occur."
(Emphasis added). See also 2 JACOB MERTENS, JR., MERTENS LAW OF FEDERAL
INCOME TAX § 12A.138, at 253 (1994) ("The liability ceases to exist
when the property of the corporation passes into the receiver's
hands.").
In effect, the majority snuffs out the state-law obligation to
pay interest and reimposes it at the end of distribution only upon
the contingency that assets remain. The majority thus presents two
difficult conceptual problems that it does not address. First, the
majority does not explain what the source of this interest would be
upon distribution. Does the majority believe that § 726(a)(5) is
an independent source for a federal property right? Second, if the
source of the right is Texas state property law, how is the risk of
ultimate distribution under § 726(a)(5) different from the risk of
distribution of any debt in bankruptcy?
-26-
The majority's non-answer to these difficult questions is to
resort to one case, Guardian Inv. Corp. v. Phinney, 253 F.2d 326
(5th Cir. 1958), which it claims "provides a framework to consider
the contingent nature of an obligation for income tax purposes."
Perhaps Guardian does, but that case is easily distinguishable from
the situation here, as in Guardian the obligation to pay the debt,
a second mortgage, was contingent by the terms of the agreement
itself. Here, the state property right is not contingent by its
terms. Moreover, Guardian does not even mention the Bankruptcy
Code. A 1958 case that fails even to mention the Bankruptcy Code
can be of little assistance in interpreting the current Code,
substantially codified in 1978. Its application is simply an
anachronism.
Rather than wander so far afield and out of time, I would turn
to the current Bankruptcy Code and interpret the interplay between
§§ 502(b)(2) and 726(a)(5) as settling a scheme for distribution of
the fixed obligation to pay interest. Section 502(b)(2), which
directs courts to ignore pendency interest, codifies a rule of
convenience in order to ease the administration of the bankruptcy
process. Section 726(a)(5) preserves the debtor's obligation to
pay this debt as a matter of fairness to the creditors.
This interpretation of the Bankruptcy Code is consistent with
the language of the statute, pre-Code caselaw, the legislative
history, the view of the leading commentary on bankruptcy, and, not
-27-
least of all, our precedent.23 In sum, Kellogg retains the
obligation to pay pendency interest. The remaining question is
whether the improbability of payment prevents Kellogg from
deducting the interest.
C.
Finally, I return to an application of Fahs, in which a
bankruptcy trustee attempted to deduct interest owed on mortgage
indentures that accrued during the pendency of bankruptcy. The
government objected, in part, on the ground that the interest was
"not accruable and deductible for income tax purposes in view of
the fact that there is little or no likelihood that it will ever be
paid." 224 F.2d at 393. We, however, held that "interest on an
unconditional legal obligation is deductible for income tax
purposes by an accrual basis taxpayer, notwithstanding the
improbability of its being paid . . . ." Id. at 395.
Contrary to the holding of the bankruptcy court here, Fahs
remains the law of this circuit.24 Even the Tax Court has
23
Even the Tax Court has recognized the continuing validity of Fahs. See
Southeastern Mail Trans. Inc. v. Commissioner, 63 T.C.M. (CCH) 2893, 2905-06
(1992). Apparently, it is also consistent with earlier IRS policy. See, e.g.,
Rev. Rul. 70-367, 1970-2 C.B. 37 (1970) (holding that interest accrued for
obligations of debtor corporation undergoing reorganization under Bankruptcy
Act). "The doubt as to the payment of such interest is not a contingency of a
kind that postpones the accrual of the liability until the contingency is
resolved." Id.
24
See, e.g., Tampa & Gulf Coast R.R. v. Commissioner, 469 F.2d 263, 264
(5th Cir. 1972); Lawyer's Title Guar. Fund v. United States, 508 F.2d 1, 6 (5th
Cir. 1975) ("The law also is that a bare possibility of non-payment or delay in
payment because of the principal's financial condition does not defeat accrual
either."); W.S. Badock Corp. v. Commissioner, 491 F.2d 1226, 1228 (5th Cir.
1974) (recognizing rule that risk of collection does not defeat fixed liability
for accrual purposes). The government does correctly note that we have created
(continued...)
-28-
recognized the continuing validity of Fahs. See Southeastern Mail
Transp. Inc. v. Commissioner, 63 T.C.M. (CCH) 2893, 2905-06
(1992).25 The majority opinion accepts as much.
The justification for the Fahs rule is simple. As every debt
is subject to the risk of non-payment, a rule requiring absolute
certainty of repayment as a prerequisite to accruing and deducting
interest would make I.R.C. § 163 a nullity. No one could rely upon
the accrual method. The Fahs court accordingly focused instead
upon the obligation to pay. To be able to deduct a debt under the
accrual method and the "all events" test, there only must be a
(...continued)
an exception to the rule in Fahs. Where there is no possibility of eventual
payment, no obligation is fixed, and therefore an interest deduction is improper.
In Tampa & Gulf Coast R.R., 469 F.2d at 264, for example, we recognized the
general principle of Fahs but held that it had to give way to extreme
circumstances of the case before it. In Tampa, a parent and subsidiary
corporation had created a tax shelter where the rent payments from the parent to
the subsidiary were offset by accrued but unpaid interest payments on debts to
the parent. The court found that Fahs did not apply, as the debt would never be
paid on account of the beneficial tax relationship between the corporations.
25
Even the Tax Court, at times, appears to apply an approach similar to,
but more restrictive than, Fahs. See Cohen v. Commissioner, 21 T.C. 855, 857
(1954) (holding that deductions are proper, except where interest "categorically"
will not be paid); Jordon v. Commissioner, 11 T.C. 914, 925 (1948) (same); see
also Zimmerman Steel Co. v. Commissioner, 45 B.T.A. 1041 (1941) (outlining
general approach), rev'd, 130 F.2d 113 (8th Cir. 1952). The Third Circuit
apparently has acquised in the Tax Court's approach. See Pearlman v.
Commissioner, 153 F.2d 560, 563 (3d Cir. 1946) (affirming Tax Court decision
reported at 4 T.C. 34 (1944) that applies Tax Court's interpretation of
Zimmerman).
The Eighth Circuit, the Eleventh Circuit, and the Court of Federal Claims,
however, follow the rule we adopted in Fahs. See Keebey's Inc. v. Paschal, 188
F.2d 113, 115-16 (8th Cir. 1951); Zimmerman Steel Co. v. Commissioner, 130 F.2d
1011, 1012 (8th Cir. 1942); Sartin v. United States, 5 Cl. Ct. 172, 176 (1984)
(citing Fahs rule with approval); cf. Bonner v. City of Prichard, 661 F.2d 1206,
1207 (11th Cir. 1981) (en banc) (holding that Fifth Circuit precedent prior to
circuit split is binding on the Eleventh Circuit). The leading case not
following Fahs originates from a district court in the Second Circuit. See In
re Continental Vending Mach. Corp., 77-1 U.S. Tax Cas. (CCH) ¶ 9121 (E.D.N.Y.
1976).
-29-
fixed and unconditional obligation to pay.26 Accordingly, the
validity of that obligation is measured at the time it is fixed,
not at the future date it should be paid.
Here, there is no dispute that the unsecured debts are valid
obligations to which Texas state law attaches the obligation to pay
interest after they are thirty days overdue. While the imposition
of bankruptcy is probative of the uncertainty concerning the
payment of the pendency interest, there is no allegation by the
government, or concession by Kellogg, that the interest debt will
never be paid. As long as the debt could be paid, the obligation
remains. I would hold that the deduction was proper, and the
bankruptcy court erred in refusing to follow Fahs.27 Accordingly,
I respectfully dissent.
26
See I.R.C. §§ 163, 461; Treas. Reg. § 1.461-1(a)(2); see also, e.g.,
United States v. Hughes Properties, Inc., 476 U.S. 593, 600 (1986) ("[T]o satisfy
the all-events test, a liability must be final and definite in amount, must be
fixed and absolute, and must be unconditional.").
27
As this result would moot the 11 U.S.C. § 505(b) issue, I do not
address it.
-30-
Matter of West Texas Marketing Corp.
Court: Court of Appeals for the Fifth Circuit
Date filed: 1995-06-01
Citations: 54 F.3d 1194
Copy CitationsCombined Opinion