Bankruptcy Taxation Committee

Volume 2, Number 1 / February 2005

In This Issue:

• Taxing Authority May Not Assert Sovereign Immunity in Post-sale Proceeding to Determine the Estate’s Tax Liability
• Protecting Trading Markets and NOLs in Chapter 11
• Committee Appoints New Chairs

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Taxing Authority May Not Assert Sovereign Immunity in Post-sale Proceeding to Determine the Estate’s Tax Liability

by Jordi Guso Esq., Berger Singerman P.A., Miami, Fla.

The U.S. Bankruptcy Court for the Southern District of Florida recently held that a county taxing authority may not invoke sovereign immunity as a defense to a debtor’s request for a determination of its tax liability, where the property upon which the taxing authority asserts a lien was sold pursuant to §363(f) of the Bankruptcy Code, and the lien of the taxing authority attached to the proceeds of the sale. In re Lake Worth Generation, LLC, 2004 Bankr. LEXIS 2040 (Bankr. S.D. Fla. Dec. 9, 2004) (Paul G. Hyman Jr., Judge). Applying the Supreme Court’s recent ruling in Tennessee Student Assistance Corporation v. Hood (In re Hood), 541 U.S. 440, 158 L. Ed. 2d 764, 124 S.Ct. 1905 (2004), the Lake Worth court held that it has exclusive jurisdiction over property of the estate, even after the estate is monetized. The res created following the sale rendered the debtor’s request for a determination of its tax liability an in rem proceeding in which sovereign immunity is not available as a defense.

Facts in Lake Worth

The debtor in the Lake Worth case was a Delaware limited liability company formed to design, build and operate a power generation plant in the city of Lake Worth, Fla. Construction on the project began in June 2001. The construction included the acquisition and installation of a General Electric—7FA turbine. While in the process of constructing the plant, the debtor’s financing for the project collapsed due in part to the financial woes of Enron, which guaranteed a portion of the financing. When the debtor exhausted all sources of debt and equity financing, the debtor could not complete construction of the project. The debtor then filed for chapter 11 protection.

During the course of the case, the debtor determined that the value of its assets could be best maximized through a court-approved sale. Accordingly, the debtor requested that the court approve competitive bidding procedures for the sale of its assets. The Palm Beach County Tax Collector (the “Tax Collector”) asserted that it held a lien on the property to collateralize the debtor’s unpaid personal property taxes.1 The Tax Collector did not file a formal proof of claim in the case. The Tax Collector sought various forms of relief, including a dismissal of the debtor’s case. It also objected to the sale and bid procedures proposed by the debtor. The court overruled the Tax Collector’s objections. The court approved sale and bidding procedures, and authorized the debtor to solicit competitive bids for the assets. The court then scheduled an auction to consider the highest and best bid. At the conclusion of the auction, the court approved a high bid of $10,050,000 for the assets. It authorized the debtor to convey the assets to the purchaser free and clear of liens, claims and encumbrances, and provided that any liens, claims or encumbrances not paid at closing would attach to the proceeds of the sale. The Tax Collector’s lien was not paid at closing.

Following the closing, the Tax Collector filed a motion seeking to compel the payment of the state’s statutory lien for unpaid personal property taxes. The Tax Collector asserted that the county was owed approximately $345,000 for the 2003 personal property taxes based on the $16,000,000 assessed value of the debtor’s assets. The 2004 personal property taxes would also be due by no later than March 2005. The debtor filed a response to the Tax Collector’s motion, which included a request pursuant to §505 of the Bankruptcy Code for a determination of the estate’s tax liability to the Tax Collector (the “505 Motion”). In response to the 505 Motion, the Tax Collector filed a number of pleadings, including a request to dismiss the 505 Motion. The Tax Collector asserted the following grounds in support of its contention that the court could not consider the 505 Motion:

1. The lack of subject matter jurisdiction pursuant to the Eleventh Amendment of the Constitution protects the sovereign immunity of the Tax Collector;
2. The Tenth Amendment precluded the court from determining the debtor’s tax liability;
3. The debtor’s challenge was not commenced as an adversary proceeding, but instead filed as a motion;
4. The 505(a) motion was a disguised attempt to secure a refund; and
5. The court should abstain from determining the debtor’s tax liabilities out of respect for state law.

The debtor argued that the court should determine the amount of the estate’s tax liability pursuant to §505(a) of the Bankruptcy Code because:

1. The Tax Collector is not an arm of the state and is, therefore, not entitled to sovereign immunity;
2. Although the Tax Collector did not file a formal proof of claim, the Tax Collector’s substantial participation in this case constituted a waiver of sovereign immunity;2 and
3. The court had exclusive in rem jurisdiction over the remaining property of the estate—the proceeds of the sale.

The Hood Rationale

In Hood, the debtor filed a complaint against the Tennessee Student Assistance Corporation (“TSAC”), seeking a determination of the dischargeability of a student loan. TSAC was created by the Tennessee Legislature to administer student assistance programs. Hood, 124 S.Ct. at 1908. In response, TSAC filed a motion to dismiss the complaint for lack of jurisdiction, asserting sovereign immunity. Id. The court denied TSAC’s motion, holding that §106(a) of the Bankruptcy Code was a valid abrogation of the state’s sovereign immunity, which TSAC could not assert. Id. at 1909. In affirming the court and the Bankruptcy Appeal Panel, the Sixth Circuit Court of Appeals expanded on the bankruptcy court’s analysis and explained that the states “ceded their immunity from private suits in bankruptcy in the Constitutional Convention and, therefore, the Bankruptcy Clause of the Constitution, Art. 1, §8, cl. 4, provided Congress with the necessary authority to abrogate state sovereign immunity in 11 U.S.C. §106(a).” Id. (citing In re Hood, 319 F.3d 755, 767 (6th Cir. 2003)).

The Supreme Court held that a student’s loan debt is dischargeable in bankruptcy, but declined to reach the Sixth Circuit’s holding that Congress validly abrogated the states’ sovereign immunity pursuant to §106(a).3 Id. Instead, the Supreme Court held that a bankruptcy court’s exercise of its in rem jurisdiction over a debtor’s bankruptcy estate would not infringe state sovereign immunity. Id. at 1913. As a consequence of the court’s in rem jurisdiction, states, even those that choose not to participate in a bankruptcy proceeding, are bound by a bankruptcy court’s discharge order in the same way as are participating creditors. Hood, 124 S.Ct. at 1911 (citing New York v. Irving Trust Co., 288 U.S. 329, 77 L. Ed. 815, 53 S. Ct. 389 (1933)).

Application of Hood Rationale Post-sale

Applying the Hood rationale, the Lake Worth court concluded that it exercised in rem jurisdiction over the proceeds of the sale of the debtor’s personal property. Reasoning that the court has the authority to authorize a sale of property “free and clear” of a state’s tax lien, Hood, 124 S.Ct. at 1911 (citing United States v. Nordic Village, Inc., 503 U.S. 30, 117 L. Ed. 2d 181, 112 S. Ct. 1011 (1992)), the Lake Worth court went on to add that the court’s in rem jurisdiction extends to the distribution of those proceeds, including distributions to satisfy tax liens. It was undisputed that the proceeds of the sale retained by the debtor far exceeded the maximum amount of the debtor’s potentially liability to the Tax Collector. Accordingly, the debtor could invoke the powers granted by §505(a) of the Bankruptcy Code to obtain a determination of its tax liability and, thus, the amount of the proceeds that should be distributed to the Tax Collector in satisfaction of the lien. The court’s power to authorize a sale of property free and clear of liens or, alternatively, to preserve the proceeds of a sale to satisfy a lien, would not make sense unless the court could first determine the extent of the debt that gave rise to an outstanding lien. The court also found that the debtor was not required to file an adversary proceeding inasmuch as, inter alia, the Tax Collector had commenced the dispute by motion, and that abstention was neither required nor warranted under the circumstances.