United States: Bankruptcy Sales: "Free And Clear" Meets Tax Injunction Act

Last Updated: May 23 2014
Article by Vicki Harding

In re Old Carco LLC, 505 B.R. 151, (Bankr. S.D.N.Y. 2014)

A bankruptcy purchaser filed a motion with the bankruptcy court to prevent state tax authorities from using the debtor's experience rating to determine purchaser's unemployment insurance tax rate. It argued that this was prevented by the court order approving the sale "free and clear" of all interests. The states responded with a variety of defenses, including sovereign immunity, lack of bankruptcy jurisdiction, and the Tax Injunction Act.

As background, employers are required to pay state unemployment taxes. In computing a state tax rate, there is an attempt to match the predicted amount of unemployment benefits to the funding necessary to pay those benefits. In predicting benefits, a state typically relies on historical claims experience for the preceding 36 months.

In this case Michigan, Illinois and Indiana calculated a portion of their state unemployment tax rate by dividing the benefits charged during the prior 36 months by the taxable wages for Federal Unemployment Tax Act purposes for that same period. The court referred to this as the "experience rating."

A new company receives a relatively low tax rate. However, if the new company is deemed to be a "successor" of an old company, the old company's experience rating will be used for the new company. In this case, each state found the purchaser (New Chrysler) to be a successor to the debtor (Old Carco). New Chrysler failed to contest any of the state determinations in a timely manner under applicable state rules.

Over a four year period this meant that New Chrysler paid in excess of $50 million more than it would have paid as a new employer. (New Chrysler was assessed in Michigan at a rate of 10.2% v. 2.7% for a new employer, and in Indiana at a rate of 5.6% instead of 2.7%.)

The bankruptcy court order approving the sale (1) enjoined a number of people, including "governmental, tax and regulatory authorities," from asserting claims against New Chrysler related to operation of the assets prior to closing, (2) provided that New Chrysler would not be liable for any pre-closing claims, and (3) provided that it was not liable for any successor liabilities "including, but not limited to, liabilities on account of any taxes arising, accruing or payable under, out of, in connection with, or in any way relating to the operation of the Purchased Assets prior to the Closing of the Sale Transaction." The court retained jurisdiction to interpret and implement the sale order.

In reaching a decision, the court focused on the Tax Injunction Act (28 USC §1341) which provides:

The district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.

The goal is "to prevent a federal court from interfering with ordinary procedural requirements imposed under state law and obstructing and avoiding potential damage to a state's budget particularly where the taxpayer faces the risk of insolvency."

The court noted that although the Act references injunctions, it also prohibits declaratory relief. Further, the court did not view this as a rule of abstention, but rather as depriving a federal court of subject matter jurisdiction.

While noting other cases in which a bankruptcy court concluded that it had jurisdiction to implement and enforce its own sale order notwithstanding the Tax Injunction Act, the Chrysler court disagreed. In its view the jurisdiction to deal with a sale order did not affect its jurisdictional analysis under the Tax Injunction Act.

The court did note that a specific provision of the Bankruptcy Code allowing adjudication of a state tax claim would provide an exception to the jurisdictional bar. Examples included Sections 362(a), 505(a), 507(a), 523(a)(1), 524 and 1146(a) (formerly 1146(c)). However, in its view the Section 363(f) provision allowing sales free and clear of interests was not such a provision.

The Tax Injunction Act itself provides an exception if a state does not provide a "plain, speedy and efficient remedy." This has been interpreted to mean that a taxpayer has a right to sue to recover a tax already paid, to assert his federal rights and to secure review by the Supreme Court. However, this exception is to be construed narrowly, and a failure to take advantage of available remedies is not sufficient to meet the test.

The court found that in each state the procedures were sufficient. New Chrysler could have argued in state court that the bankruptcy sale order precluded the state from using the debtor's experience rating to calculate New Chrysler's unemployment insurance tax rate.

Consequently, the Tax Injunction Act was applicable, and the court did not have jurisdiction to consider the New Chrysler's request. Because the court found that it did not have subject matter jurisdiction, it declined to enjoin any of the states – even those that did not raise the Tax Injunction Act.

As noted above, there are various provisions of the Bankruptcy Code relating to state taxes that are not affected by the Tax Injunction Act. However, as illustrated by this case, there may be circumstances where the Act can override the Bankruptcy Code. This suggests that a purchaser of assets out of a bankruptcy should give careful consideration to contesting adverse tax determinations in the applicable state forum, as opposed to relying on an ability to obtain relief in the bankruptcy court.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki Harding
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