Contributed by Yvanna Custodio and Max Goodman
“Attention Kmart shoppers:” Judge Susan Pierson Sonderby of the United States Bankruptcy Court for the Northern District of Illinois issued a memorandum decision in Kmart Corp. v. Ill. Dep’t of Rev. (In re Kmart Corp.) regarding the application of what is now section 1146(b) of the Bankruptcy Code, which allows the bankruptcy court to rule on questions of law with respect to the state or local income tax consequences of a plan under section 346 of the Bankruptcy Code if there is disagreement on such tax consequences between the plan proponent and the state or local taxing authority. In the case, Kmart Corporation, a retailer known for its “blue light specials” on discounted items, commenced a post-confirmation adversary proceeding seeking declaratory relief regarding the effects under section 346 of Kmart’s plan of reorganization on its Illinois income tax liability. The court dismissed the adversary proceeding for lack of subject matter jurisdiction, holding that declarations of the effect under section 346 of a plan on the debtor’s state income tax liability can only be brought via section 1146(b), and that proceedings seeking such relief under section 1146(b) cannot be commenced after plan confirmation.
The debtor, Kmart, had suffered significant operating losses and had accumulated net operating losses (“NOLs”) for federal and Illinois income tax purposes prior to and during its bankruptcy. As a result of the entry of the confirmation order approving Kmart’s plan of reorganization, the reorganized debtor was discharged of certain debt, including certain principal amounts of borrowed funds evidenced by promissory notes (referred to in the decision as the “Borrowed Debt”). At issue was whether the pre-2005 version of section 346 required the reorganized debtor to reduce its NOLs by the amount of the cancelled Borrowed Debt for Illinois income tax purposes. Kmart wanted to retain as much of its NOLs as possible in order to reduce its post-bankruptcy Illinois income tax liability, and argued that section 346 mandated that “the cancelled Borrowed Debt should not be included in the cancelled debt that reduces its NOLs.” The Illinois Department of Revenue asserted the opposite.
Kmart initiated its adversary complaint for declaratory relief more than seven years after its plan confirmation. The court raised jurisdictional concerns on its own initiative and asked the parties to brief the issue.
After finding that the proceeding involved an actual controversy—one of the requisites for subject matter jurisdiction over a proceeding seeking declaratory relief—the court analyzed whether it possessed “arising under,” “arising in,” or “related to” jurisdiction—the three sources of subject matter jurisdiction for bankruptcy courts. According to the court, “related to” jurisdiction exists only where the determination affects the amount or allocation of property available for distribution among creditors. As acknowledged by the parties, “related to” jurisdiction did not exist in this case because “resolution of this dispute will have no direct appreciable impact on the distribution to creditors of the Kmart estate or the allocation of estate property among them.” Although not discussed in any detail by the court, “arising in” jurisdiction presumably did not exist because the proceeding was initiated after the effective date of the plan.
Kmart argued that “arising under” jurisdiction existed because the proceeding involved the application of section 346, and the court could grant declaratory relief involving section 346 under its general bankruptcy jurisdiction. The court, however, concluded that section 1146(b) provides the sole avenue permitting a bankruptcy court to review the effect under section 346 of a plan on a debtor’s state income tax liability. To hold otherwise, according to the court, would render section 1146(b) superfluous. Therefore, the court had subject matter jurisdiction over the proceeding only if section 1146(b) applied. (Query whether section 1146(b) might be more properly viewed as the sole pre-confirmation avenue for a bankruptcy court to review the effect under section 346 of a plan on a debtor’s state income tax liability, with such court retaining general bankruptcy jurisdiction to resolve actual controversies involving section 346 post-confirmation — an interpretation that would not render section 1146(b) superfluous.)
The court then noted that section 1146(b) requires a request for a determination of the state income tax effects of a plan under section 346 to be brought by a “plan proponent.” According to the court, Kmart was no longer a plan proponent when it initiated the complaint because the plan had been confirmed, and the use of the phrase “plan proponent” in section 1146(b) connotes that “the proceeding must be brought and resolved prior to confirmation.” The court cited legislative history describing section 1146(b) as allowing a plan proponent to request “an advance ruling on the tax effects of the proposed plan” in support of this conclusion. While noting that section 1146(b) is included in a subchapter entitled “Postconfirmation Matters,” the court first stated that subchapter headings are not controlling, and then observed that section 1146(b) in a sense concerns postconfirmation matters because determinations thereunder are binding on the debtor and state taxing authority after confirmation. The court thus held that “declarations of the effect under section 346 . . . of a plan on the debtor’s state income tax liability can only be sought via section 1146(b) and are limited to the pre-confirmation time period at the request of a plan proponent. Because this proceeding was commenced after the confirmation of the plan, this court does not have jurisdiction and therefore cannot make such a declaration.”
The Kmart decision is important to bankruptcy practitioners because its narrow view of the time period during which section 1146(b) may be invoked successfully severely restricts the utility of section 1146(b) to plan proponents. Under section 1146(b), a bankruptcy court can declare the state and local income tax consequences of a plan only if the plan proponent has (with bankruptcy court approval) requested a determination from the taxing authority and either (i) the taxing authority has responded adversely or (ii) 270 days (i.e., approximately 9 months) since the request have lapsed. Accordingly, the Kmart court’s holding that bankruptcy courts cannot make determinations under section 346 outside of section 1146(b) leaves debtors who cannot timely avail themselves of section 1146(b) and who wish to challenge state income tax determinations that they believe are inconsistent with section 346 to pursue such disputes in forums that are perceived to be less debtor-friendly. A further discussion of section 1146(b) may be found in Section 1102.17 of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2012 ed.).