In Central Valley AG Enterprises v. United States,1 the United States Court of Appeals for the Ninth Circuit addressed the issue of whether a bankruptcy court has jurisdiction under section 505 of the Bankruptcy Code to redetermine a debtor’s tax liability on partnership income, despite the issuance of a Notice of Final Partnership Administrative Adjustment (“FPAA”) by the IRS Appeals Office. In Central Valley, although neither the debtor nor any other partner of the debtor had challenged the FPAA decision within the 150-day readjustment period provided under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”),2 the Ninth Circuit Court of Appeals held that the bankruptcy court had jurisdiction to redetermine the partnership tax liability, notwithstanding the possibility that there could be inconsistent findings with respect to the non-debtor partners.
In 1991, Orange Coast Enterprises (“Orange Coast”), a wholly owned subsidiary of Central Valley AG Enterprises (“Central Valley”), acquired a 98 percent partnership share in Astropar Leasing Partnership (“Astropar”). Since the adoption of TEFRA,3 all partners in a partnership are deemed parties to a single tax court proceeding pursuant to Internal Revenue Code (“I.R.C.”) section 6226(c), and the tax treatment of any partnership item is determined at the partnership level.4 For TEFRA purposes, and under I.R.C. sections 6231(a)(2) and (10), Central Valley qualified as an “indirect partner” in Astropar by virtue of its ownership of Orange Coast.
As a result of participation in a tax shelter, Astropar reported significant losses on its partnership tax returns for 1993, 1994 and 1995. As partnerships are not taxed directly, 98 percent of these reported losses passed to Central Valley through its Orange Coast subsidiary, thereby decreasing Central Valley’s reported tax liability. The losses were eventually disallowed upon the IRS’s determination that the tax shelter was invalid, and Central Valley was consequently left with a tax deficiency.
After the IRS made adjustments to Astropar’s returns for these tax years, the Astropar partners filed protests on Astropar’s behalf. The protests led to a conference with the IRS Appeals Office, with Central Valley participating through the Astropar partners. The conference failed to produce a settlement, and the IRS Appeals Office sustained in full the IRS’s proposed adjustments to Astropar’s tax returns. The IRS issued the FPAA on March 28, 2001. TEFRA provides a readjustment period in which individual partners may contest an FPAA by filing a petition for readjustment within 150 days from the mailing of the FPAA with either the Tax Court, a United States District Court, or the Court of Federal Claims.5 However, none of the Astropar partners filed such a petition.
Decisions of the Lower Courts
On December 3, 2001, 250 days after the FPAA was issued and 100 days after the TEFRA readjustment period expired, Central Valley filed a voluntary chapter 11 bankruptcy petition in the United States Bankruptcy Court for the Eastern District of California (the “Bankruptcy Court”). The Government filed a $1.3 million unsecured priority claim against the estate for the tax years 1993, 1994 and 1995 (the “Tax Claim”), and Central Valley responded by filing an objection to the Tax Claim.
Upon the Government’s motion, the United States District Court for the Eastern District of California (the “District Court”) withdrew the reference from the Bankruptcy Court and decided it would hear the dispute. The Government then moved for summary judgment (which was converted into a motion to dismiss) in the District Court,6 arguing that neither the Bankruptcy Court nor the District Court had jurisdiction to determine the tax liability because the TEFRA readjustment period under I.R.C. section 6226 had expired; thus, the Government argued, the tax liability on the partnership items was final and not subject to further determination. In response, Central Valley argued that the District Court should be permitted to hear the matter pursuant to section 505(a) of the Bankruptcy Code. Section 505(a)(1) of the Bankruptcy Code allows a bankruptcy court to “determine the amount or legality of any tax” liability of a debtor, unless, as provided in section 505(a)(2), such liability “was contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction before the commencement of the [bankruptcy] case.”7 Section 505(a) is jurisdictional in that it either confers or deprives a bankruptcy court of the authority to determine certain tax claims. This section is intended to protect a debtor from being bound by a prebankruptcy tax liability determination that the debtor was unable to contest due to a lack of financial resources.
The Government acknowledged that the statutory res judicata provision of section 505(a)(2)(A) was inapplicable because “the default of the FPAA was not ‘contested’ before an ‘administrative tribunal’ and so the tax determination of the debtor does not fall within the exclusionary language of section 505(a)(2)(A).”8 The Government nevertheless contended that the expiration of the FPAA readjustment period, which allowed for judicial review, resulted in a final and binding tax ruling that was not subject to further review. The District Court agreed that further review was not appropriate but disagreed with the Government’s reasoning. The District Court held that because (a) the IRS Appeals Office had issued an FPAA, (b) the opportunity for judicial review through a filing of a petition for readjustment in Tax Court was offered, and (c) the FPAA became final only after no partner sought judicial review within the TEFRA limitations period, the res judicata provision of section 505(a)(2)(A) applied to prevent redetermination of the debtor’s tax liability.
Ninth Circuit Decision
Central Valley appealed the District Court’s decision to the United States Court of Appeals for the Ninth Circuit, which reversed the decision of the District Court. The Court of Appeals held that the District Court erred in concluding that it lacked jurisdiction to hear Central Valley’s objection to the Government’s Tax Claim.
The Court of Appeals first found that the issuance of an FPAA by the IRS Appeals Office does not satisfy the statutory requirement of section 505(a)(2)(A). Section 505(a)(2)(A) requires that a tax matter be “contested before and adjudicated by a judicial or administrative tribunal.”9 The Court of Appeals held that the FPAA did not represent the result of such adjudication. The Court of Appeals also determined that the fact that the opportunity for judicial review of the FPAA was available did not mean that such review had in fact taken place. The Court explained, “it is immaterial whether or not a party chooses not to avail itself of that opportunity by filing a petition for readjustment in Tax Court. Section 505(a)(2)(A) requires that a matter be actually contested and adjudicated before it is entitled to preclusive effect in a bankruptcy proceeding.”10 The Court explained that a tax matter is adjudicated when a court of competent jurisdiction enters a judgment determining the extent, if any, of tax liability. The Court was not persuaded by the fact that one of Central Valley’s partners, Astropar, had filed protests with the IRS, had participated in conferences with the IRS Appeals office and had received an FPAA. The Court added that the IRS Appeals Office was more of a dispute resolution forum than a judicial forum. The Court noted that proceedings in this office (i) are generally informal conferences, (ii) are aimed at reaching a settlement, (iii) involve no fact finder presiding over the hearing, (iv) prohibit discovery, (v) are not recorded, and (vi) do not permit use of evidentiary rules.
The Court of Appeals also addressed the Government’s argument that, even if the tax liability at issue had not been determined in a manner that satisfied the provision of subsection 505(a)(2)(A), the lower court was nevertheless prohibited from determining the issue in light of section 505(a)(1) of the Bankruptcy Code. Section 505(a)(1) authorizes the district court to “determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax,” so long as a previous adjudication has not been made.11 The Government argued that because Central Valley’s liability was being determined through Astropar, Central Valley sought to have “partnership items” rather than “tax liability” determined by the lower court. The Ninth Circuit held that, while the lower court did not have jurisdiction to determine the tax liability of a non-debtor partner, it had the power to determine the tax liability of a partner-debtor, even if such liability was in the form of a partnership item. The Court explained that:
[R]ather than distinguish a partner’s tax liability from its partnership items, we have consistently treated them as fundamentally interrelated and inseparable in considering the proper forum for a partner’s tax dispute. Accordingly, we reject the Government’s proposed distinction and continue to read § 505 of the Bankruptcy Code as extending bankruptcy jurisdiction not only to the ultimate tax liability of a debtor partner but also to any partnership items affecting that liability. 12
The Ninth Circuit then addressed the Government’s alternative argument that TEFRA’s requirement of determination of partnership items at the partnership level is a laterenacted limitation on bankruptcy jurisdiction, which effectively overrides section 505 of the Bankruptcy Code. The Government argued that Treasury Regulation section 301.6231(c)-7T(a), which provides that the partnership items of any debtor-partner “shall be treated as nonpartnership items,” provides the sole basis under TEFRA for a bankruptcy court to exercise jurisdiction. Under TEFRA, if one of the partners in a partnership files a petition for relief under any section of the Bankruptcy Code, the Tax Court proceeding which affects all partners would ordinarily be subject to the automatic stay of section 362(a)(8) of the Bankruptcy Code. To avoid this result, the U.S. Department of Treasury issued Treasury Regulation section 301.6231(c)-7T,13 which severs the debtorpartner from the Tax Court case by deeming any “partnership items” of the debtor-partner to be “nonpartnership items” not subject to TEFRA.14 The effect of this redefinition is to avoid the automatic stay dilemma by creating two separate proceedings regarding identical partnership items—one in the bankruptcy court involving the debtor-partner, and one in the Tax Court involving the remaining partners.
The Government argued that this regulation does not apply because the TEFRA readjustment period had expired. The Court agreed that the regulation did not apply; however, it summarily rejected the argument that the regulation overrides section 505 of the Bankruptcy Code. The Court noted that the regulation has nothing to do with preventing TEFRA from divesting bankruptcy courts of jurisdiction they would otherwise possess under the Bankruptcy Code. Rather, the express purpose of this regulation was to prevent the automatic stay applicable in bankruptcy proceedings from interfering with the operation of a Tax Court proceeding or the resolution of the non-debtor partners’ tax liability under TEFRA.
Finally, the Court of Appeals considered the Government’s argument that allowing bankruptcy courts to exercise jurisdiction over a debtor’s partnership items conflicts with TEFRA’s purpose of avoiding inconsistent judicial determinations of partnership matters. The Court stated that while this is a valid purpose, it is not absolute. The Court reasoned that the result of the treasury regulation discussed above was the creation of separate proceedings and separate determinations of partnership items in the Tax Court and bankruptcy court. Thus, the Court stated, “it cannot be said that TEFRA mandates consistent and therefore unified treatment among all partners in all cases.”15 While acknowledging that this may result in inequitable results, the Court stated that Congress has provided mechanisms for mitigating any such inequities: bankruptcy provides only a very limited exception to TEFRA, and a bankruptcy court, in its discretion, may decline to exercise its authority to redetermine a debtor’s tax liabilities, as section 505(a)(1) is permissive rather than mandatory.
By rejecting the contention that the Bankruptcy Court’s jurisdiction under section 505 of the Bankruptcy Code is limited by TEFRA,16 the Ninth Circuit Court of Appeals in Central Valley preserved a powerful tool for a debtor in bankruptcy— the ability to have its tax liability determined in its bankruptcy case. The Court made clear that bankruptcy courts do indeed have jurisdiction over the determination of a debtorpartner’s tax liability, even after the enactment of TEFRA, including the ability to determine partnership items.
In a broader sense, the Court of Appeals found that it is not enough that the debtor be given the mere opportunity pre-petition to seek judicial review of its tax liability. If a tax determination is the result of a process that did not involve a true contest and adjudication, such a liability can be redetermined by the bankruptcy court. Provided that no real adjudication occurred pre-petition, this interpretation of section 505(a)(2)(A) preserves the important right of the debtor under section 505(a) to ask that its tax liability be redetermined by the bankruptcy court as part of its reorganization case.