Bankruptcy Professional Fees Are Not SLLs for Carryback Purposes

B, a retail store, filed for Chapter 11 bankruptcy. Under the supervision of the bankruptcy court, it employed various legal, accounting and other professionals who incurred fees and expenses. The bankruptcy court eventually entered awards of final compensation to the professionals.

On its 1993 and 1994 Federal returns, B deducted some of the professional fees and expenses resulting from the bankruptcy and capitalized the remaining $5,429,186. In 1998, it filed Form 1120X (claim) for the 1997 tax year, claiming the capitalized bankruptcy costs as a specified liability loss (SLL), carrying them back to the 1987 tax year under Sec. 172. B sought a $2,497,426 refund for that tax year.

Analysis

The issue is whether Bs capitalized bankruptcy costs were SLLs under Sec. 172(f)(1)(B) and, thus, eligible for the special 10-year carryback period. During the relevant period, Sec. 172(f) defined SLL as follows:

(1) In general.The term specified liability loss means the sum of the following amounts to the extent taken into account in computing the net operating loss for the taxable year....

(B) Any amount...allowable as a deduction under this chapter with respect to a liability which arises under a Federal or State law, or out of any tort of the taxpayer if (i) In the case of a liability arising out of a Federal or State law, the act (or failure to act) giving rise to such liability occurs at least 3 years before the beginning of the taxable year.

To apply, there must have been an act which gave rise to a liability under state or Federal law, and the act must have occurred more than three years before the tax year in question.

The IRS has not issued regulations under Sec.172(f), and there is no relevant legislative history. Additionally, whether the cost of hiring outside professionals during a bankruptcy proceeding is a liability arising under a Federal law has not yet been determined by any appellate court. However, several decisions provide guidance for the analysis.

In Sealy Corp., 171 F3d 655 (9th Cir. 1999), the Ninth Circuit held that fees paid to CPAs to publish reports on employee benefit plans (as required by the Employee Retirement Income Security Act of 1974) and those paid to lawyers and accountants (to comply with an IRS audit) did not arise under a Federal law. The Ninth Circuit explained, [i]t is...not simply an expense incurred with respect to an obligation under Federal law [that meets the statutory definition of a specified liability loss] but an act giving rise to the liability that qualifies as a specified liability under the statute. The court further stated, [t]he act giving rise to each of the liabilities in question was the contractual act by which Sealy engaged lawyers or accountants.

In Host Marriott Corp., 267 F3d 363 (4th Cir. 2001), the Fourth Circuit held that liabilities arising from a Federal income tax deficiency and costs for workers compensation payments did arise under Federal and state law. It reasoned that the liability for Federal income tax deficiency interest arose explicitly out of Sec. 6601(a) under a rate established by Sec. 6621. The existence of the interest liability and its amount were expressly set by Federal law, not based on the taxpayers choice. The court distinguished Sealy, explaining that the liability for the accounting and professional fees at issue did not arise under Federal law, because the statutory provisions did not establish the taxpayers liability to pay the amounts at issue; rather, the taxpayers choice of the means of compliance determined the costs nature and amount.

The Tax Court has also held that liabilities arising from Federal and state income tax deficiencies arise under Federal and state law (Intermet Corp., 117 TC 133 (2001)).

In this case, B asserts that liability for its capitalized bankruptcy costs arose
out of a Federal law (the Bankruptcy Code), because the incurring of the capitalized bankruptcy costs followed automatically under that Code when it filed for bankruptcy. B argues that the Bankruptcy Code makes the bankruptcy judge (not a contract between the parties) the determiner of whether, when and how much an outside professional will be paid. Thus, the costs for hiring outside professionals arise under the Bankruptcy Code.

The Bankruptcy Code requires the appointment of a committee of creditors holding unsecured claims (11 USC Section 1102(a)(1)). Further, the committee may select and authorize the employment...of one or more attorneys, accountants, or other agents, to represent or perform services for such committee (11 USC Section 1103(a)). Also, the bankruptcy court may allow compensation different from that provided under any agreement between the committee and the professional for his or her services and it is up to the bankruptcy judge to approve any compensation for such services (11 USC Sections 328(a), 330 and 331).

However, to say that simply because an entity files for bankruptcy, any costs for outside professionals arise under the Bankruptcy Code in the context of Sec. 172(f), stretches the limits of the Internal Revenue Code. Bs fees incurred for hiring outside professionals did not automatically arise under the Bankruptcy Code from its having commenced a bankruptcy reorganization proceeding. B has not shown that the capitalized bankruptcy costs are anything beyond a liability for an obligation under a Federal (or state) law. As in Sealy, the statutory provisions do not establish the taxpayers liability to pay the amounts at issue. It was the creditors committee and Bs choice, subject to final approval by the bankruptcy judge, of the means of compliancethe accounting and/or law firm to retain, the work to assign, the hourly rate, etc.that determined the nature and amount of the costs. Accordingly, Bs argument that the liability for the capitalized bankruptcy costs arose under Federal bankruptcy law is unpersuasive.

Major Paint Co., Fed. Cir., 6/27/03