In re Cassidy, 88 B 09741 C.

• Decision Date: 12 February 1991
• Docket Number: No. 88 B 09741 C.,88 B 09741 C.
• Parties: In re Lucius Fredric CASSIDY, Jr., a.k.a. Lucius F. Cassidy, Jr., D.D.S., a.k.a. "Pete" Cassidy, Debtor.
• Court: United States Bankruptcy Courts. Tenth Circuit. U.S. Bankruptcy Court — District of Colorado

126 B.R. 94 (1991)

In re Lucius Fredric CASSIDY, Jr., a.k.a. Lucius F. Cassidy, Jr., D.D.S., a.k.a. "Pete" Cassidy, Debtor.

No. 88 B 09741 C.

United States Bankruptcy Court, D. Colorado.

February 12, 1991.

Stephen W. Seifert, and Caroline C. Fuller, Fairfield and Woods, P.C., Denver, Colo., for petitioner.

Bruce A. Anderson, Special Asst. U.S. Atty., Denver, Colo., for debtor.

ORDER

PATRICIA A. CLARK, Bankruptcy Judge.

This matter is before the Court upon the disbursing agent's objection to tax claims of the Internal Revenue Service (IRS) and the IRS's response thereto. The parties represented to the Court that no facts are in dispute and thus, the matter was submitted on the briefs of the parties. The debtor filed a reply brief in support of the IRS's position.

All facts have been stipulated to and are as follows: The debtor, Dr. Lucius F. Cassidy, Jr., (debtor), filed his voluntary Chapter 11 petition on July 25, 1988. The debtor is an orthodontist who operated his practice as a professional corporation since 1969. The professional corporation established two pension and profit sharing plans qualified pursuant to 26 U.S.C. § 401. In order to secure personal loans for various partnerships in which the debtor was involved, a substantial portion of the plan assets were pledged to various banks. When the debtor encountered financial difficulties and defaulted on the loans, the banks foreclosed on the plan assets. The debtor's joint 1987 federal income tax return included $468,807 of pledged plan assets as income from plan distributions. As part of the debtor's 1987 tax liability, approximately $46,881 was assessed as a 10% "additional tax" pursuant to 26 U.S.C. § 72(t) for early withdrawals from the plans. Of that amount, $13,196 remains due and owing. In 1988, the debtor's taxable income included $358,664 of pledged plan assets distributed from the qualified plans. The debtor still owes $35,867 from the 1988 26 U.S.C. § 72(t) 10% additional tax for early distributions. The total amount owed to the IRS pursuant to 26 U.S.C. § 72(t) is $49,063.

This case appears to be one of first impression, and involves the interpretation of 26 U.S.C. § 72(t).¹ The Court must determine whether the 10% additional tax imposed pursuant to the Internal Revenue Code (IRC) section is actually a tax, or is in reality a penalty. If it is a tax, the obligation will be entitled to priority status in this case pursuant to 11 U.S.C. § 507(a)(7)(A)(i) and must be paid in full with interest through the debtor's plan. If the 10% additional tax on early distributions is determined to be a penalty, it may still be entitled to priority status if the penalty is a pecuniary one. If the Court finds that Congress intended 26 U.S.C. § 72(t) to be in the nature of a punitive penalty, then the tax liability imposed pursuant to that section will not be afforded priority treatment in this case.

The disbursing agent asserts that in City of New York v. Feiring, 313 U.S. 283, 61 S.Ct. 1028, 85 L.Ed. 1333 (1941) and subsequent cases, a four-prong test has been developed for determining whether a particular exaction qualifies for treatment as a tax for bankruptcy purposes. The disbursing agent argues that the assessment in the case at bar does not qualify as a tax under that test, and is in reality a penalty. Further, the disbursing agent contends that the 26 U.S.C. § 72(t) penalty is a punitive one, and not one imposed as a result of actual pecuniary loss to the government. Therefore, he alleges that the penalties are not entitled to priority status.

The IRS takes the position that the assessment imposed pursuant to Section 72(t) does in fact qualify as a tax. Alternatively, the IRS asserts that if the Court finds the exaction to be a penalty, the Court must also find it to be a pecuniary one which was intended to help the government recoup revenues while it was precluded from collection by statute.

The debtor contends that the Feiring test has been met and thus the tax qualifies for priority treatment. In accord with the IRS position, the debtor also alternatively argues that if the assessment is a penalty, the Court must find it to be a pecuniary one which will be entitled to priority status.

"Whether the present obligation is a `tax' entitled to priority within the meaning of the statute is a federal question." City of New York v. Feiring, supra, at 285, 61 S.Ct. at 1029. The IRS asserts that Section 72(t) is in the portion of the Internal Revenue Code which deals with income taxes, not penalties. They contend that had Congress intended the liability contained in Section 72(t) to be a penalty, it would have been codified in that portion of the IRC which deals with civil penalties.² However, courts have recognized the principle that merely denominating an obligation as a tax "does not mean it is such for all purposes." In re Airlift Intern, Incorporated, 97 B.R. 664, 669 (Bankr.S.D.Fla.1989). See also In re Kline, 403 F.Supp. 974 (D.Md.1975), aff'd, 547 F.2d 823 (4th Cir.1977); In re Wheeling-Pittsburgh Steel Corporation, 103 B.R. 672 (W.D.Pa.1989).

In the Feiring case supra, the Supreme Court defined taxes for bankruptcy purposes as "pecuniary burdens laid upon individuals on their property, regardless of their consent, for the purpose of defraying expenses of government or undertakings authorized by it." 313 U.S. at 285, 61 S.Ct. at 1029. From that definition, courts have developed a four-part test which must be met in order for an obligation labeled as a tax to actually be considered a tax in the bankruptcy context. The four factors are:

1. an involuntary pecuniary burden, regardless of name, laid upon individuals or property;

2. imposed by, or under authority of the legislature;

3. for public purposes, including the purposes of defraying expenses of government or undertakings authorized by it; and

4. under the police or taxing power of the state or government.

See, In re Lorber Industries of California, Inc., 675 F.2d 1062 (9th Cir.1982), Matter of Mansfield Tire and Rubber Company, supra, In re Airlift Intern Inc., supra, In re Skjonsby Truck Line, Inc., 39 B.R. 971 (Bankr.D.N.D.1984).

There is no question that the first prong of the test has been satisfied. The monetary assessment was laid upon the debtor without his consent. The exaction has also been imposed pursuant to the Internal Revenue Code, a set of statutes enacted by Congress. Thus, the second criteria of the test has been met. It is undeniable that the obligation has been imposed under the taxing power of the federal government. As a result, the fourth prong of the test has been complied with. The remaining issue is whether the 26 U.S.C. § 72(t) exaction was imposed by the legislature for a public purpose.

Both the IRS and the debtor state that Section 72(t) was partially enacted to help defray the expenses of government by recapturing revenues previously lost from the tax-free accumulation of funds placed into qualified plans. The debtor advances an additional argument that by discouraging early withdrawals from qualified plans, the government is encouraging taxpayers to save for their retirement. This allegedly serves the public purpose of taking pressure off the overburdened Social Security System.

The disbursing agent contends that under the third prong, any obligation which is punitive in nature cannot be imposed for public purpose. While recognizing that no cases interpret Section 72(t) for bankruptcy purposes, the disbursing agent points the Court to authority which has interpreted other IRC sections in relation to the tax or penalty analysis. For example, In re Kline, supra, and In re Mansfield Tire & Rubber, supra, both held that where the statutes in question were enacted to penalize wrongful conduct, the tax assessed would not be entitled to priority status under the Bankruptcy Code.³

The Court must inquire into the purpose of the statute in question to determine whether its intent is punitive, or merely a revenue raising measure. The legislative history of 26 U.S.C. § 72(t) provides the Court with important insight.⁴ In S.Rep. No. 313, 99th Cong., 2nd Sess. (1986), the Senate Finance Committee advanced certain reasons for changing the law and imposing the 10% additional tax. The report states, in pertinent part,

Present law imposes withdrawal sanctions with respect to certain tax-favored retirement arrangements and requires withdrawal restrictions to be provided under others. The absence of withdrawal restrictions in the case of some tax-favored arrangements allows participants in those arrangements to treat them as general savings accounts with favorable tax features rather than as retirement savings arrangements. Moreover, taxpayers who do not have access to such arrangements, in effect, subsidize the general purpose savings of those whose employers maintain plans with liberal withdrawal provisions.

Although the committee recognizes the importance of encouraging taxpayers to save for retirement, the committee also believes that tax incentives for retirement savings are inappropriate unless the savings generally are not diverted to non-retirement uses. One way to prevent such diversion is to impose an additional income tax on early withdrawals from tax-favored retirement savings arrangements in order to discourage withdrawals and to recapture a measure of the tax benefits that have been provided. . . .

Moreover, the committee is concerned that the present-law level of the additional income tax appears in many instances to be an insufficient deterrent to the use of retirements funds for non-retirement purposes, because for taxpayers whose income is taxed at a higher marginal rate, sanctions may be neutralized by the tax-free compounding of interest after a relatively short period of time."

S.Rep. No. 99-313, 99th Cong., 2nd Sess. 612-613 (1986) (emphasis added).

The report of the House of Representatives Ways and Means Committee in essence tracks the...