In re Knudsen

• Citation: 356 B.R. 480
• Decision Date: 20 November 2006
• Docket Number: No. 05-03136M.,05-03136M.
• Parties: Anders H. KNUDSEN, Cynthia J. Knudsen, Debtors.
• Court: United States Bankruptcy Courts. Eighth Circuit. U.S. Bankruptcy Court — Northern District of Iowa

Page 480

356 B.R. 480

Anders H. KNUDSEN, Cynthia J. Knudsen, Debtors.

No. 05-03136M.

United States Bankruptcy Court, N.D. Iowa.

November 20, 2006.

Joseph A. Peiffer, Cedar Rapids, IA, for Debtors.

DECISION RE PLAN CONFIRMATION

WILLIAM L. EDMONDS, Chief Judge.

Anders and Cynthia Knudsen seek confirmation of their chapter 12 plan. Objections were filed by the United States on behalf of the Internal Revenue Service (hereinafter "IRS") and by the trustee Carol F. Dunbar. Hearing on confirmation was held July 12, 2006 in Fort Dodge. Joseph A. Peiffer appeared as attorney for Knudsens. Martin J. McLaughlin, Assistant United States Attorney, appeared for the IRS. Carol F. Dunbar appeared on her own behalf. This is a core proceeding under 28 U.S.C. § 157(b)(2)(L).

Anders (hereinafter "Knudsen") and his wife, Cynthia, filed their chapter 12 petition on July 1, 2005. Knudsen is 45 years old. He graduated from Iowa State University with a bachelor's degree in agricultural business and minor studies in farm management. Cynthia has associates degrees in arts and in science. The couple has four daughters, ages 21, 17, 14 and 12. The oldest daughter is presently a junior at Iowa State University. The middle girls will be in ninth and twelfth grades. The youngest daughter has a learning disability. She receives tutoring in addition to her public schooling. The extra help is recommended by her school. The family lives in Mitchell County, Iowa, near St. Ansgar.

Knudsen is a farmer. He started farming part-time while in high school. He purchased his first farm while in college. When he graduated from college, he began farming 200 acres; he also had a small hog-operation. He has farmed over the years with his younger brother, James. The two men own various pieces of farm equipment together. Knudsen owns several interests in farm real estate acquired over the years by purchase, inheritance, and through family exchanges. Some of his interests are fractional, undivided remainder interests owned with siblings. He and Cynthia own 160 acres in Mitchell County. They own 80 of the acres as joint tenants with right of survivorship and 80 acres as tenants in common. The 160 acres include the couple's 40-acre homestead, which has been claimed as exempt.

In the early 1990s; Knudsen enlarged his hog operation. During 1992-1993, he increased the sow herd to 250. He built a farrowing house, and started selling feeder pigs. Initially he hired others to fatten his hogs, but in the spring of 1995, he built his own finishing barn. He built a second finishing barn in 1996. By 1996 he was operating a farrow-to-finish operation and was selling his own hogs as his main source of income. During 1999, two occurrences of swine disease impaired the growth and profitability of Knudsen's hog operation. Beginning in 2000 and through 2003, Knudsen and his lender, the St. Ansgar State Bank, became concerned about the financial direction of his farming operation. The bank was increasingly unwilling to lend money to finance it.

Knudsen investigated the idea of becoming a custom livestock operator. In December 2003, he and Cynthia entered into two contracts to grow swine for Squealers Pork, Inc., an Austin, Minnesota corporation (SPI). SPI was to provide grower pigs to be finished at the Knudsen facility. Under the two contracts, Knudsens were to receive $14,338.00 per month. The duration of the contracts was 10 years. In addition to using his own hog facilities, Knudsen leased from his father a barn used for the gestation of SPI's sows. The rent was $20,000.00 per year. Because of concerns over disease, SPI required that Knudsen completely dispose of his own swine.

Knudsen decided to end his grain farming. He leased out his 160 acres to a friend for cash rent of $20,000.00 per year.

Knudsen and Cynthia both work off the farm. Cynthia is employed part time by a jewelry store located in Austin, Minnesota. She earns about $7,000.00 per year. In 2005, Knudsen began employment for a local radio station as on-air talent and as a salesman. He is paid $28,000.00 in annual salary plus benefits, including health insurance.

During 2004, Knudsen sold the last of his breeding sows. Also during 2004 he sold all of his slaughter hogs (fat hogs). The fat hogs were those raised by Knudsen and sold in the ordinary course of his business. Knudsen used the proceeds to pay the St. Ansgar State Bank, whose loan was secured by the hogs.

Knudsen's change in operations allowed him to sell his interest in some of the farrowing equipment that he owned jointly with his brother. During 2004 he sold his interest in seven pieces of such equipment to his brother. He also sold a livestock trailer.

Knudsens filed their joint federal tax return for 2004 on or after March 1, 2005. Sales of "livestock, produce, grains, and other products" were reported at $525,384.00 (exhibit 1, Schedule F, line 4). This figure included sales of slaughter hogs. Knudsen's net farm income for 2004 was reported as $65,336.00 (exhibit 1, schedule F). Gains from the sale of the farrowing equipment to his brother and from the sale of the livestock trailer were reported as ordinary gain on form 4797 and on line 14 of Knudsens' form 1040. Income from sales of Knudsen's breeding sows was reported as capital gain (exhibit 1, form 4797). Knudsens' total tax for 2004, as shown on their initial return, was $19,550.00 (exhibit 1, form 1040, line 62).

They filed an amended return on June 21, 2005, which showed their 2004 tax as $55,839.00 (exhibit 64). The increased taxes resulted from a decision to revoke an election to treat certain hog building remodeling costs as expenses rather than to depreciate the costs over time. The revocation had the effect of decreasing farm expenses for 2004, thereby increasing income. See 26 U.S.C. § 179. It also had the effect of increasing depreciation expenses for future tax years.

Under the initially filed return for 2004, there was self-employment tax of $9,232.00 (exhibit 1, form SE). Under the amended return, the self-employment tax was $15,176.00 (exhibit 64).

Knudsens filed their chapter 12 bankruptcy petition on July 1, 2005. They have filed a Fifth Amended and Substituted Chapter 12 Plan (doe. 136) and modified it twice to provide "technical amendments" (does. 169, 162).

The essence of the proposed plan is to take advantage of 11 U.S.C. § 1222(a) as amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), Pub.L. No. 109-8, 119 Stat. 23. Section 1222 deals with the mandatory and permissive contents of a chapter 12 plan.

Prior to amendment, subsection 1222(a) provided that

[t]he plan shall provide for the full payment, in deferred cash payments, of all claims entitled to priority under section 507 of this title, unless the holder of a particular claim agrees to a different treatment of such claim.

11 U.S.C. § 1222(a)(2) (prior to amendment in 2005).

The section was amended by BAPCPA to state:

The plan shall ... provide for the full payment, in deferred cash payments, of all claims entitled to priority under section 507, unless — (A) the claim is a claim owed to a governmental unit that arises as a result of the sale, transfer, exchange, or other disposition of any farm asset used in the debtor's farming operation, in which case the claim shall be treated as an unsecured claim that is not entitled to priority under section 507, but the debt shall be treated in such manner only if the debtor receives a discharge; or (B) the holder of a particular claim agrees to a different treatment of that claim.

11 U.S.C. § 1222(a)(2)(A) and (B). Although many BAPCPA amendments did not become effective until October 17, 2005, the amendment to § 1222(a)(2) became effective on enactment of BAPCPA on April 20, 2005.

As part of his plan to restructure his farming operation, Knudsen plans to sell machinery and equipment and a remainder interest in certain farmground, 120 acres of the 160-acre farm. It is estimated that outside of bankruptcy, the sales would generate significant capital gains. Knudsen concede that in order for their proposed chapter 12 plan to be feasible, the income taxes resulting from the capital gains on the sales must be given the favorable treatment provided by 11 U.S.C. § 1222(a)(2)(A), meaning that a portion of the income taxes must be treated as unsecured debt rather than as priority debt to the IRS, and that if they perform their plan successfully, the unsecured portion must be discharged, including any penalties and interest. Also, Knudsens contend that the same favorable treatment should apply to their prepetition restructuring sales of fat hogs, sows, and equipment.

The disputes over confirmation in this case involve issues as to which sales and their resulting taxes should receive special treatment under section 1222(a)(2)(A), the extent of the discharge of taxes if Knudsens successfully perform their plan, and the method of calculation for separating priority taxes from unsecured taxes in applying § 1222(a)(2)(A). There is also a disposable income issue over the payment of college expenses for their adult daughter.

Knudsens contend that the 1222(a)(2)(A) treatment should apply to prepetition and postpetition sales; that favorable tax treatment should apply to assets normally sold to produce ordinary income; that taxes from asset sales receiving favorable treatment under 1222(a)(2)(A) should be calculated on a marginal rate basis rather than a proportional basis to arrive at the division between priority and unsecured tax debt; and that when they successfully complete their plan, they should receive a full payment discharge of any taxes treated as general unsecured debt under 1222(a)(2)(A), including prepetition taxes and taxes resulting from sales during bankruptcy.

The trustee objects to the proposed plan because Knudsens propose to pay costs of their adult daughter's college education out of their income, in...