Knudsen v. I.R.S.
| Citation | 581 F.3d 696 |
| Decision Date | 16 September 2009 |
| Docket Number | No. 08-2820.,No. 08-3627.,08-2820.,08-3627. |
| Parties | Anders H. KNUDSEN, doing business as A & C Knudsen Farms; Cynthia J. Knudsen, Appellees, v. INTERNAL REVENUE SERVICE, Appellant, Carol F. Dunbar, Trustee, U.S. Trustee, U.S. Trustee. In re James Daniel Schilke, Debtor, United States of America, Appellant, v. James Daniel Schilke; Holly D. Schilke, also known as Holly Denise Schilde; Diane Schilke; Larry Schilke; State of Nebraska, Department of Revenue, Appellees. |
| Court | United States Courts of Appeals. United States Court of Appeals (8th Circuit) |
Patrick J. Urda, D.O.J., Tax Division, argued, Washington, DC, Patrick J. Urda and Bruce R. Ellisen, D.O.J., Washington, DC, Matt M. Dummermuth, USA, Northern District of Iowa, and Joe W. Stecher, USA, District of Nebraska, on the brief, for appellants.
Joseph A. Peiffer, argued, Cedar Rapids, IA, Joseph A. Peiffer, Cedar Rapids, IA, James R. Nisley, North Platte, NE, on the brief, for appellees.
Before RILEY, SMITH, and COLLOTON, Circuit Judges.
Section 1222(a)(2)(A) of 11 U.S.C. provides that a debtor's Chapter 12 plan must provide for the full payment of all priority claims under 11 U.S.C. § 507 "unless . . . the claim is a claim owed to a governmental unit that arises as a result of the sale . . . 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. . . ." In these consolidated appeals, the government challenges the applicability of § 1222 to income taxes arising out of sales of the property of the debtors, Anders H. Knudsen and Cynthia J. Knudsen (No. 08-2820) and James Daniel Schilke (No. 08-3627). In Nos. 08-2820 and 08-3627, the government asserts that § 1222(a)(2)(A) is inapplicable to the debtors' postpetition sale of farm assets. In No. 08-2820, the government contends that (1) the Knudsens' prepetition sale of their slaughter hogs does not constitute a sale of a "farm asset used in the debtor's farming operation" under § 1222(a)(2)(A) and (2) the proper method for allocating the Knudsens' 2004 tax liability between the tax arising out of the transactions within the scope of § 1222(a)(2)(A) and the tax arising from those transactions outside of its scope is the "proration method" as opposed to the "marginal method."
For the reasons discussed below, we hold: (1) a Chapter 12 debtor may treat postpetition income taxes imposed on the debtor's income earned during the pendency of the case as administrative expenses under 11 U.S.C. § 503; (2) the Knudsens' prepetition sale of their slaughter hogs in 2004 constitutes the sale of a "farm asset used in the debtor's farming operation" under § 1222(a)(2)(A); and (3) the "marginal method" is the correct method to determine the allocation of taxes between priority and non-priority claims under § 1222(a)(2)(A).
Accordingly, we affirm the judgment of the bankruptcy court1 in No. 08-3627.
In No. 08-2820, we affirm in part and reverse in part the judgment of the bankruptcy court. First, we reverse the part of the bankruptcy court's decision holding that the Knudsens' prepetition sale of their slaughter hogs in 2004 is not entitled to the benefit of § 1222(a)(2)(A). Second, we reverse the part of the bankruptcy court's decision holding that the "proration method" is the correct method to determine the allocation of taxes between priority and non-priority claims, as opposed to the "marginal method." Finally, we affirm the part of the bankruptcy court's decision holding that a Chapter 12 debtor may treat postpetition income taxes imposed on the debtor's income earned during the pendency of the case as administrative expenses under § 503. We remand to the bankruptcy court with instructions to confirm the Knudsens' Fifth Amended and Substituted Plan of Reorganization in accordance with this opinion.
The Knudsens, owners of a 160-acre Iowa farm, filed a voluntary bankruptcy petition under Chapter 12 of the Bankruptcy Code. The Knudsens' farming enterprise includes raising hogs. In the early 1990s, the Knudsens enlarged their hog operation, increasing their sow herd to 250. They also built a farrowing house and started selling feeder pigs. Although the Knudsens initially hired others to fatten their hogs, they eventually built two finishing barns, the first in 1995 and the second in 1996. By 1996, the Knudsens were operating a farrow-to-finish hog operation and were selling their own hogs as their main source of income.
In 1999, two swine disease outbreaks stifled the growth and profitability of the Knudsens' hog operation. Between 2000 and 2003, the Knudsens and their lender, St. Ansgar State Bank ("St. Ansgar"), became concerned about the financial future of the Knudsens' farm. St. Ansgar became less willing to lend money to finance the Knudsens' farm business. As a result, the Knudsens considered reorganizing their farming operation. In December 2003, the Knudsens entered into two ten-year contracts to raise hogs for Squealers Pork, Inc. (SPI). Under the contract's terms, SPI would provide baby pigs to the Knudsens, and the Knudsens would raise the pigs to market weight. Because of its fears of swine disease, SPI required the Knudsens to completely dispose of their own swine before they started raising hogs for SPI. Consequently, the Knudsens, in 2004, sold the last of their breeding sows and all of their slaughter hogs. They used the hog sale proceeds to make a payment on a loan from St. Ansgar, which was secured by the hogs. Additionally, because of the change in their hog operation, the Knudsens sold a livestock trailer and their interest in some farrowing equipment. The Knudsens also ended their grain farming operation and leased their 160 acres for cash rent of $20,000 per year.
In their joint 2004 federal income tax return, the Knudsens reported farm income of $525,384 for sales of "livestock, produce, grains, and other products." This figure included the sale of the slaughter hogs. The Knudsens reported (1) net farm income of $65,336 for 2004, (2) the sale of their breeding sows as a capital gain of $34,077, and (3) proceeds of the sale of the farrowing equipment and the livestock trailer as an ordinary gain of $21,659. As shown on their initial 2004 return, the Knudsens' total tax for 2004 was $19,550.
Thereafter, the Knudsens filed an amended 2004 federal income tax return, showing their 2004 federal tax to be $55,839. The Knudsens' taxes increased because they revoked an election to treat certain hog building remodeling costs as expenses rather than to depreciate the costs over time. This amendment decreased farm expenses for 2003, thus increasing the Knudsens' income. The Knudsens filed for bankruptcy shortly after submitting their amended 2004 tax return.
In their reorganization plan, the Knudsens contended that income tax relating to the 2004 sale of the slaughter hogs qualified for treatment as an unsecured claim pursuant to 11 U.S.C. § 1222(a)(2)(A). As a result, the Knudsens asserted that $43,248 of their 2004 total tax liability of $55,839 should be classified as an unsecured claim. The plan further proposed funding the reorganization by selling certain machinery and equipment, as well as 120 acres of the 160-acre farm. As with the sale of the slaughter hogs, the Knudsens asserted that the taxes arising from these postpetition sales would qualify for treatment as an unsecured claim under § 1222(a)(2)(A).
The Internal Revenue Service (IRS) objected to the Knudsens' proposed plan, challenging, among other things, the Knudsens' proposed treatment of federal taxes attributable to the 2004 sale of the slaughter hogs and the postpetition sale of the machinery and land. According to the IRS, § 1222(a)(2)(A) did not apply to taxes arising out of the 2004 sale of the slaughter hogs because slaughter hogs did not qualify as a "farm asset used in the debtor's farming operation." The IRS contended that the slaughter hogs were not an asset used in a farming operation but rather were the end product produced by the farming operation. See 11 U.S.C. § 1222(a)(2)(A). The IRS also opposed the Knudsens' proposed method for allocating their 2004 tax liability between unsecured and priority tax claims, contending that the Knudsens' method took "an incorrect and unwarranted advantage of lower tax rates." Finally, the IRS maintained that § 1222(a)(2)(A) did not apply to the Knudsens' postpetition sale of the machinery and land, arguing that § 1222(a)(2)(A) restricted its benefits to claims that qualified for priority treatment under 11 U.S.C. § 507, which sets forth certain claims and expenses entitled to priority, and that the postpetition taxes did not qualify for any of § 507's enumerated categories.
The bankruptcy court denied confirmation of the Knudsens' plan. First, the bankruptcy court held that the beneficial tax treatment for farms under § 1222(a)(2)(A) did not apply to the Knudsens' prepetition sale of the slaughter hogs. According to the court, the phrase "used in the debtor's farming operation" in § 1222(a)(2)(A) should be accorded the same meaning and treatment as the phrase "property used in the trade or business" in 26 U.S.C. § 1231(b)(3) of the Internal Revenue Code (IRC). In re Knudsen, 356 B.R. 480, 485-86 (Bankr.N.D.Iowa 2006) (internal quotations omitted). Section 1231(b)(3) "provides capital gain treatment for taxes arising from the sale of breeding livestock." Id. at 485. The court concluded that § 1222(a)(2)(A), like § 1231, is limited to capital assets. Id. at 486.
Second, as to the allocation of taxes, the bankruptcy court applied the IRS's "proration method" to determine the amount of tax that qualifies for beneficial treatment under § 1222(a)(2)(A) instead of the Knudsens' "marginal method." The court found
that the proration method is the better method for determining what amount of tax qualifies for beneficial...
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