Pettibone Corp. v. U.S.

• Decision Date: 07 September 1994
• Docket Number: No. 93-4027,93-4027
• Citation: 34 F.3d 536
• Parties: -6214, 63 USLW 2215, 94-2 USTC P 50,472, Bankr. L. Rep. P 76,066 PETTIBONE CORPORATION, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 536

34 F.3d 536

74 A.F.T.R.2d 94-6214, 63 USLW 2215,

94-2 USTC P 50,472,

Bankr. L. Rep. P 76,066

PETTIBONE CORPORATION, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 93-4027.

United States Court of Appeals, Seventh Circuit.

Argued June 7, 1994.

Decided Sept. 7, 1994.

Gary R. Allen, Kenneth W. Rosenberg (argued), Dept. of Justice, Tax Div., Appellate Section, Charles J. Cannon, Dept. of Justice Tax Div., Mayer Y. Silber, Dept. of Justice Tax Div., Appellate Section, Washington, DC, for U.S.

Steven P. Handler, Steven F. Pflaum (argued), Nancy M. Hoffman, McDermott, Will & Emery, Chicago, IL, for Pettibone Corp.

Before CUMMINGS, ALARCON, ^* and EASTERBROOK, Circuit Judges.

EASTERBROOK, Circuit Judge.

This appeal marks the third time we have addressed issues arising out of Pettibone Corporation's bankruptcy. See Pettibone Corp. v. Easley, 935 F.2d 120 (1991); Moser v. Universal Engineering Corp., 11 F.3d 720 (1993). At least one more appeal is pending before another panel. This go-'round presents interesting questions about the interaction of the Internal Revenue Code and the Bankruptcy Code.

The United States is a creditor in Pettibone's reorganization. It filed proofs of claim asserting unsecured priority claims against Pettibone for various pre-petition corporate income and withholding taxes. See 11 U.S.C. Sec. 507(a)(7). Although these claims specified a fixed amount due, they stated that the amount was subject to change because the IRS had yet to complete audits for four of the five tax years immediately preceding the bankruptcy petition. The IRS spent nearly two more years completing the audit. In November 1988 the IRS filed a single amended claim that superseded all prior claims. This final proof of claim alleged that Pettibone had underpaid its taxes by $5,518,116 as of the petition date but was entitled to a refund of $2,132,584 for overpayments during the same period. The IRS asserted a secured claim in the amount of the refund (see 11 U.S.C. Sec. 506) and an unsecured claim for the balance of $3,385,532. The bankruptcy court allowed the IRS to file this amended claim.

Approximately one month later the bankruptcy court confirmed Pettibone's plan of reorganization. The plan gave Pettibone six years to pay "Unsecured Tax Claims" in the "full amount of such Allowed Claims" plus interest "at such rate as may be approved by the Bankruptcy Court". It did not, however, quantify these "Allowed Claims." Pettibone challenged the methodology of the IRS's tax claims and filed an adversary proceeding seeking a declaratory judgment barring the IRS from using the refunds to offset any underpayments. Pettibone asked the court to direct the IRS to disburse the refunds to it immediately, while waiting six years for payment in the other direction.

Pettibone and the IRS later agreed on the amounts of the tax underpayments and overpayments for each year. They did not agree, however, on the manner in which these sums should be netted or on how interest should be calculated. The IRS argued for continuous netting of overpayments, underpayments, and interest on the balance. The parties stipulated that under that approach Pettibone owed $2,379,189 on the date it filed for bankruptcy. The IRS conceded that it had no right to interest until confirmation of the plan of reorganization. See 11 U.S.C. Sec. 502(b)(2); In re Fesco Plastics Corp., 996 F.2d 152, 155 (7th Cir.1993). A resumption of interest on the confirmation date brought the current total over $3 million. Pettibone responded that continuous netting is a setoff within the meaning of Sec. 553 of the Bankruptcy Code and that its plan of reorganization forbids setoffs. According to Pettibone, if the IRS wanted to use this method it should have ensured that the plan preserved its rights. Because the IRS failed to do so, Pettibone contended, the correct approach is to tally the overpayments and the underpayments separately. Interest also accrues separately, with no interest on Pettibone's debt during the reorganization. Under this approach, the same series of over- and underpayments results in the IRS owing Pettibone $254,054 by the time of trial. Both the bankruptcy court and the district court agreed with the IRS, although for different reasons.

I

Pettibone agreed to a Chapter 11 reorganization plan that calls for full payment of its tax obligations. See 11 U.S.C. Sec. 1129(a)(9). The plan does not, however, provide the rules to use in determining what these tax obligations are. The IRS conducted an audit of the 13-year period immediately preceding the bankruptcy. The audit revealed that Pettibone had overpaid taxes in some years and underpaid in others. Following its established procedures, the IRS netted these overpayments and underpayments to establish the total tax liability. See 26 U.S.C. Sec. 6402(a). Pettibone does not contend that the netting of these overpayments violated either the Internal Revenue Code or the implementing regulations. Rather it says that by banning setoffs its plan of reorganization bars the IRS from treating its tax obligations in the normal manner.

Did the netting of overpayments against underpayments constitute a setoff? The bankruptcy court said "No." It held that because the debts lack mutuality, see 11 U.S.C. Sec. 553, netting them is not a setoff and hence is not barred by the Bankruptcy Code or the plan. The Internal Revenue Code leaves to the Commissioner's discretion whether to apply overpayments to delinquencies or to refund them to the taxpayer. 26 U.S.C. Sec. 6402(a). Until the Commissioner exercises this discretion, the taxpayer has no right to payment. Because Pettibone lacks similar discretion with respect to its underpayments, the bankruptcy court found that the debts are non-mutual. It concluded from this that the IRS's approach is not a setoff and may be used to determine Pettibone's aggregate tax liability.

This analysis contains a basic flaw. That debts are non-mutual is a reason for forbidding a setoff, not a factor in determining whether the cancellation of debts is a setoff. There is no doubt, for example, that pre-petition and post-petition debts are non-mutual. Boston & Maine Corp. v. Chicago Pacific Corp., 785 F.2d 562, 564 (7th Cir.1986). Under the bankruptcy court's reasoning, a creditor could offset any claim it had against the bankruptcy estate against post-petition debts it owed the debtor. Yet such a result would be improper. Id. at 565; Braniff Airways, Inc. v. Exxon Co., 814 F.2d 1030, 1036 (5th Cir.1987).

The district court disagreed with the bankruptcy court's conclusion on mutuality but agreed that the IRS could perform the offset. The court characterized the netting of tax overpayments against tax underpayments as "an accounting method" and "not the type of 'setoff' or 'offset' contemplated by the Bankruptcy Code." 161 B.R. 960. We agree with this conclusion.

Unless the parties have distinct obligations to each other, the concept of "setoff" makes no sense. By reopening and adjusting each of the tax periods from 1973 through 1986 at the same time, the IRS effectively transformed the 13-year stretch into one accounting period. Nominal "underpayments" and "overpayments" within the audit period were merely intermediate steps in an attempt to determine Pettibone's taxes. Although this audit stated taxes for each year, the calculations spanned many years. Corporate taxpayers file yearly returns, but those returns are in many respects contingent. They are subject to modification when future events with tax consequences for the year in question come to pass. For instance, many of the underpayments and overpayments in the present case resulted from tax loss carrybacks: losses from later years attributed to earlier years for tax purposes. See 26 U.S.C. Sec. 172.

Loss carrybacks exemplify the interdependence among periods within the corporate taxation system and show that from both economic and legal standpoints the nominal one-year accounting period for taxes is deceiving. See Marvin A. Chirelstein, Federal Income Taxation Sec. 10.01 (6th ed. 1991); Myron C. Grauer, The Supreme Court's Approach to Annual and Transactional Accounting for Income Taxes: A Common Law Malfunction in a Statutory System?, 21 Ga.L.Rev. 329 (1986); Mazzocchi Bus Co. v. CIR, 14 F.3d 923, 932 (3d Cir.1994). This interdependence acquires special significance during an audit, when many tax years are open simultaneously. Operating losses shift among the periods, altering tax consequences; an underpayment for one year may reflect nothing more than the movement of a loss from that year to another, simultaneously resulting in an overpayment for the latter year. Treating the calculations within an audit period as setoffs would make sense only if the tax obligation for each year were independent. Interdependence among the periods makes such a characterization inappropriate for corporate taxpayers.

An approach based on strict separation between tax periods may work with natural persons. See, e.g., United States v. Norton, 717 F.2d 767 (3d Cir.1983); United States v. Reynolds, 764 F.2d 1004, 1007 (4th Cir.1985); In re Conti, 50 B.R. 142, 150 (Bankr.E.D.Va.1985). Unlike corporations, natural persons rarely shift tax consequences across years. When the end of the year closes the books on taxes, applying refunds from one year to debts from another more closely resembles the traditional notion of a setoff. See Boston & Maine Corp., 785 F.2d 562 (netting a series of interline debts between rail companies where those debts are finalized on a monthly basis is a setoff). For a corporate taxpayer, this resemblance does not hold true.

At all events, to focus exclusively on whether the procedure the IRS employed should be characterized as a setoff would miss the point. Pettibone's obligations are defined by its plan of reorganization. 11 U.S.C. Sec. 1141; In re Orange Tree Associates, Ltd., 961 F.2d 1445, 1448...