West Texas Marketing Corp., Matter of

• Decision Date: 31 May 1995
• Docket Number: No. 94-10089,94-10089
• Citation: 54 F.3d 1194
• Parties: -2719, 63 USLW 2760, 95-1 USTC P 50,296, Bankr. L. Rep. P 76,511 In the Matter of WEST TEXAS MARKETING CORPORATION, Debtor. Walter C. KELLOGG, Trustee, West Texas Marketing Corporation, Appellant, v. UNITED STATES of America, (Internal Revenue Service), Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1194

54 F.3d 1194

75 A.F.T.R.2d 95-2719, 63 USLW 2760,

95-1 USTC P 50,296,

Bankr. L. Rep. P 76,511

In the Matter of WEST TEXAS MARKETING CORPORATION, Debtor.

Walter C. KELLOGG, Trustee, West Texas Marketing

Corporation, Appellant, v. UNITED STATES of America, (Internal Revenue Service), Appellee.

No. 94-10089.

United States Court of Appeals, Fifth Circuit.

May 31, 1995.

Stacy R. Obenhaus, Brett B. Flagg, Garere & Wynne, Dallas, TX, for appellant.

James I. Shepard, Fresno, CA, for amicus curiae.

Joan I. Oppenheimer, Atty., Gary R. Allen, Chief, Appellate Sec., Linda E. Mosakowski, Gary D. Gray, Attys., Tax Div., U.S. Dept. of Justice, Washington, DC, for appellee.

Appeal from the United States District Court for the Northern District of Texas.

Before SMITH, and BARKSDALE, Circuit Judges, and FITZWATER, ¹ District Judge.

RHESA HAWKINS BARKSDALE, Circuit Judge:

At issue in this Chapter 7 liquidation is whether the district court erred in holding that the estate of West Texas Marketing Corporation (WTMC), the debtor, (1) could not, for federal income tax purposes, accrue and deduct post-petition interest on undisputed and resolved general unsecured claims; and (2) was liable for a tax penalty, even though the Internal Revenue Service assessed it outside the period allowed by Sec. 505(b) of the Bankruptcy Code. We AFFIRM.

I.

This case was tried on stipulated facts, which are developed more fully in In re West Texas Mktg. Corp., 155 B.R. 399 (Bankr.N.D.Tex.1993), and are restated here only as necessary. In 1982, WTMC filed a voluntary bankruptcy petition under Chapter 11 of the Bankruptcy Code; but, the bankruptcy court converted the case to a Chapter 7 liquidation in 1983.

In 1991, Kellogg, as trustee for the estate, filed amended tax returns for 1988 and 1989, on the basis that the estate (1) failed previously to deduct post-petition interest on undisputed and resolved general unsecured claims for 1988 and 1989; and, (2) could deduct net operating loss carryforwards based, in part, on post-petition interest for such claims for 1982 through 1987. ² On WTMC's 1991 return, Kellogg sought also to deduct post-petition interest for such unsecured claims. The total interest expense was approximately $12.6 million, with a total refund claim of approximately $1.1 million. The IRS disallowed the refunds.

In addition, prior to the attempt to deduct post-petition interest, the IRS had assessed a penalty of approximately $23,000 against WTMC for 1989, because it failed to make estimated tax payments. Eventually, the IRS set off this penalty against a refund due WTMC for 1988.

As a result of, inter alia, both actions by the IRS, Kellogg filed this adversary proceeding. The bankruptcy court denied relief; the district court affirmed.

II.

A.

It goes without saying that, generally, pursuant to I.R.C. Sec. 163, a corporation may deduct all interest paid or accrued within the taxable year on indebtedness. Kellogg maintains that WTMC's liability vel non for post-petition interest is a question of state law: that, because the unsecured claims constitute a fixed liability when the petition was filed, the Texas statutory rate of 6% establishes a present and unconditional liability for interest on those claims; and that federal law determines only the priority of how assets of the estate are to be distributed in satisfaction of the claims against it.

In Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156, 67 S.Ct. 237, 91 L.Ed. 162 (1946), the Court recognized that "[w]hat claims of creditors are valid and subsisting obligations against the bankrupt at the time a petition in bankruptcy is filed, is a question which, in the absence of overruling federal law, is to be determined by reference to state law." Id. at 161, 67 S.Ct. at 239 (emphasis added). Thus, the validity of any interest that may have accrued prior to the filing of the petition is resolved generally by state law. But, once the petition is filed, federal law controls. Id. at 163, 67 S.Ct. at 240 ("[w]hen and under what circumstances federal courts will allow interest on claims against debtors' estates being administered by them has long been decided by federal law").

Sections 446(a) and 461(a) of the Internal Revenue Code provide that taxable income is computed, and deductions taken, under the accounting method that the taxpayer normally uses for his books. I.R.C. Secs. 446(a), 461(a). ³ WTMC maintained its books, and calculated its federal income tax liability, utilizing the accrual method. Under that method, the standard for determining when an expense has been incurred for federal income tax purposes has been the "all events" test. During the years at issue, the test required that two elements be met before accrual of an expense would be allowed: first, all the events must have occurred that establish the fact of the liability; and, second, the amount of the liability must be capable of being determined with reasonable accuracy. ⁴ Only the first element is at issue.

"[A]lthough expenses may be deductible before they have become due and payable, liability must first be firmly established.... [A] taxpayer may not deduct a liability that is contingent...." United States v. General Dynamics Corp., 481 U.S. 239, 243, 107 S.Ct. 1732, 1736, 95 L.Ed.2d 226 (1987); accord United States v. Hughes Properties, Inc., 476 U.S. 593, 600-01, 106 S.Ct. 2092, 2096-97, 90 L.Ed.2d 569 (1986). In describing this noncontingent requirement, the Supreme Court has required also that the liability be "fixed and absolute", Hughes, 476 U.S. at 600, 106 S.Ct. at 2096 (quoting Brown v. Helvering, 291 U.S. 193, 201, 54 S.Ct. 356, 360, 78 L.Ed. 725 (1934)), and "unconditional", id. (quoting Lucas v. North Tex. Lumber Co., 281 U.S. 11, 13, 50 S.Ct. 184, 184-85, 74 L.Ed. 668 (1930)).

The issue is not the ability vel non of WTMC to pay post-petition interest on the unsecured claims. See Fahs v. Martin, 224 F.2d 387 (5th Cir.1955) (interest for which an accrual basis taxpayer is presently and unconditionally liable, but which is unlikely to be paid by reason of his insolvency, is still deductible). ⁵ Rather, we must determine whether WTMC's liability for post-petition interest is fixed, absolute, unconditional, or not subject to any contingency. See 2 MERTENS LAW OF FED INCOME TAX Sec. 12 A.139 (1993) ("[w]hile cases have held interest is deductible when there is improbability of payment it is well to note that in none was there any uncertainty (substantial contingency) of the liability itself").

Section 502 of the Bankruptcy Code sets forth a general rule that claims for post-petition interest are not allowed against the estate. 11 U.S.C. Sec. 502(b)(2). ⁶ One of the principles underlying this provision is that "interest stops accruing at the date of the filing of the petition." H.R.REP. NO. 595, 95th Cong., 1st Sess. 353 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6309; S.R.REP. No. 989, 95th Cong., 2d Sess. 63 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5849; see In re Brints Cotton Mktg., Inc., 737 F.2d 1338, 1341 (5th Cir.1984) ("post-petition accumulation of interest (allowable by state law) on claims against a bankrupt's estate are suspended").

The Code provides, however, for several exceptions to this general rule. Section 726(a) establishes hierarchial priorities when distributing a debtor's estate in a Chapter 7 liquidation. Included within the priorities is the payment of post-petition interest on claims against the estate if any assets remain after distributions for prioritized claims, unsecured claims, and penalties, fines, and nonpecuniary damages. 11 U.S.C. Sec. 726(a)(5). The only distribution occupying a lower position on the hierarchy is the return of any remaining assets to the debtor. ⁷

In Guardian Investment Corp. v. Phinney, 253 F.2d 326 (5th Cir.1958), a taxpayer sought to deduct interest on a second mortgage, even though no payments of principal or interest would be due until payment of the first mortgage. Additionally, according to the terms of the second mortgage, payments on it could be made only from the net proceeds of any sale of the mortgaged property. Thus, the potential existed that no payments on the second mortgage would ever be made.

Although Guardian Investment addressed whether the principal due on the second mortgage was contingent, it still provides a framework to consider the contingent nature of an obligation for income tax purposes. ⁸ In finding the indebtedness to be contingent, the Guardian Investment court examined five aspects of the obligation: (1) is there a fixed or determinable date of maturity; (2) is the obligation owed only upon the happening of a condition; (3) is the happening of that condition uncertain; (4) is that condition to occur in futuro; and, (5) is there a fixed or determinable liability? Id. at 331. Considering the aggregate of these factors, our court held that the liability on the second mortgage was not "a fixed, definite, existing obligation". Id.

Implicit in the obligation under Sec. 726 to pay post-petition interest on unsecured claims is the necessary condition that sufficient assets remain following distributions under Sec. 726(a)(1)-(4). These distributions could not occur during the taxable years at issue, and there is no fixed or determinable date when these distributions will occur; the condition is in futuro. Because Kellogg seeks to deduct post-petition interest on undisputed claims, the amount of such liability can easily be determined. When taken in the aggregate, and based upon the principles of accrual accounting, we conclude that, under the all events tests, WTMC's liability for post-petition interest has not been established. Our court recognized in Guardian Investment that, "if the proceeds from the sale of the mortgaged property [were] not sufficient to pay off the first mortgage, the taxpayer [would] not [be] under any obligation to pay any interest or principal of the...