1 District Judge of the Northern District of Texas, sitting by

designation. UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

_____________________

No. 94-10089

_____________________

IN THE MATTER OF: WEST TEXAS MARKETING CORPORATION,

Debtor.

WALTER C. KELLOGG, Trustee,

West Texas Marketing Corporation,

Appellant,

VERSUS

UNITED STATES OF AMERICA,

(Internal Revenue Service),

Appellee.

____________________________________________________

Appeal from the United States District Court

for the Northern District of Texas

_____________________________________________________

(May 31, 1995)

Bef o re 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-pet ition interest on

undisputed and resolved general unsecured claims; and (2) was

liable for a tax penalty, even though the Internal Revenue Service2 WTMC's accounting period runs from October 1 to September 30.

For example, taxable y ear 1988 represents October 1, 1987, to

September 30, 1988.

- 2 - assessed it outside the period allowed by § 505(b) of the

Bankruptcy Code. We AFFIRM

.

I.

This case was tried on stipulated facts, which are developed

more full y in I n 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 op erating loss carryforwards based, in part, on postpetition interest fo r 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.- 3 -

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. §

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 un secured 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

(1946), the Court recognized that "[w]hat claims of creditors are

valid and subsisting obligations against the bankrupt at the time

a petition in b ankruptcy is filed , is a question which, in the

absence of overruling federal law, is to be determined by reference

to state law." I d. at 161 (emphasis added). Thus, the validity of

any interest that may have accrued prior to the f iling of the

petition is resolved generally by state law. But, once the

petition is filed, federal law controls. Id. at 163 ("[w]hen and

under what circumstances federal courts will allow intere st on3 I.R.C. § 446(a) provides: "Taxable income shall be computed

under the method of accounting on the basis of which the taxpayer

regularly computes his income in keeping his books".

I.R.C. § 461(a) provides: "The amount of any deduction or

credit allowed by this subtitle shall be taken for the taxable year

which is the proper taxable year under the method of accounting

used in computing taxable income".

4 The Treasury Regulation in f orce from 1982 to 1991 provided

that "an expense is deductible for the taxabl e year in which all

the events have occurred which determine the fact of the liability

and the amount thereof can be determined with reasonable accuracy".

Treas. Reg. § 1.461-1(a)(2) (1991). In 1992, the Regulation was

modified to provide for the deduction of expenses "in the taxable

year in which all the events have occurred that establish the fact

of the liability, the amount of the liability can be determined

w ith reasonable accuracy, and economic performance has occu rred

with respect to the liability". Treas. Reg. § 1.461-1(a)(2)(i)

(1992).

- 4 - 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

pro vide that taxable income is computed, and deductions taken,

under the accounting method that the taxpayer normally uses for his

books. I.R.C. §§ 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.5 For all but one of the years at i ssue, the total undisputed

and resolved claims against WTMC exceeded WTMC's assets. Thus, it

was extremely unlikely that WTMC would be able to pay such claims.

As noted, however, this fact is not dispositive of the issue before

us.

- 5 - "[A]lthough expenses may be deductible before they have become

due and payable, liability must first be firmly established....

[A] taxpayer m ay not deduct a liability that is contingent...."

United States v. General Dynamics Corp.

, 481 U.S. 239, 243 (1987);

accord United States v. Hughes Properties, Inc.

, 476 U.S. 593, 600-

01 (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 (quoting Brown v. Helvering

, 291

U.S. 193, 201 (1934)), and "unconditional", id. (quoting Lucas v.

North Tex. Lumber Co. , 281 U.S. 11, 13 (1930)).

The issue is not the ability vel non of WTMC to pay postpetition interest on the unsecured claims. S ee 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, unconditio nal, or

not subject to any contingency. See 2 M ERTENS L AW OF F ED I NCOME T AX §

12A.139 (1993) ("[w]hile cases have hel d interest is deductible

when there is improbability of payment it is well to note that in

none was there any uncertainty (substantial contin gency) of the

liability itself").6 Section 502 of the Bankruptcy Code provides, in perti nent

part:

(a) A claim or in terest, proof of which is

f iled under section 501 of this title, is deemed

allowed, unless a party in interest ... objects.

(b)

... if such an objectio n to a claim is

made, the court, after notice and a hearing, shall

determine t he amount of such claim ... and shall

allow such claim in such amount, except to the

extent that --

....

(2) such claim is for unmatured interest.

11 U.S.C. § 502.

- 6 - 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. § 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. R EP

. N O

. 595, 95th Cong., 1st Sess.

353 (1977), reprinted in 19 78 U.S.C.C.A.N. 5963, 6309; S.R. R EP

.

N O

. 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

i nterest (allowable by state law) on claims against a bankrup t'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 Ch apter 7 liquidation.

Included within the priorities is the payment of post-petition

interest on claims against the estate if any assets remain after7 Section 726 of the Bankruptcy Code provides that:

(a)

... property of the estate shall be

distributed --

(1) first, in payment of claims of the

kind specified in, and in the order specified

in, section 507 of this title [(prioritized

claims)];

(2) second, in payment of any allowed

unsecured claim, other than a claim of a kind

specifi ed in paragraph (1), (3), or (4) of

this subsection ...;

(3) third, in payment of any

allowed unsecured claim proof of which is

tardily filed under section 501(a) of

this title, other than a claim of the

kind specified in paragraph 2(C) of this

subsection;

(4) fourth, in payment of any

allowed cla im, whether secured or

unsecured, for any fine, penalty, or

forfeiture, or for multiple, exempla ry,

or punitive damages, arising before the

earlier of the orde r for relief or the

appointment of a trustee, to the extent

that such fine, penalty, forfeiture, or

damages are not compensation for actual

pecuniary loss suffered by the holder of

such claim;

(5) fifth, in pa yment of interest

a t the legal rate from the date of the

filing of the petition, on any claim paid

under paragraph (1), (2), (3), or (4) of

this subsection; and

(6) sixth, to the debtor.

- 7 - distributions for prioritized claims, unsecured claims, and

penalties, fines, and nonpecuniary damages. 11 U.S.C. § 726(a)(5).

The only distribution occupying a lower position on the hierarchy

is the return of any remaining assets to the debtor. 78 We rely upon Guardian Investment to provide structure for our

analysis of the contin gent nature of WTMC's liability for postpetition interest, not to command of itself the result we reach on

the basis of §§ 502(b) and 726(a). We need not, therefore, concern

ourselves with factual distinctions between Guardian Investment and

the present case.

- 8 - In G uardian 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 conting ent nature of an obligation for

i ncome 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? I d. 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 § 72 6 to pay post-petition

interest on unsecured claims is t he necessary condition that9 Of course, if assets remain after distributions are made

pursuant to § 726(a)(1 ) -(4), then liability for post-petition

interest will be established.

- 9 - sufficient assets remain following distributions under § 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-petitio n interest has not been

established. Our court recognized in G uardian 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

second mortgage". I d. at 331. Similarly, if, in the distribution

of WTMC's assets in accordance with § 726(a)(1)-(4), all assets are

depleted, then the estate will not have incurred any obligation to

pay interest on unsecured claims. This is not due to the fact that

payment became impossible, but because the condition necessary to

create the liability for the post-petition interest failed to

occur.

Accordingly, Kellogg may not now deduct post-petition interest

on undisputed and resolved, general unsecured claims against the

estate. 910 As a preliminary matter, the IRS contends, erroneously, that,

because the United States did not wa ive sovereign immunity, the

district court lacked j urisdiction to consider whether WTMC was

entitled to a refund for the pe nalty. It maintains that, as a

statutory condition precedent to a refund suit, the taxpayer must

file a claim for the refund.

Section 7422 of the Internal Revenue Code provides that "[n]o

suit or proceeding shall be maintained in any court for the

recovery of any internal revenue tax ... until a claim for refund

or credit has been duly filed with the Secretary, according to the

provisions of law in that regard, and the regulations of the

Secretary establish ed in pursuance thereof". I.R.C. § 7422(a).

Furt hermore, Bankruptcy Code § 505(a)(2)(B) provides that a

bankruptcy court may not determine

any right of the estate to a tax refund, before the

earlier of --

(i) 120 days after the trustee properly

requests such refund from the governmental unit

from which such refund is claimed; or

(ii) a determination by such governmental unit

of such request.

11 U.S.C. § 505(a)(2)(B).

Between submission of briefs and oral argument, however,

Congress enacted the Bankruptcy Reform Act of 1994 by which it,

inter alia , abrogated expressly, and retrospectively, a claim of

sovereign immunity with respect to § 505. Pub. L. No. 103-394, §

113, 108 Stat. 4106, 4117. Section 113 of the Act provides in

pertinent part:

Section 106 of title 11, Unit ed States Code,

is amended to read as follows:

" § 106. Waiver of sovereign immunity

"(a) Notwithstanding an assertion of

- 10 - B.

The other issue is whether the IRS violated the tax liability

discharge provision of 11 U.S.C. § 505(b) when it assessed the

estimated tax penalty for 1989 and us ed it as a setoff against a

refund due for 1988. 10 Section 505(b) allows trustees to requestsovereign immunity, sovereign immunity is

abrogated a s to a governmental unit to the

extent set forth in this section with respect

to the following:

"(1) Section[]

... 505

... of this

title.

"(2) The Court may hear and

determine any issue arising with respect

to the application of such sections to

governmental units.

...."

108 Stat. 4106, 4117- 18. And, pursuant to § 702(b)(2)(B) of the

Act, this amendment is made applicable to all pending cases:

The amendments made by sectio ns 113 and 117 shall

apply with respect to cases commence d under title

11 of the United States Code before, on, and after

the date of the enactment of this Act.

108 Stat. 4106, 4150.

Although, in his rebuttal at oral argument, coun sel for

Kellogg noted the recent Act, neither side filed a letter citing

sup plemental authority as permitted by F E D

. R. A PP

. P. 28(j). We

note that the Government is obviously cognizant of Rule 28(j), in

that it filed a 28(j) letter on a different issue in this case. Needless to say, supplemental briefs should have been filed.

11 Section 505(b) of the Bankruptcy Code provides:

A t rustee may request a determination of any

unpaid liability of the estate for any tax incurred

during the administration of the case by submitting

- 11 - a determination of any unpaid tax liability from the appr opriate

governmental unit, and provides that, unless that entity notifies

t he trustee within 60 days that the return has been selected for

examination, "the trustee, the debtor, and any succ essor to the

debtor are discharged from any liability for such tax" unless the

return is fraudulent or contains a material misrepresentation. 11

U.S.C. § 505(b) (emphasis added). 11 Kellogg made a § 505(b)a tax return for such tax and a request for such a

determination to the governmental unit charged with

responsibility for collection or determination of

suc h tax. Unless such return is fraudulent, or

contains a material misrepresentation, the trustee,

the debto r, and any successor to the debtor are

discharged from any liability for such tax --

(1) upon payment of the tax shown on such

return, if --

(A) such governmental unit does not

notify the trustee, within 60 days after such

request, that such return has been selected

for examination; or

(B) such governmental unit does not

complete such an examination and notify the

trustee of any tax due, within 180 days after

such request or within such additional time as the court, for cause, permits;

(2) upon payment of the tax determined by the

court, after notice and a hearing, after completion

by such governmental unit of such examination; or

(3) upon payment of the tax determined by

such governmental unit to be due.

11 U.S.C. § 505(b).

12 Kellogg challenges the underlying merits of the penalty. The

only time Kellogg previously raised this issue was in a reply brief

to the bankruptcy court. (It was not in the pretrial order.) It

appears that the issue was not raised in, or c onsidered by, the

district court. In any event, we consider it waived.

- 12 - request, but the IRS did not assess the penalty within the 60 day

limit. We must determine, therefore, whether § 505(b) bars the

subsequent ass essment and collection of the penalty against the

estate. 12

1.

The IRS contends that Kellogg's r eliance on § 505(b) is

misplaced because this issue does not involve the IRS seeking to13 Section 505(a)(1) of the Bankruptcy Code provides that

the court may determine the amount or le gality of

any tax, any fine or penalty relating to a tax, or

any addition to tax, whether or not previously

assessed, whether or not paid, and whether or not

c ontested before and adjudicated by a judicial or

administrative tribunal of competent jurisdiction.

11 U.S.C. § 505(a)(1).

- 13 - assess or collect taxes; rather, any tax liability for the penalty

has been extinguished because it was used as a setoff against the

r efund due for 1988. Thus, the IRS maintains, this claim is

instead for a refund, governed by § 505(a). 13

As noted, Kellogg filed a timely return for 1989, and

requested a prompt determination pursuant to § 505(b). A month

later, the IRS notified Kellogg that the return had been accepted

as filed and issued a refund check. But, over three months after

the 1989 return was filed, the IRS notified Kellogg of the penalty

and, subsequently, used it as a setoff against the refund due for

1988. If WTMC had not had that refund due, the IRS would not have

been able to collect the penalty as it did. Only because the IRS

found WTMC in the fortuitous position of being entitled to a refund

for the prior tax year was it able to offset. Claiming that these

events mandate th at Kellogg is not entitled to raise a § 505(b)

timeliness issue places form over substance.

2.

Under 505(b), the failure of the IRS to act in a timely manner

discharges potential tax liability of, inter alia , the debtor and

the trustee. At issue is whether this failure discharges the- 14 -

estate as well, under the section's nomenclature of "any successor

to the debtor". This is an issue of first impression for any

circuit court. Of the two lower courts to have considered directly

this issue, both h ave held that the estate does not enjoy the

discharge given to "any successor to the debtor". I n re Fondiller

,

125 B.R. 805 (N.D. Cal. 1991); In re Rode

, 119 B.R. 697 (Bankr.

E.D. Mo. 1990); but see In re Flaherty

, 169 B.R. 267, 270 n.4

(Bankr. D.N.H. 1994) (declaring, in dictum, that "[a] lthough the

actual wording of subsection (b) of the statute is `the trustee,

the debtor, or any successor to the debtor are discharged from any

liability for such tax,' ... this language effectively discharges

the estate of the tax, as well").

It g oes without saying that our interpretation of a statute

begins with its language. The Bankruptcy Code defines a debtor as

a "person or municipality concerning which a case under this title

has been commenced", 11 U.S.C. § 101(13); and a "person" includes

an "individual, partnership, and corporation". 11 U.S.C. §

101(41). Thus, a "debtor" must be an individual, partnership or

corporation, and it follows that any "successor to the debtor" must

also be an individual, partnership or corporation. It becomes more

obvious that the estate cannot be a "successor" when we consider

what is an "estate". An "estate" is created at the commencement of

the bankruptcy case, and is "comprised" of, inter alia

, "all legal

and equitable interests of the debtor in property as of the

commencement of the case". 11 U.S.C. § 541(a), (a)(1).- 15 -

Furthermore, § 505(c) uses the term "estate" as distinct from

the terms "debtor" and "successor to the debtor". Section 505(c)

provides that, after the court makes a determination of tax under

§ 505, "the governmental unit charged with responsibility for

collection of such tax may assess such tax against the estate, the

debtor, or a successor to the debtor ...." Thus, the clear

distinction between the "estate" and "successor to the debtor"

demonstrates that Congress did not intend for the discharge of tax

liability under § 505(b) to apply to the estate.

In addition to the Code's plain language, the situation faced

by trustees prior to the enactment of the Bankruptcy Code illumines

the purpose to be served by § 50 5. Prior to the Code, trustees

lacked a mechanism for obtaining a prompt determination of the tax

liability of the estate. Therefore, a trustee wishing to have the

case closed was confronted with the choice of leaving the estate

open until the IRS's opportunity to review the estate's tax

expired, or proceed to have the case closed and face the potential

of personal lia bility for additional taxes that the IRS might

determine subsequently were due. Section 505(b) provided the

solution to this dilemma. 1A Collier on Bankr. (MB) ¶ 12.04[3].

Although [§ 505(b)] was envisioned a s a mechanism

t o permit a determination of tax liability at the

conclusion of the administration of an estate,

i.e.

, a single request for a prompt determina tion

of all the relevant tax periods, there is nothing

i n its language to prevent successive requests as

each tax period is completed and a re turn filed

apart from the obligation to pay the taxes shown on

such returns.

Id.- 16 - III.

For the foregoing reasons, the judgment is

AFFIRMED

.-17-

JERRY E. SMITH, Circuit Judge, dissenting:

Ever since this circuit decided Fahs v. Martin , 224 F.2d 387

( 5th Cir. 1955), the settled rule has been that an accrual basis

taxpayer immediately may deduct, under the Internal Revenue Code,

an expense such as interest legally owed, notwithstanding the

improbability of payment. I d. at 393. No distinction is made

between a debt ba cked by the full faith and credit of the United

States and one owed by a creditor who has not only tottered at the

brink of bankruptcy but h as fallen into the chasm. The majority

today would retreat from our rule in the case of interest imposed

by state law during the pendency of bankruptcy ("pendency interest"). As I believe the majority misinterprets the Bankruptcy

Code, extinguishes a state property right and creates a federal

one, and confuses the distinction between improbable and contingent

payment, I respectfully dissent.

A.

I begin by examining the source of the interest at issue. The

obligation to pay interest for debts owed on contracts and accounts

is a creation of the law of contract. Generally, contract law

among private parties in our federalist system is state law. Under

the state law of contract here, Texas law, the background rule for

debts owed on accounts and contracts is that interest at six

percent will be imposed thirty days after the debt was due, unless

the parties agree otherwise. T E X

. R EV

. C IV

. S TAT

. A NN

. art. 5069-1.03

(West 1987). The majority does not doubt that such a property-18-

right and its obligations existed prior to the imposition of

bankruptcy.

The majority, however, believes that, post-petition, federal

law controls. See Vanston Bondholders Protective Comm. v. Green

,

329 U.S. 156, 163 (1946) ("When 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."). The majority does not specify what it means by "controls."

Presumably, however, the majority means that federal law defines

which debts are valid, as that was the position taken here by the

government and bankruptcy court below. S ee Kel logg v. United

State s (In re West Texas Mktg. Corp.) , 155 B.R. 399, 402 (Bankr.

N.D. Tex. 1993) (positing that both state and federal law are

"sources of liability for postpetition interest on general

unsecured claims"). This view is only half right.

The federal law of bankruptcy is not designed to create debts

among parties but to determine how existing debts should be

distributed to creditors fairly. Justice Frankfurter's concurrence

in Vanston explains as much:

The business of bankruptcy administration is to determine

how existing debts should be satisfied out of the

bankrupt's estate so as to deal fairly with the various

creditors. The existence of a debt bewteen the parties

to an alleged creditor-debtor relation is independent of

bankruptcy and precedes it. Parties are in a bankruptcy

court with their rights and duties already established,

except insofar as they subsequently arise during the

course of bankruptcy administration or as part of its

c onduct. Obligations to be satisfied out of the bankrupt's estate thus arise, if at all, out of tort or contract or other relationship created under applicable

law. And the law that fixes legal consequences to

transactions is the law of the several States.-19-

Vanston , 329 U.S. at 169 (Frankfurter, J., concurring); see also

id. at 161 ("What claims of creditors are valid and subsisting

obligations against t he 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.") (Black, J.) (majority opinion); G rogan v. Garner

, 498 U.S.

279, 283 (1991) ("The validity of a creditor's claim is determined

by rules of state law.").

This point bears stressing. Nothing in the Bankruptcy Code

awards damages for failure to deliver goods or injury from the

negligent operation of a vehicle. Nor does it create the right to

collect interest from an unpaid debt.

Bankruptcy law does control in the sense that courts ultimately may not enforce such rights in carrying out their constitutional and statutory obligations. As Justice Frankfurter continued:

Of course a State may affix to a transaction an obligation which the courts of other States or the federal

courts need not enforce because of overriding considerations of policy. And so, in the proper adjustment of

the rights of creditors and the desire to reh abilitate

the debtor, Congress under its b a nkruptcy power may

authorize its courts to refuse to allow existing debts to

be proven.

Vanston

, 329 U.S. at 169. Thus, a state-law debt may enter the

controls of the Bankruptcy Code as valid, but ultimately may not be

enforced if the bankruptcy court, through its congressionally

granted equitable powers, determines otherwise. S ee Fahs

, 224 F.2d

at 395 (" [W]e interpret [ V anston ] only as establishing the14 In Fahs , we further explained our position, stating:

The majority opinion [in V anston ] may be reconciled with [the

concurrence's] unquestionably correct pr inciples only if it is

regarded, as we regard it, as not declaring the obligation

(regardless of validity under state law) void, but merely as

subordinating it.

224 F.2d at 395 n.5. S ee also P epper v. Litton

, 308 U.S. 295, 310-12 (1939)

(holding that bankruptcy court has e quitable power to disallow or subordinate

state judgment); Addison v. Langston (In re Brints Cotton Mktg., Inc.)

, 737 F.2d

1338, 1341-42 (5th Cir. 1984) ("[W]hile state law ordinarily determines what

claims of creditors are valid and subsisting obligations, a bankruptcy court is

entitled (if authorized by the federal bankruptcy statute) to determine how and

what claims are allowable for bankruptcy purposes, in order to accomplish the

statutory purpose of advancing a ratable distribution of assets amo ng the

creditors."); s ee generally 3 D ANIEL R. C OWANS , C OWAN'S B ANKRUPTCY L AW AND P RACTICE § 12.7,

at 39-40 (1994) (examining interrelationship of state law claims and

"allowability" under the Bankruptcy Code).

-20- equitable power and duty of bankruptcy courts to subordinate such

a claim."). 14

B.

I have stressed the distinction between state property law and

federal bankruptcy law in some deta il, as that distinction is

critical in understanding how federa l bankruptcy law "controls"

here. Kellogg's state law obligation to pay interest on its overdue debts pre-dates the imposition of bankruptcy. Now, the

question we must answ er is when, in the bankruptcy proceedings,

such a state law right is extinguished.

Turning to the Bankrup tcy Code, I note that section 502(a),

11 U.S.C. § 502(a), provides, in pertinen t part, that a claim is

allowed unles s a party in interest objects. Upon objection,

section 502(b) provides, in relevant part, that "the court, after

notice and a hearing, shall determine the amount of such a claim

. . . and shall allow such a claim in such amount except to the1 5 S ee Sexton v. Dreyfus , 219 U.S. 339, 344-46 (1911) (examining origins

of American rule derived from En glish bankruptcy system); s ee also Thomas v.

Western Car Co. , 149 U.S. 95, 116-17 (1893) (recognizing rule); American Iron

& Steel Mfg. Co. v. Seaboard Air L ine Ry. , 233 U.S. 261, 266-67 (1914)

(recognizing rule and exceptions); C ity of New York v. Saper

, 336 U.S. 328, 330

& n.7 (1949) (same).

1 6 In fact, the Code provides at least three exceptions. Section

726(a)(5) is discussed in the text. Section 506(b) allows interest to a secured

creditor to the extent the secured property is greater than the amount of the

claim. S ee U nited States v. Ron Pair Enters., Inc.

, 489 U.S. 235, 245-46 (1989)

(interpreting § 506(b)). Section 1124 specifically permits reinstatement of a

debt according to its original contractual terms if the debtor brings current the

payments of principal and interest accrued during bankruptcy. S ee U nited Sav.

Ass'n v. Timbers of Inwood Forest Assocs., Ltd. (In re Timbers of Inwood Forest

Assocs., Ltd.)

, 808 F.2d 363, 380 (5th Cir. 1987) (en banc) (Jones, J.,

dissenting), aff'd , 484 U.S. 365, 371 (1988).

-21- extent that ))

. . . (2) such a claim is for unmatured int erest."

This section is a codification of the pre-Code rule that courts

need not recognize the accrual of interest during the pendency of

bankruptcy. 15 When read in isolation, the plain language of

§ 502(b)(2) a ppears to extinguish a creditor's right to earn

interest and a debtor's obligation to pay it.

A court's duty in interpreting the Bankruptcy Code, however,

is to read the statute holistically. U nited Sav. Ass'n v. Timbers

of Inwood Forest Assocs., Ltd. , 484 U.S. 365, 371 (1988). As the

majority recognizes, Congress has codified an exception to the

general rule. 16 Section 726(a) of the Bankruptcy Code, which

controls the order of distribution in chapter 7 cases, mandates to

the court that the

property of the estate shall be distributed ))

(5) fifth, in payment of interest at the legal rate from

the date of the filing of the petition, on any claim paid

under paragraph (1), (2), (3), or (4) of this subsection

. . . .1 7 Thus, while pre-Code precedent supports the argument that interest

stops running when a bankruptcy petition is filed, Sexton

, 219 U.S. at 344, this

practice was not absolute. Two, if not three, exceptions were recognized. S ee

Ron Pair

, 489 U.S. at 246. The two well-recognized rules were: If the alleged

bankrupt proved solvent, creditors received post-bankruptcy interest before any

surplus was returned to the bankrupt; and if securities of the bankrupt produced

interest or dividends during bankruptcy, such amounts were supplied to postbankruptcy interest. S aper

, 336 U.S. at 330 n.7. Of more doubtful origin, under

pre-Code precedent, was an exception for oversecured claims. R on Pair

, 489 U.S.

at 246.

1 8 Because § 726(a)(5) states that the interest should be set "at the

legal rate," Te xas state law determines the existence and amount of interest.

See generally Chaim J. Fortgang & Lawrence P. King, The 1978 Bankruptcy Code:

Some Wrong Policy Decisions , 56 N.Y.U.L. Rev. 1148, 1151-52 (1981) (discussing

whether "legal rate" means statutory rate or rate set by contracts). As no rate

was set by the contracts here, this problem is not presented.

-22- This rule, like that codified in § 502(b)(2), claims an impressive

pedigree from a long line of pre-Code decisions. S ee, e.g.

,

2 W IL LIAM B LACKSTONE

, C OMMENTARIES *488 ("[T]hough the usual rule is,

that all interest on debts carrying interest shall cease from the

time of issuing the commission, yet, in the case of a surplus left

after payment of every debt, such interest shall revive, and be

chargeable to the bankrupt or his representatives."). 17 Its effect

is that when sufficient assets remain in the estate after prior

distributions, the bankruptcy court is re quired to pay the

creditors interest. 18 The only lower distribution returns the

remaining assets to the debtor. § 726(a)(6).

Accordingly, throughout bankruptcy, the debtor retains the

obligation to pay its creditors interest. When sufficient assets

remain upon distribution, the court must provide for the payment of

interest. No doubt the creditors would insist on as much. And,

while actual payment may be unlikely, the obligation to pay is not.

Such an oblig ation, therefore, is not extinguished, but, for

purposes of the bankruptcy proceedings, is ignored until the time1 9 Courts in applying the general rule of 502(b)(2) have used various

terms to describe its effect: Interest is "suspended," N icholas v. United

States

, 384 U.S. 678, 682 & n.9 (1966), ceases to run, Ron Pair

, 489 U.S. at 246,

stops, Saper , 336 U.S. at 330, is "not computed," Sexton , 219 U.S. at 344, and

is not allowed, Vansto n , 329 U.S. at 163. The exact terminology, while

important, does not overcome the requirements of the Bankruptcy Code, however.

As discussed below, where the Code provides an exception to the general rule, the

right to the interest continues to exist.

20 The leading commentary on bankruptcy has recognized as much:

[C]are must be taken not to confuse tax accrual concepts and payment

in a title 11 context. Section 502(b)(2) of the Bankruptcy Code

prescribes the grounds for objecting to claims in a title 11 case.

By itself, it does not change the legal rights of the holder of an

obligation against the debtor. Put another way, the general rule in

title 11 cases that there is no accrual of postpetition interest is

a rule of convenience governing distributions to creditors. It is

not a rule of substantive law that conv erts an interest-bearing

indebtedness to a nonenforceable, non-interest-bearing indebtedness.

Even I n re Continental Vending Mach. Corp.

, [77-1 U.S. Tax C as.

(CCH) ¶ 9,121, at 86,093 (E.D.N.Y. 1976)], which is often cited for

the opposite position against tax accrual of post-petition interest,

state unequivocally:

A bankruptcy petition, whether straight or a corporate

reorganization,

. . . suspends or postpones the accrual of interest

even though the "claim has not lost its interest-bearing quality."

Id. at 86,097-98 (citin g 6A C O LLIERS ON B ANKRUPTCY ¶ 9.08, at 194 (14th

ed.)).

1A E LIOT G. F REIER ET AL. , C OLLIERS ON B ANKRUPTCY ¶ 22.05, at 22-40 (Lawrence P. King ed., 15th

ed. 1988) [hereinafter C OLLIERS ON B ANKRUP TCY ] ; s ee also 3 C OLLIERS ON B ANKRUPTCY , supra

, ¶ 502.02[2] (discussing general principles of bankruptcy as applied to unmatured

interest).

-23- the court determines wh ether the debtor's assets can meet the

obligation. 19 Only upon discharge, s ee § 727, is the state law

obligation to pay extinguished.

This result occurs because § 502 (b)(2) is a matter of

convenience, not substantive law. 20 That section is premised upon

the idea of making bankruptcy proceedings easier and fairer to

administer, not replacing state prop erty law with federal. The

Supreme Court explained the pre -Code justification of the rule

thus:2 1 Indeed, the legislative history in the Senate and House reports

accompanying the Bankruptcy Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549, shows

that the current Bankruptcy Code enacted much of the pre-Code rules regarding

pendency interest. S ee S. Rep. No. 989, 95th Cong., 2d Sess. 62-63 (1978),

reprinted in 1978 U.S.C.C.A.N. 5787, 5848-89 (stating that § 502(b)(2) contains

"two principles of current law," including rule that unmatured interest is

disallowed); H. Rep. No. 595, 95th Cong., 1st Sess., 352-53 (1977), reprinted in

1978 U.S.C.C.A.N. 5963, 6308 (same); S. Rep. No. 989, 95th Cong., 2d Sess. 97

(1978), repr i nted in 1978 U.S.C.C.A.N. 5787, 5883 (stating that §726(a)(4)

provides that punitive penalties are subrogated to all other claims, "except

interest accruing during the case"; § 726(a)(5) provides for post-petition

interest where assets remain); H. Rep. No. 595, 95th Cong., 1st Sess. 383

(1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6339 (same); see also Report of the

Committee of Finance, S. Rep. No. 95-1106, 95th C o ng., 2d Sess. 22-23 (1978),

reprinted in 3 app. C OLLIERS ON B ANKRUPTCY , supra

, at Tab VI (recognizing "subordination

rule" for post-petition interest and recommending that tax liens and interest be

"non-dischargeable"). A search of the Congressional Record reveals no discussion

or even language sug g esting that the pre-Code rules should be discarded or

Vanston legislatively overtu r ned. S ee 124 Cong. Rec. 1783 (1978); 124 Cong.

Rec. 32,383 (1978); 124 Cong. Rec. 34,143 (1978); 124 Cong. Rec. 28,257 (1978).

Finally, the suggested bill contained in the report of the Commission of the

Bankruptcy Laws of the United States, which provided much of the legislative

impetus for the 1978 Act, provided an expli cit provision for the payment of

interest. McCoid, s upra

, at 8-9 (citing Report of the Com mission on the

Bankruptcy Laws of the United States § 4-405(a)(8), H.R. Doc. No. 137, 93d Cong.

1st Sess., Part II, at 110 (1973)).

(continued...)

-24- Accrual of simple interest on unsecured claims in

bankruptcy was prohibited in order that the

administrative inconvenience of continuous recomputation

of interest causing recomputation of claims could be

avoided. Moreover, different creditors whose claims bore

diverse interest rates or were paid by the bankruptcy

cou rt on different dates would suffer neither gain nor

loss caused solely by delay.

Vanston , 329 U.S. at 164. Nothing in the text or the legislative

history of this section of the Bankruptcy Code, which admits to

codifying much of the p re-Code practice, suggests that Congress

adopted this rule for any other purpose. See John C. McCoid, II,

Pendency Interest in Bankruptcy

, 68 Am. Bankr. L.J. 1, 9 (1994)

("Though Congress said more this time, there is nothing in the

legislati ve history that indicates any intention to effect any

change in the law on the subject of pendency interest by virtue of

these sections."). 21(...continued)

I have examined the legislative history to show that the majo rity's

reliance upon the Senate and House reports discussing § 502(b)(2) is incomplete.

That section must be read in context with the other sections of the Code, their

legislative history, and the pre-Code practice that the Code adopted.

2 2 See N icholas v. United States

, 384 U.S. 678, 689 (196 6) (quoting

Vanston passage with approval); B runing v. United States

, 376 U.S. 362, 362 n.4

(1964) (same); A

merican Iron

, 233 U.S. at 266 (explaining that the pre-Code rule

applies, "not because the claims had lost their interest-bearing quality during

[receivership], but [because it] is a necessary and enforced rule of

distribution, du e to the fact that in case of receiverships the assets are

generally insuff icient to pay debts in full."); 3 C O LLIER ON B ANKRUPTCY

, supra

, ¶ 502.2[2], at 34-34.1 (noting that § 502(b)(2)'s "disall owance of claims for

unmatured interest or claims accruin g after the date of the filing of the

petition is one of policy and convenience rather than a statement of substantive

law").

-25- Moreover, our precedent and Supreme Court caselaw con clude

that § 502(b) does not void the state property interests, but only

ignores it until distribution as a matter of policy. In Fahs , we

stated that

[t]he Vanston case seems to us to establish a rule only

for the distribution of a bankrupt's assets. It did not

hold that such a claim was void, but only that the

claimant should not participate i n the distribution of

assets until all claims superior in conscience and

fairness were paid.

224 F.2d at 394. We have followed this reasoning in applying the

current Bankruptcy Code. S ee United Sav. Ass'n v. Timbers of

Inwood Forest Assocs., Ltd. (In re Timbers of Inwood Forest

Assocs., Ltd.

, 793 F.2d 1380, 1386 n.5 (5th Cir. 1986) ("Put

differently, the petition suspended the c ontract right to accrue

interest; it did not extinguish the right."), reinstated

, 808 F.2d

363 (5th Cir.), (en banc), aff'd , 481 U.S. 1068 (1987).

Likewise, the Supreme Court has continued to adhere to

Vanston

. 22 In sum, § 502(b)(2), as a non-substantive rule, does not-26-

void the state right to interest, but merely limits its eventual

distribution.

While the majority does not say so explicitly, it treats

section 502(b) as a substantive rule. According to the majority,

the non-contingent, state-law obligation to pay pendency interest

becomes "contingent" upon the filing of the b ankruptcy petition.

The majority does not mean that paym ent is contingent, as

sufficient funds must remain in order for the debt to be paid.

Rather, reasoning that the ultimate distribution of any interest is

contingent upon there being assets remaining in the estate to pay

it, the majority holds that "the condition necessary to create the

liability for the post-petition interest failed to occur."

(Emphasis added). S ee also 2 J ACOB M ERTENS

, J R

., M ERTENS L AW OF F EDERAL

I NCOME T AX § 12A.138, at 253 (1994) ("The liability ceases to exist

when the property of the corporation passes into the receiver's

hands.").

In effect, the majority snuffs out the state-law obligation to

pay interest and reimposes it at the end of distribution only upon

the contingency that assets remain. The majority thus presents two

difficult conceptual problems that it does not address. First, the

majority does not explain what the source of this interest would be

upon distribution. Does the majority believe that § 726(a)(5) is

an independent source for a federal property right? Second, if the

source of the right is Texas state property law, how is the risk of

ultimate distribution under § 726(a)(5) different from the risk of

distribution of any debt in bankruptcy?-27-

The majority's non-answer to these difficult questions is to

resort to one case, Guardian Inv. Corp. v. Phinney , 253 F.2d 326

(5th Cir. 1958), which it claims "provides a framework to consider

the contingent nature of an obligatio n for income tax purposes."

Perhaps Guardian does, but that case is easily distinguishable from

the situation here, as in Guardian the obligation to pay the debt,

a second mortgage, was contingent by the terms of the agreement

itself. Here, the state property right is not contingent by its

terms. Moreover, G uardian does not even mentio n the Bankruptcy

Code. A 1958 case that fails even to mention the Bankruptcy Code

can be of little assistance in interpreting the current Code,

substantially codified in 1978. Its application is simply an

anachronism.

Rather than wander so far afield and out of time, I would turn

to the current Bankruptcy Code and interpret the interplay between

§§ 502(b)(2) and 726(a)(5) as settling a scheme for distribution of

the fixed obligation to pay interest. Section 502(b)(2), which

directs courts to ignore pendency interest, codifies a rule of

convenience in order to ease the administration of the bankruptcy

process. Section 726(a)(5) preserves the debtor's obligation to

pay this debt as a matter of fairness to the creditors.

This interpretation of the Bankruptcy Code is consistent with

the language of the statute, pre-Code casel aw, the legislative

history, the view of the leading commentary on bankruptcy, and, not2 3 Even the Tax Court has recognized the continuing validity of F ahs

. S ee

Southeastern Mail Trans. Inc. v. Commissioner

, 63 T.C.M. (CCH) 2893, 2905-06

(1992). Apparently, it is also consistent with earlier IRS policy. S ee, e.g.

, Rev. Rul. 70-367, 1970-2 C

. B. 37 (1970) (holding that interest accrued for

obligations of debtor corporation undergoing reorganization under Bankrupt c y

Act). "The doubt as to the payment of such interest is not a contingency of a

kind that postpones the accrual of the li ability until the contingency is

resolved." Id.

2 4 See, e.g.

, Tampa & Gulf Coast R.R. v. Commissioner

, 469 F.2d 263, 264

(5th Cir. 1972); L awyer's Title Guar. Fund v. United States

, 508 F.2d 1, 6 (5th

Cir. 1975) ("The law also is that a bare possibility of non-payment or delay in

payment because of the principal's financial condition does not defeat accrual

either."); W.S. Badock Corp. v. Commissioner , 491 F.2d 1226, 1228 (5th Cir.

1974) (recognizing rule that risk of collection does not defeat fixed liability

for accrual purposes). The government does correctly note that we have created

(continued...)

-28- least of all, our precedent. 23 In sum, Kellogg retains the

obligation to pay pendency interest. The remaining question is

whether the improbability of payment prevents Kellogg from

deducting the interest.

C.

Finally, I return to an application of Fahs

, in which a

bankruptcy trustee attempted to deduct interest owed on mortgage

indentures that accrued during the pendency of bankruptcy. The

government objected, in part, on the ground that the interest was

"not accruable and deductible for income tax purposes in view of

the fact that there is little or no likelihood that it will ever be

paid." 2 24 F.2d at 393. We, however, held that "interest on an

unconditional legal obligation is deductible for income tax

purposes by an accrual basis taxpayer, notwithstanding the

improbability of its being paid . . . ." Id. at 395.

Contrary to the holding of th e bankruptcy court here, F ahs

remains the l aw of this circuit. 2 4 Even the Tax Court has(...continued)

an excepti on to the rule in F ahs

. Where there is no possibility of eventual

payment, no obligation is fixed, and therefore an interest deduction is improper.

In Tampa & Gulf Coast R.R.

, 469 F.2d at 264, for example, we recognized the

general principle of Fahs but held that it had to give way to extreme

circumstances of th e case before it. In T ampa

, a parent and subsidiary

corporation had created a tax shelter where the rent payments from the parent to

the subsidiary were offset by accrued but unpaid interest payments on debts to

the parent. The court found that F ahs did not apply, as the debt would never be

paid on account of the beneficial tax relationship between the corporations.

2 5 Even the Tax Court, at times, appears to apply an approach similar to,

b ut more restrictive than, F ahs

. S ee Cohen v. Commissioner

, 21 T.C. 855, 857

(1954) (holding that deductions are proper, except where interest "categorically"

will not be paid); J ordon v. Commissioner

, 11 T.C. 914, 925 (1948) (same); s ee

also Zimmerman Steel Co. v. Commissioner

, 45 B.T.A. 1041 (1941) (outlining

general approach), rev'd

, 130 F.2d 113 ( 8th Cir. 1952). The Third Circuit

apparently has acquised in the Tax Court's ap proach. S ee Pearlman v.

Commissioner

, 153 F.2d 560, 563 (3d Cir. 1946) (affirmin g Tax Court decision

reported at 4 T.C. 34 (1944) that applies Tax Court's i nterpretation of

Zimmerman ).

The Eighth Circuit, the Eleventh Circuit, and the Court of Federal Claims,

however, follow the rule we adopted in Fahs

. S ee Keebey's Inc. v. Paschal

, 188

F.2d 113, 115-16 (8th Cir. 1951); Z immerman Steel Co. v. Commissioner

, 130 F.2d

1011, 1012 (8th Cir. 1942); Sartin v. United States , 5 Cl. Ct. 172, 176 (1984)

(citing Fahs rule with approval); cf. Bonner v. City of Prichard

, 661 F.2d 1206,

1207 (11th Cir. 1981) (en banc) (holding that Fifth Circuit precedent prior to

circuit split is binding on the Elev enth Circuit). The leading case not

following Fahs originates from a district court in the Second Circuit. See In

re Continental Vending Mach. Corp.

, 77-1 U.S. Tax Cas. (CCH) ¶ 9 1 21 (E.D.N.Y.

1976).

-29- recognized the continuing validity of Fahs

. S ee Southeastern Mail

Transp. Inc. v. Commissio ner , 63 T.C.M. (CCH) 2893, 2905-06

(1992). 25 The majority opinion accepts as much.

The justification for the Fahs rule is simple. As every debt

is subject to the risk of non-payment, a rule requiring absolute

certainty of repayment as a prerequisite to accruing and deducting

interest would make I.R.C. § 163 a nullity. No one could rely upon

the accrua l method. The F ahs court accordingly focused instead

upon the obligation to pay. To be able to deduct a debt under the

accrual method and the "all events" test, the re only must be a2 6 See I.R.C. §§ 163, 461; Treas. Reg. § 1.461-1(a)(2); see also, e.g.

,

United States v. Hughes Properties, Inc.

, 476 U.S. 593, 600 (1986) ("[T]o satisfy

the all-events test, a liability must be final and definite in amount, must be

fixed and absolute, and must be unconditional.").

27 As this result would moot the 11 U.S.C. § 505(b) issue, I do not

address it.

-30- fixed and unconditional obligation to pay. 26 Accordingly, the

validity of that obligation i s measured at the time it is fixed,

not at the future date it should be paid.

Here, there is no dispute that the unsecured debts are valid

obligations to which Texas state law attaches the obligation to pay

interest after they are thirty days overdue. While the imposition

of bankruptcy is probative of the uncertainty concerning the

payment of the pendency interest, there is no allegation by the

government, or concession by Kellogg, that the interest debt will

never be paid. As long as the debt could be paid, the obligation

remains. I would hold that the deduction was proper, and the

bankruptcy court erred in refusing to follow Fahs

. 27 Accordingly,

I respectfully dissent.