Opinion ID: 1266472
Heading Depth: 2
Heading Rank: 1

Heading: Knudsens

Text: 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 treatment under § 1222(a)(2)(A) and what does not. It recognizes all income, deductions, exemptions, and credits in arriving at a tax and allocates according to the percentage of each type of income. It divides the actual tax without regard to which sales produced the last dollar of income. Id. at 487. Third, as to the applicability of § 1222(a)(2)(A) to postpetition transactions, the bankruptcy court held that the Knudsens may pay through the estate, as administrative expenses, income taxes incurred by them during the pendency of the case, that they may treat a portion of such taxes as nonpriority unsecured claims under the plan pursuant to § 1222(a)(2)(A) and that such nonpriority unsecured taxes incurred postpetition may be discharged with prepetition unsecured debts after completion of the plan. Id. at 492. Ultimately, the bankruptcy court rejected confirmation of the Knudsens' proposed plan because its rulings against certain of [the Knudsens'] positions make the plan as proposed unconfirmable. Id. Both parties appealed to the district court. The Knudsens argued that the bankruptcy court erred by (1) excluding their prepetition sale of slaughter hogs in 2004 from the benefit provided by § 1222(a)(2)(A) and (2) applying the IRS's proration method to determine the amount of tax that qualifies for beneficial treatment under § 1222(a)(2)(A) instead of their marginal method. The IRS challenged the bankruptcy court's ruling on the applicability of § 1222(a)(2)(A) to postpetition sales of assets. The district court affirmed in part and reversed in part the bankruptcy court, remanding to the bankruptcy court with instructions to confirm the Knudsens' plan. In re Knudsen, 389 B.R. 643, 682 (N.D.Iowa 2008). First, the district court held that the slaughter hogs that the Knudsens sold in order to convert their farrow-to-finish hog operation into a reorganized custom hog-raising operation qualified as farm assets used in the Knudsens' farming operation under § 1222(a)(2)(A). Id. at 664-65 (internal quotations omitted). Second, it determined that the marginal method is the correct method to determine the allocation of taxes between priority and non-priority claims. To apply that method, the Knudsens should calculate a return for all income, then a second pro forma tax return removing all qualifying sales income, so that non-qualifying income would be taxed at lower marginal tax rates, and the taxes shown on the pro forma return would represent the portion of the tax claim entitled to priority status, while the difference between the taxes shown on the return for all income and the taxes shown on the pro forma return would represent the unsecured portion of the tax claim. The bankruptcy court erred, as a matter of law, in choosing the proration method instead. Id. at 669. Finally, the court affirm[ed] the bankruptcy court's conclusion that a Chapter 12 debtor may treat post-petition income taxes imposed on the debtor's income earned during the pendency of the case as administrative expenses under § 503 and that the plan may propose payment of such expenses by the estate. Id. at 682. According to the court, such taxes were incurred by the estate within the meaning of § 503(b)(1)(B)(i), despite the fact that a Chapter 12 estate is not a separate taxable entity, because incurred by the estate refers to when tax liability is incurred rather than to the existence of an estate as a separate taxable entity. Id. at 680-82.