IRS objects to Chapter 11 bankruptcy plan based on alleged tax avoidance purpose
IRS has filed an objection to the proposed joint Chapter 11 bankruptcy plan of Solyndra, a solar panel manufacturer that controversially received a $535 million governmental loan guarantee before its demise, and its parent company. IRS asserted that the principal purpose of the proposed plan is tax avoidance, arguing that the parent company is a mere shell designed to preserve substantial net operating losses (NOLs) and enable its owners to avoid their future tax liabilities.
Background on Chapter 11 bankruptcies. Chapter 11 relief is a business reorganization that allows the debtor to continue operating and remain in control of its business, while also providing the debtor protection from creditors. Creditors to a Chapter 11 debtor are generally paid out of the debtors' future earnings or given interests in the reorganized entity. However, Chapter 11 can also be used as a vehicle for liquidation.
When a corporation or partnership files for bankruptcy under Chapter 11, no separate taxable estate is created. (Code Sec. 1399) Thus, NOL preservation can be a significant issue for corporations in Chapter 11 cases.
Under 11 USC 1129(d), on the request of a governmental unit (e.g., IRS), a bankruptcy court may not confirm a reorganization plan if the “principal purpose” of the plan is the avoidance of taxes.
Background on NOL limitations. After an “ownership change,” Code Sec. 382 limits the amount by which a loss corporation (i.e., one with a current or carryover NOL) can offset its taxable income for post-change years by pre-change losses. However, the Code Sec. 382 limitation does not apply to an ownership change if the old loss corporation is under the jurisdiction of a court in a bankruptcy case, and if certain other conditions are met.
Facts. Solyndra LLC was a California-based solar panel manufacturer that faced financial difficulty in 2010 and ultimately filed a voluntary Chapter 11 bankruptcy petition in 2011. Before filing, the company strategized extensively as to how to protect its large amounts of NOLs in light of the pending bankruptcy and Code Sec. 382 limitations.
Solyndra submitted a joint plan with its parent, 360 Degree Solar Holdings, Inc. (Holdings; collectively, the debtors). IRS asserts that Holdings is a mere shell corporation that has had no business operation since February of 2011. The plan sponsors are two entities which are also the senior secured lenders and the putative holders of nearly 100% of the equity in Holdings. Under the plan, only Solyndra would be liquidated, and Holdings would be reorganized. The plan, which would be funded with Solyndra's assets and a $7.5 million cash infusion from the plan sponsors, would fully pay its administrative claims and pay only a small portion of the debtors' general unsecured creditors' claims (roughly three cents on the dollar).
According to IRS, Holdings would emerge from bankruptcy with tax attributes (i.e., NOLs) valued as high as $350 million. This value is disputed, but regardless of what value the court accepts, it is significantly higher than the amount of payments to unsecured creditors.
IRS's objection. IRS has objected to the debtors' bankruptcy plan on the ground that its principal purpose is tax avoidance. Specifically, it alleges that “Holdings will emerge from bankruptcy as a no-asset, no-business entity, whose only purpose is to provide future tax benefits to its owners” (i.e., by allowing the plan sponsors to avoid their future tax liabilities).
IRS cited to In re South Beach Securities, (CA 7 2010) 105 AFTR 2d 2010-2390, a case in which a plan was denied confirmation under §1129(d) because its principal purpose was tax avoidance. In that case, when it filed its petition, South Beach Securities was a shell with significant NOLs and no employees or business activities. South Beach Securities, in its petition, sought to have all its stock turned over to its sole creditor, a commonly controlled corporation, thus allowing the corporation to shield future income from tax and benefitting the individual who controlled both entities. The bankruptcy court denied confirmation, noting that “there is nothing here to reorganize, no business to resuscitate, no going concern to keep going.” Rather, the whole point of the bankruptcy was to make use of the NOLs. The Seventh Circuit affirmed.
IRS also analogized Solyndra facts to In re Maxim Industries, (Bktcy Ct MA 1982) 22 BR 611, which similarly involved a shell corporation's attempt to emerge from bankruptcy with control over significant NOLs. The court found that the plan wasn't proposed in good faith, since it was motivated by tax avoidance rather than the legitimate rehabilitation of a business, and accordingly denied confirmation under §1129(a)(3).
Finally, IRS also cited to In re Scott Cable Communications, Inc., (Bktcy Ct CT 1998) 83 AFTR 2d 99-1028, where a plan was denied due to its tax avoidance purpose despite the fact that it also proposed making distributions to its creditors.
IRS noted that the existence of tax benefits isn't necessarily fatal to a proposed plan, but that the tax benefits must “support the rehabilitative purposes of the plan” and not be its principal purpose. In this case, according to IRS, the overall facts and circumstances show that the principal purpose of the plan is to enable the owners of Holdings to emerge from bankruptcy with tax attributes, the value of which far exceeds the total amount of the payments that would be paid to the unsecured creditors under the plan.
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