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October 8, 2008
Technical Objections to the Bailout
by Lee A. Sheppard

Full Text Published by Tax Analysts®

Document originally published in
Tax Notes on October 6, 2008.

Your children should see the Dreamworks animated feature Kung Fu Panda — if they haven't already, since it has been a huge hit.

The movie contains important lessons — but probably not the ones the creators intended. It's basically Crouching Tiger, Hidden Dragon with anthropomorphic characters. The student is an overweight panda, and the master is a racoon. Chinese children will recognize the animals and their place in the social pecking order better than American children, but where did the rhinoceroses come from?

The panda, a short-order cook in his father's noodle shop, dreams of becoming a martial arts master. The animation and drawing are great — the characters have hairy paws and expressive eyes. There's a wonderful scene in which the panda and the master fight over a dumpling.

The panda is big, dumb, earnest, and round-eyed. All the other characters are lithe, agile, clever, and almond-eyed. The panda represents America, and the others represent China. But since Americans wrote this script, the plucky panda triumphs, accidentally vanquishing the traitorous snow leopard, without ever losing weight or learning martial arts. Then he goes back to his job in food services.

So, far from being a cautionary tale about the perils of being overweight, the movie serves as a useful introduction to the creditors. The Chinese own about $1 trillion of American securities. And if the present unsustainable situation continues, Americans will be engaged in the financial equivalent of food services for the Chinese.

A week ago, a narrow majority of House members composed of right-wing Republicans, left-wing Democrats, nervous members running for reelection, and representatives of poor districts rejected the bailout bill, the Emergency Economic Stabilization Act of 2008, which would amend H.R. 3997, an existing vehicle. The naysayers are being pilloried as antediluvians who don't understand modern finance. On Friday afternoon, however, the bailout plan passed 263-171.

The chief provision of the bailout plan is called the Troubled Asset Recovery Program, which forms the suitable acronym TARP — as in putting a canvas cover over the problem. TARP and the other bailout provisions were combined with the "extenders" and energy bills in the Senate, and then loaded up with bribes for wayward senators, so that the package passed the Senate by a wide margin. H.R. 1424, a dormant tax bill, was the vehicle.

The naysayers are not wrong. The whole banking establishment wants this bailout, and that should be enough to give legislators pause. The remainder of this article looks at technical problems with the bailout bill, as well as some recent IRS guidance on credit meltdown questions. But first, your correspondent's general objections to TARP:

1. The plan would not work as advertised. It would not put a floor under house prices. House prices have to be affordable for the prevailing wage levels of the location; that is, their natural, economic equilibrium level. Low interest rates and aggressive lending put the equation out of whack. House prices have to fall 30 percent from their 2006 peak, which means they need to fall another 10 to 20 percent depending on the location. There is nothing that will prop them up.

Even if house prices were propped up, so what? Lenders are demanding 20 percent down payments, which no one has. Here it is instructive that countries that did not experience housing bubbles and do not now have this problem are the ones where consumer credit is tight and down payments are high, like France and Italy.

2. The Treasury would overpay for bad assets. That is the essence of the plan, and nothing in the larger bill would change this. The Treasury proposed to pay what is billed as a nondistress price for assets, but the fair market value is lower. The vulture price is the price. We know that because Merrill Lynch unloaded some CDOs at 22 cents on the dollar a short while back, and took a very low settlement from its bond insurer.

Oh, but aren't the bad assets worth more in the long run? Maybe and maybe not; some of this stuff might be truly garbage. Wanting to get rid of mark-to-market accounting is just shooting the messenger. We cannot pretend that financial intermediaries have better balance sheets than they have. We cannot deny reality.

This would be a bailout for Wall Street. Buying the bad assets for more than the market-clearing price would only prop up the equity markets. Shares of financial intermediaries (which make up a major portion of the indexes) are being pummeled. Shareholders are supposed to take the hits. That's what it means to be a shareholder. Moreover, even if we were wanting to prop up these prices, it probably would not persuade the purchasers of last resort — the Asians and Arabs — to buy more shares of American financial intermediaries.

3. The plan would essentially aim to preserve the financial intermediation industry as presently constituted, but with fewer players. Only Goldman Sachs, JP Morgan, and Citigroup will be left, and they will be too big to fail. They are scooping up assets on the cheap and seeing their contractual relationships with Bear Stearns and AIG sustained by federal assistance to those firms. Former House Speaker Newt Gingrich warned about crony capitalism, and he has a point (Bloomberg, Sept. 29, 2008).

We should not be preserving insolvent firms like Lehman and WaMu, but we have to ask ourselves hard questions about the new landscape. We need to ask about the derivatives exposure of these three huge survivors. The governments of Belgium, Luxembourg and the Netherlands have taken over Fortis, which is larger than the GDP of Belgium. Ireland just guaranteed bank liabilities equal to twice its GDP.

The Treasury's present course of picking and choosing which entities will survive -- shades of J.P. Morgan locking the bankers in his library in 1907 — is not a whole lot different from the bailout plan. The main difference is that the bailout plan would be an acknowledgement of what it is going to cost. Treasury and the Fed have been exercising this discretionary power already. The Fed essentially bought $29 billion of bad assets from Bear Stearns.

4. The philosophical debate here is not free market capitalism (which results in too much leverage) versus socialism (we have basically decided to socialize the losses), but who is going to take the hit. The opponents are not wrong to argue that big boys, rather than homeowners, should take the loss. The trouble is that some of the big boys are foreign investors, foreign governments, and foreign sovereign wealth funds.

5. No help for homeowners. Bankruptcy court is a court of equity. Yet a bankruptcy judge cannot modify a mortgage, though he or she can modify virtually any other debt. This is bad bankruptcy policy and even worse social policy. The polity is better off if the homeowners (who are mere titleholders) stay in their houses, because they will take care of them and preserve the neighborhoods. Cleveland, Baltimore, Detroit, and other areas have dangerous, blighted neighborhoods of empty foreclosed houses. Do we really want more of that?

6. The Federal Reserve should lower interest rates. Interest rate reductions would be the usual approach to this kind of liquidity crisis, but the Fed seems loath to lower them again. This makes no sense, because banks are only lending to each other at rates which, though higher, are not especially high by historical standards. The Fed is thinking about lowering rates as this article is being written. (The Wall Street Journal, Oct. 2, 2008, p. A1.)

Levels of lending of the past few years will not return. We are experiencing a painful deleveraging. We are not going to have growth fueled by indiscriminate mortgage borrowing or consumer borrowing anymore. That does mean less growth. Britain is in even worse shape, since it has a higher per capita level of consumer borrowing and has taken over three mortgage lenders, while the United States let their counterparts fail.

The rest of this article looks at technical problems with the bill, and then some IRS guidance. We do not confine ourselves to tax problems. The first section deals with the accounting problem, which is the worst aspect of the bill.

Mark to Market

The whole of the banking establishment, aided by the Securities and Exchange Commission and a handful of confused House Republicans, is engaged in a giant game of blaming the messenger. Bank balance sheets, after all, would look so much better if they didn't have to tell the truth about how little their mortgage-backed securities are worth.

Indeed, some House Republicans who voted against the bailout argued that the bill's failure to eliminate mark-to-market accounting was one of the reasons for their vote. Former Federal Deposit Insurance Corp. Chair William Isaac, an otherwise credible guy, is behind some of this support. Isaac's argument is that repealing mark- to-market is a cost-free way to stimulate lending again. Legislators who do not want to reward speculators are cottoning to this argument. (The Wall Street Journal, Oct. 1, 2008, p. A4.)

The gist of the argument is that banks will be able to lend more if they can hide the fact that they have no capital. You read that right.

What financial rabbit hole did we just fall down? Isn't that what we've been doing for about the past decade? Wouldn't that mean lending beyond any reasonable base of capital support? Isn't that what got us in the trouble we're in?

Accounting and investor groups protested, and their entirely reasonable protests were relegated to the interior pages as pro- business columnists piled on with the false argument that mark-to- market accounting is the work of the devil. (The Wall Street Journal, Oct. 2, 2008, p. A6.)

The truth hurts. Section 132 of the Senate amendment version of the bailout bill would empower the SEC to suspend mark-to-market accounting, with the obvious implication that Congress would like to see a suspension. Although the SEC may already have that authority, the provision would reaffirm that it does. The provision has a savings clause that says that negative inferences are not to be drawn from Congress conferring suspension power. As the following discussion will show, the SEC is doing what it can to water down the current standard.

Section 133 asks the SEC to study mark-to-market accounting, with a bias toward finding problems. The SEC is to study whether mark-to-market accounting contributed to any bank failures in 2008 and whether it affected the quality of information available to investors. The SEC is also asked to study the feasibility of modifications and alternatives.

House Ways and Means Committee member Richard E. Neal, D-Mass., who supports the bailout, opposed authorizing the SEC to suspend mark-to-market accounting. "In valuing derivatives, I believe it is important that there be transparency in the market, and mark-to- market accounting is probably the closest to the actual value and is therefore an essential tool for investors," he said in a floor statement.

"Think of it this way: If someone asked you for a loan, and their only asset is their house, which could be sold for $100,000, would you care that they had paid $200,000 for it a year ago?" said Neal.

The lack of new suspension authority has not stopped the SEC from creating a subtly worded dilution of mark-to-market standards. The SEC has put out guidance in the form of accounting release 2008- 234. The gist of the release is that the SEC will allow reporting companies to determine for themselves whether observable prices for bad assets are reliable. (For the release, see

This release is important because the suspension power is still in play, so the question is whether the SEC's move might instead placate opponents of the bailout. This release amends Financial Accounting Standards Board Statement 157, which governs fair value. Statement 157 says that assets held for sale or available for sale must be marked to market, but that the range of values used can be explained in footnotes. (For Statement 157, see

Fair market value, the concept used by the tax law, is a subset of fair value, the concept used in financial accounting. The important qualifier on fair value is that the price must not be a fire-sale price — one that is the product of compulsion. But Statement 157 does require today's price, not tomorrow's hoped-for price. It states: "The objective of fair value measurement is to determine the price that would be received to sell the asset . . . at the measurement date [an exit price]."

In the guidance, the SEC is essentially saying that reporting companies can minimize relevance of lowball brokers' bids as indicators of the fair value of their dodgy assets. Reporting companies are being allowed to argue that markets are not "liquid," so that the bid is not the fair value. Statement 157 does not discuss liquidity of markets. Statement 157 regards bids as good pricing information.

In an active market, fair value means marking to bid, under international standards, or to something between bid and asked, under more permissive FASB standards. But in an inactive market, according to the SEC, bids are "inputs when measuring fair value, but would likely not be determinative." And then, in a statement that makes no sense, the SEC states: "If prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to arrive at fair value." What are "current prices" if they are not bid?

Spreads that are too big or a dearth of buyers are indicators of an inactive market, in the SEC's view. Both of these phenomena would fairly characterize the current market for bad mortgage-backed assets. Statement 157 says that an active market has sufficient frequency and volume that price information is continuously available. An inactive market is one in which participants are few and prices are stale. But in the Statement 157 hierarchy of data, prices in inactive markets still rank high.

"The determination of whether a market is active or not requires judgment," the SEC states. This leaves it to the discretion of the reporting companies to declare a market "inactive." While Statement 157 allows for adjustment of inactive market prices, the release seems to go further when it proclaims these prices "not determinative."

Well, gee, what if similar assets are sold at that undesirably low market-clearing price? That must have been in a "disorderly" market. The SEC states flatly that "the results of disorderly transactions are not determinative when measuring fair value." Fair value asks for market exposure, and a market assumes the existence of willing buyers and sellers, not unwilling sellers. This is a reiteration of Statement 157.

The SEC goes on to say that "distressed or forced liquidation sales are not orderly transactions, and thus the fact that a transaction is distressed or forced should be considered in weighing the available evidence." This statement is also a reiteration of Statement 157.

But then the SEC says "determining whether a particular transaction is forced or disorderly requires judgment." That means that the reporting company can disregard some transactions as "disorderly" in its own discretion. Statement 157 does not say who gets to decide whether a transaction was "disorderly."

Much later in the release, the SEC says that management should disclose its exercises of significant judgment, which would presumably include disclosure of rejection of low bids, low prices paid for similar assets, and prices paid in markets that management has judged to be inactive. Statement 157 says these low prices cannot be ignored entirely because they are observable market information.

Then there's the concept of impairment. Determining whether impairment is temporary or permanent also requires judgment. Factors to be considered include how long the market has been down, the issuer's financial condition and prospects, and the holder's investment purpose. But if the holder has the asset in its investment book — "held to maturity" — it does not have to be marked. Only inventory and available-for-sale assets have to be marked.

When the president says the bad assets will recover and the taxpayers will make money, he is arguing that the impairment is temporary. When your correspondent argues that some stuff may be garbage, that is an argument that impairment is permanent.

Consider a CDO. The top tranches of some of these issues were AAA-rated because they were overcollateralized. But when the bottom tranches blew up, investors became suspicious of the top tranches, and the contagion spread. It could be argued that the top tranches are only temporarily impaired, but what Merrill Lynch sold the other day was the top tranche. SEC release 2008-234 might allow a reporting company to minimize that sale as evidence of the values it should report for similar assets.

If Congress votes to tell the SEC to repeal mark-to-market accounting, and banks are allowed to prettify their balance sheets, the market may well vote the opposite way. Just because the banks say everything is rosy does not mean investors have to believe them.

"I don't think that FAS 157 truly contemplated the types of markets — or lack of them — that we have today. That might be the rationale behind the SEC release," said Leon Metzger, adjunct faculty member at Yale, New York University, and Cornell.

"I find it ironic, however, that the prices of shares of some financial services companies declined recently, possibly because investors may have lost confidence in the reliability of the reported asset values," said Metzger.

Moreover, the existing marking rules may not be all that credible. "In other words, managers of those firms may have already 'overvalued' the assets, for example, using a value somewhere between the bid and the asked rather than at the bid, a practice that the accounting literature permits," he said. "The market, because of a loss of confidence in valuations generally, effectively discounted those values to perhaps a value even lower than the bid."

Bailout Bill

The big tax provision in the bailout bill is the executive compensation provision, which would use the tax law to prevent executives of companies whose dodgy assets were being acquired from compensating themselves too lavishly.

Though the drafting is tighter than usual for these largely symbolic provisions, only the top five executives would be covered. Executives covered would be limited to the chief executive, the chief financial officer, and the three other most highly compensated officers. Chief financial officers had been administratively removed from the covered group. Moreover, once in the covered group, an executive is in that group permanently. Similar changes were proposed for section 162(m) last year.

Section 111 of the bill would limit the compensation of executives of companies taken over by the government. Technically, that means companies whose bad assets are directly purchased by the government, without an auction, and in which the government acquired a meaningful equity or debt interest. Treasury would be given authority to set compensation limits. No golden parachutes would be allowed. Those administrative standards can include provisions for the clawback of excessive compensation, as included in the takeovers of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp.

For companies offering their bad assets in government auctions under the bailout program, the bailout bill would hook into sections 162(m) and 280G, which are hardly known for their efficacy in reducing excessive compensation.

Section 302 of the bill would add a new section 162(m)(5) that would deny a deduction for combined current and deferred compensation in excess of $500,000 for companies whose bad assets of $300 million or more are purchased in a government auction under the bailout program. Importantly, section 162(m)(5)(E) would define covered compensation ("executive remuneration") expansively to include items now excluded by section 162(m)(4), that is, options and performance-based compensation. The new provision would also reach existing contracts.

Section 280G would have a new subsection (e), which would apply the golden parachute excise tax rules to severance payments to the same executives. The excise tax would also reach severance payments in bankruptcy or liquidation in addition to terminations, but would not reach retirement. The payer would be denied a corresponding deduction. Section 111 of the bailout bill would prohibit new golden parachute contracts when $300 million of bad assets were purchased in a government auction.

A deduction won't mean much to a company with only net operating losses. It has been suggested that any executive who cannot beat these provisions is not intelligent enough to run a publicly traded company (Bloomberg, Sept. 30, 2008).

Clawback is authorized only in the case of government takeovers. Why the Democrats did not instead require more of these guys to cough up some of their past gains from the years of big profits from big leverage is a mystery to us. What Congress should really be asking for is a seven- or eight-figure check from each of the masters of the universe regurgitating past profits.

Sen. Bernard Sanders, I-Vt., advocated a surtax, but that would be for the future. Such is the fear of the wrath of the electorate that the Senate defeated this proposal by voice vote. The senators have made it clear to whom they feel answerable by anonymously defeating a proposal the angry, indebted electorate might support.

When Fannie and Freddie were taken over, many of the shareholders who were wiped out turned out to be smaller banks. Section 301 of the bailout bill would allow these banks to take ordinary losses on sales of their holdings of Fannie and Freddie preferred shares.

IRS Guidance

Section 1058 is an exception to the realization requirement and to the code's obsession with identified shares. It precludes gain or loss on a share loan as long as the lender has identical shares returned to it. The borrower has the contractual power to dispose of the shares. The lender of shares may never see those identified shares again. Section 1058 establishes that the borrower need only return shares of the same class as the ones borrowed, not the identified shares.

But what if the borrower defaults, because it is a big investment bank gone bad? Does the lender then have a taxable disposition of the shares?

In many cases, institutional investors lent their securities, for some very nice fees, to investment banks like Lehman, with the full knowledge (and contractual permission) that the borrowers would use the securities in their business. This act of taking ownership and control of borrowed shares is called rehypothecation.

When the borrowers went down, the lenders couldn't get their securities back. But their lending contracts gave them the right to apply any collateral they held to offset the borrower's obligation to return identical securities. If they had gotten their securities or identical securities back, section 1058 would not require recognition of an exchange.

The tax question becomes whether there has been a taxable exchange of the securities when the lenders reclaim collateral instead. It would seem obvious that there has been a taxable exchange. Proposed reg. section 1.1058-1(e)(2) makes this clear. It states:

      If securities are transferred pursuant to an agreement which meets the requirements of section 1058(b) and section 1.1058-1(b) and the borrower fails to return to the lender securities identical to the securities transferred as required by the agreement, or otherwise defaults under the agreement, gain or loss is recognized on the day the borrower fails to return identical securities as required by the agreement, or otherwise defaults under the agreement.

This proposed regulation never became final, but an example suggested that the wash sale rule of section 1091 could apply if there was an immediate application of the collateral to replacement of the lost securities. So representatives of lenders asked for guidance on whether they could avoid recognition by using the reclaimed collateral to immediately acquire securities identical to those that were lent. Why? Some investors want to hold every security that is in the major indexes.

The IRS must have been in a generous mood that day, because in Rev. Proc. 2008-63, 2008-42 I.R.B. 1, it forgave tax when the securities lender applied the collateral to the purchase of identical securities as soon as commercially practicable following the default, provided this was accomplished within 30 days of the default.

What was the justification for this? The IRS cited legislative history in which Congress blathered about the desirability of nonrecognition treatment for securities loans in the cause of encouraging liquid markets. This same passage of legislative history had been supplied by the proponents of the change. The IRS cautioned that no inference should be drawn about the treatment of securities loan defaults that fall outside the revenue procedure.

The proponents of the change cited the wash sale rules, which the IRS did not rely on. The IRS was correct in using a revenue procedure as the vehicle for a result that is contrary to law. Section 1058 is an exception to the realization requirement. Exceptions are to be narrowly interpreted as a matter of statutory construction. This one is being broadly interpreted.

Reclaiming the collateral is a foreclosure. The tax law does not care what the lender does with the collateral. Other foreclosures are not treated as nonrecognition events. If a lender forecloses on property, it has a loss on the loan and then a possible gain or loss on the sale of the property.

Why is the IRS allowing sophisticated institutions that took the risk of making securities loans to go without paying tax when they did get paid? It's not as though they're standing in line with the other Lehman creditors. These were big boys, they could read the agreements, they knew they had counterparty risk. All the securities lenders are accomplishing is deferring ultimate recognition of built- in gain in their securities.

Moreover, consider which institutional investors we are talking about here — the taxable ones, not the pension funds. Pension funds lend a lot, but they have no reason to care whether reclaiming collateral is a taxable event. So we are talking about mutual funds and hedge funds whose ultimate owners are taxable. And the affected funds would be the lucky ones that actually have appreciated securities.

For the funds that had built-in losses on their loaned securities, the revenue procedure would not stop them from recognizing the loss. All they would have to do is fall outside the criteria of the revenue procedure, meaning delaying replacement of their lost securities or not replacing them at all. The implicit rejection of the wash sale argument in the revenue procedure may mean that the IRS is not willing to argue for an expansive interpretation of the wash sale rules.

The IRS is doing its own little bailout for the creditor class without a revenue estimate. It took 25 years in the tax business for your correspondent to understand that the phrase "tax policy" means the government forgoing tax it really ought to be collecting.

Perpetual Loss Carryovers

Section 382 is complicated and unintelligible and not much better than a straight cutoff of net operating loss carryovers. It was drafted with the assistance of the American Bar Association Section of Taxation, which somehow has not had to answer for this mess. In the current credit meltdown, the IRS has taken to forgiving the harsher aspects of this rule, recognizing that loss carryovers may be the only attractive remaining asset of some deadbeat financial institutions.

First up for section 382 assistance were Fannie and Freddie. They had an ownership change when the government took them over, but their loss carryovers are valuable assets that the government would want to preserve for the next owner — if there is to be a next owner.

The loss preservation guidance took the form of Notice 2008-76, 2008-39 I.R.B. 1. Technically, the rules issued under the notice would preclude an ownership change by preventing any testing date from occurring on or after the date the government took over the corporation. (See reg. section 1.382-2(a)(4).) The AIG takeover is also eligible for this treatment.

The other day, the IRS put out another piece of section 382 guidance, which would liberalize the use of built-in asset losses by acquired banks. This took the form of Notice 2008-83, 2008-42 I.R.B. 1. Even bank representatives were bowled over by the generosity of this notice.

Notice 2008-83 allows banks to rely on its one sentence of guidance until further notice. There is no prospective effective date, so acquired banks might want to try to use the notice right now. That one sentence states:

      For purposes of section 382(h), any deduction properly allowed after an ownership change (as defined in section 382(g)) to a bank with respect to losses on loans or bad debts (including any deduction for a reasonable addition to a reserve for bad debts) shall not be treated as a built-in loss or a deduction that is attributable to periods before the change date.

What does that mean? Section 382 limits not only the use of net operating loss carryovers, but also the use of built-in losses in assets. The notice would free up the use of the latter. It is good for all commercial banks and thrift institutions as defined by the code, not merely those small enough to be allowed to use the reserve method of accounting for loan losses. Large banks are required to use the specific charge-off method for accounting for losses from bad debts.

The notice states that for banks, current deductions for losses on bad debts will be allowed despite the lid that section 382 would put on them. Here it is important to understand that built-in losses include deductions accrued but not yet allowed, such as write-downs of shaky loans. So a bank that is acquired can use its old loss carryovers, subject to limits, simultaneously with its new deductions for specific loan losses or additions to bad debt reserves, without limit.

The notice effectively suspends the section 382 limits on the use of built-in losses after an ownership change, according to Cleary, Gottlieb, Steen & Hamilton, which advises many financial intermediaries. The notice could allow the preservation of the acquired bank's built-in losses in its assets.

What built-in loss assets might we be talking about? The notice refers only to "loans." Cleary questions whether loans held in securitized form might also be included under the rubric of "loans." Most banks don't keep loans on their books. They securitize them, keeping part of the issue of securities, and may also buy more similar securities backed by loans. The technical question is whether the phrase "losses on loans" includes losses on pieces of loans the bank owns but did not make.

Cleary argues that the notice should apply not only to acquisitions of equity of banks and bank holding companies, but also to asset acquisitions in tax-free reorganizations. But it should not apply to a bank's sale of assets in a taxable transaction, because the losses are recognized on the sale.

Preparer Penalties

While the bailout is being debated, Congress is trying to reenact the tax code in the form of the extenders bills. The Senate combined the extenders with the bailout to gain votes for the latter. Both the House and Senate extenders bills would amend section 6694(a) to reduce the preparer penalty standard of care from "more likely than not" to "substantial authority," which is the standard of care for taxpayers to avoid section 6662 penalties.

The extenders bills would lower the standard for preparers to substantial authority. The standard of reasonable belief that the position is more likely than not to prevail would be retained for tax shelters and reportable transactions. The disclosure rule would be the same, asking for a reasonable basis for a position disclosed as provided in section 6662(d)(2)(b)(ii). The reasonable cause and good- faith exception would be retained. (See section 506 of the Senate amendment to H.R. 1424.)

This is what practitioners, who suddenly discovered that they were return preparers, have been howling for since the standard was raised last year, along with the amounts of the preparer penalties.

What's this got to do with bailouts? The Bankruptcy Code allows a taxpayer to file a tax return with the bankruptcy court, and it allows the bankruptcy judge, who has equitable powers, to adjudicate the debtor's tax liability. It is possible to have a tax proceeding in bankruptcy administration.

Section 505(a) of the Bankruptcy Code allows the bankruptcy court to determine the amount or legality of any tax, "whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction." Although this section is usually invoked for tax claims the IRS has before the court, it is sufficiently broad that a debtor could argue that a section 505(a) determination is necessary to ensure the feasibility of a plan that is heavily dependent on tax results.

Section 505(b) of the Bankruptcy Code permits a debtor in possession to request a determination of any unpaid tax liability of the bankruptcy estate incurred during the administration of the case. This procedure requires a debtor to submit a tax return under Rev. Proc. 81-17, 1981-1 C.B. 688, which the IRS will then review and, if necessary, audit.

That's bad enough for tax administration, but, as we saw during the last round of large business bankruptcies, debtors tend to take very aggressive positions on their returns. Why not? There are no assets for the IRS to recover, and under many circumstances a corporation's income taxes are dischargeable. (The trust fund portion of employment taxes is, however, not dischargeable in bankruptcy.)

Tax claims have seventh priority under section 507(a)(8)(A) of the Bankruptcy Code. In United States v. Energy Resources Co., 495 U.S. 545 (1990), the Supreme Court held that a bankruptcy court may allocate priority tax payments under a reorganization plan first to nondischargeable trust fund taxes if it was necessary for the success of the plan. The government prefers to allocate corporate payments to dischargeable taxes first and then go after corporate officers for nondischargeable taxes.

So while Congress might be sympathetic to the whinges of the self-interested preparer class, it should have been mindful of the larger economic context, in which seat-of-the-pants return positions would inevitably be taken by debtors with nothing left to lose. Might have been better to leave the law as it was, which would have had the effect of requiring those positions to be disclosed.

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