It was a good try by the trustee, and would have been great for professionals and creditors other than the IRS —
In Reed v. United States, 2006 U.S. Dist. LEXIS 25040 (N.D. Tex. May 2, 2006), the Chapter 7 Trustee came up with a novel theory to reduce the estate’s tax liability. Pre-petition, the debtor was in the business of transporting medical specimens between doctors’ offices and laboratories. After conversion to a Chapter 7, the Trustee settled an adversary, resulting in real property being transferred to the debtor’s estate. The property was subsequently sold by the Trustee.
The Trustee claimed an ordinary loss, rather than a capital loss, on the sale of the property. Without getting bogged down in the Tax Code, the treatment of the sale as an ordinary loss resulted in substantial tax benefits to the estate. The basis for the Trustee’s position was that, at the time of the acquisition and sale of the property, the “business” of the debtor was “liquidating assets for the benefit of the creditors.” At no time, the Trustee argued, did she acquire or hold the property for investment as a capital asset.
The Bankruptcy Court and District Court disagreed, finding that the trustee “really can be in no other position than the debtor” and the debtor was not in the business of selling real estate. Further, the trustee did not have the authority to unilaterally operate or alter the nature of the debtor’s pre-petition business.
Had the Trustee prevailed, the tax consequences for business debtors would potentially be drastic. The liquidation of factories, machinery, and equipment could be characterized as ordinary losses, potentially leading to massive refunds for current and past tax years. Would capital assets simple “disappear” insofar as the IRS is concerned? Would trustees have to obtain specific authority under § 721 to operate the “liquidation business?” Would portions of § 363 go out the window?