Secured Creditors Liquidating Trust Denied Tax Refund for Net Operating Losses Based on Product-Liability Settlements and Pension Plan Contributions
by Eric L. Pruitt
Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C.; Birmingham, Ala.
The U.S. District Court for New Jersey recently considered the technical requirements for a taxpayer to successfully claim a specified liability loss (a type of net operating loss) under §172 of the Internal Revenue Code, 26 U.S.C. §101 et. seq. (I.R.C.). See Internal Revenue Service v. Harvard Secured Creditors Liquidating Trust, 2005 No. 02-50586, WL 2397224 (D. N.J. Sept. 28, 2005). Harvard Industries, Inc. filed a tax refund motion in June 2003 seeking a refund of payments that Harvard claimed were specified liability losses under I.R.C. §172(f). The payments at issue were amounts expended by Harvard in 1996 to settle product-liability claims relating to parts manufactured by its Elastic Stop Nut of America (ESNA) division; amounts contributed by Harvard to its pension plans as part of a settlement with the Pension Benefit Guaranty Corporation (PBGC) and workers’ compensation payments made by Harvard. As part of its bankruptcy case pending before the U.S. Bankruptcy Court for the District of New Jersey, Harvard confirmed its chapter 11 plan prior to the resolution of the tax-refund motion. Pursuant to the confirmed plan, which assigned certain assets and causes of actions to various trusts, the Harvard Secured Creditors Liquidation Trust became the party in interest for the tax-refund litigation.
The bankruptcy court treated the tax-refund motion as a contested matter in the chapter 11 case. The Internal Revenue Service (IRS) and Harvard both filed motions for summary judgment. Following oral arguments by the parties, the bankruptcy court entered an order granting Harvard’s motion for summary judgment and denying the IRS’s motion. In re Harvard Indus., Inc., 324 B.R. 238 (Bankr. D. N.J. 2005). The IRS appealed. The workers' compensation issue was addressed by an earlier action of the bankruptcy court and was not considered on appeal.
Product-Liability Settlements
ESNA manufactured lock-nuts that were sold to distributors. The distributors, Harvard’s customers, were unable to resell the lock-nuts purchased from ESNA due to a manufacturing defect. In 1996, ESNA entered into settlements with its customers to forgive their accounts receivable and made a payment to its largest customer due to a lawsuit based on the defective lock-nuts. Pursuant to I.R.C. §172, in effect since 1996, the payment of certain liabilities that were attributable to a product liability qualified as specified liability losses that could be carried back and deducted 10 years prior to the date of the payment. See I.R.C. §172(f)(1)(A). The statute defined product liability as:
(A) Liability of the taxpayer for damages on account of physical injury or emotional harm to individuals, or damage to or loss of the use of property, on account of any defect in any product which is manufactured, leased or sold by the taxpayer, but only if
(B) such injury, harm or damage arises after the taxpayer has completed or terminated operations with respect to, and has relinquished possession of, such product.
I.R.C. §172(f)(4)(A)-(B).
The court stated that the bankruptcy court had correctly analyzed the component words of the statute and accorded the words “property” and “use” with their ordinary meanings, since neither was defined in the statute, but did not address the word “loss.” The IRS argued on appeal that Harvard’s distributors could not have lost the use of the lock-nuts shipped to them since they were defective when shipped. Finding that the IRS’s use of the words “loss” and “use” matched the standard usage of such terms, and that the intended use of the lock-nuts was inventory for resale, the court further opined that “Harvard’s customers could not have lost the use of the property for its intended purpose where they did not possess usable lock-nuts in the first place.” Harvard Secured Creditors, 2005 WL at *3. The court then turned to the text of I.R.C. §172(f)(4)(B), which requires that the “damage arises after the taxpayer has competed or terminated operations with respect to, and has relinquished possession of, such product.” The court held that the plain language of the statute exempted the lock-nuts at issue since the damage occurred during manufacturing and before Harvard relinquished possession of the property. See Id.
Pension Plan Contributions
Pursuant to a settlement agreement, Harvard contributed $6 million to its pension plans in 1996 to prevent PBGC from terminating one or more of the pension plans. In 1996, I.R.C. §172 allowed the payment of certain liabilities, which both occurred at least three years prior to the taxable year and arose under federal or state law, to qualify as specified liability losses and to be carried back and deducted 10 years prior to when the payment was made. The bankruptcy court held that the payments to Harvard’s pension plans qualified as specified liability losses and found that the payment arose under federal law (ERISA) at least three years prior to the taxable year.
On appellate review, the court relied on Major Paint Co. v. United States, 334 F.3d (Fed. Cir. 2003), which stated that the “arising out of federal law” language of I.R.C. §172(f) means that the “liability must be traceable to a specific law and cannot be the result of choices made by the taxpayer and others.” The court found that Harvard’s payment was only tenuously traceable to a specific law, which was the result of choices made by Harvard and PBGC, and therefore it was not a specified liability loss under I.R.C. §172(f). The court further found that the unfunded benefit liabilities were merely speculative at the point the parties entered into their settlement agreement, and that such agreement between the parties was motivated by Harvard’s desire to issue senior notes to fund its reorganization plan without objection by PBGC.
Finding that neither Harvard’s settlement expenditures due to the defective lock-nuts nor the contribution to its pension plan qualified for a refund of tax payments as specified liability losses under I.R.C. §172(f), the court reversed the order of the bankruptcy court and remanded the matter with instruction to enter judgment consistent with the court's opinion.