It’s a bit of a Catch-22. When LCI Holding Company, Inc., which operates 27 hospitals under the trade name LifeCare, filed for business bankruptcy in March, it calculated that it could continue to operate if it sold off some of its assets and restructured its debt. It had even hired an investment banker to handle the sale, and its creditors — the only bidders — were preparing for the auction.
If that sale goes through, however, the IRS says it will generate some $24 million in capital gains taxes that the company won’t be able to pay. Therefore, the IRS has asked the bankruptcy judge to force the company into a Chapter 7 liquidation instead of the Chapter 13 that could save it.
LCI owes $353 million. Its creditors had proposed trading much of that debt for ownership interests in the reorganized company. LCI does not have the liquid cash to pay $24 million in capital gains taxes — but those taxes will only be accrued if the debt/ownership swap occurs, and they cannot be discharged in this bankruptcy.
Tax debt is high-priority, meaning that the IRS is supposed to be among the first creditors to be paid in any bankruptcy. Although the IRS is not a creditor seeking payment in the current case, the fact that tax debts are high priority has another important legal consequence. According to the Justice Department’s Tax Division, which represents the IRS in tax litigation, whenever high-priority claims would go unpaid in a Chapter 13, the court is supposed to convert the case to Chapter 7.
In LCI’s response, its lawyers derided the IRS’s argument as a “misery loves company” objection. In essence, explains the brief, the Justice Department’s contention is that if “circumstances do not allow for the payment of the IRS claims, all other stakeholders — including the Debtors’ patients and 4,500 employees — should suffer too.”
The Justice Department did propose an alternative settlement. If the Chapter 13 sale goes through, the capital gains taxes should be paid out of the administrative expense account set up in any business bankruptcy to cover costs such as court costs, legal fees and expenses for hiring certain vendors to assist in the bankruptcy process. Since the administrative expense account only contains $3 million, the IRS proposes that account be divvied up proportionally among those entitled to payment.
Source: Thomson Reuters News & Insight, “United States threatens LifeCare hospital chain bankruptcy over tax bill,” Tom Hals, April 2, 2013