The recent bankruptcy case of In re Creative Hairdressers, Inc. et al,  Case Nos. 20-14583 and 20-14584 (jointly administered) (Bankr. D. Md., March 3, 2022) involved the intersection of IRC section 4980H‘s employer shared responsibility payment and bankruptcy law.

Bankruptcy and Section 4980H’s Employer Shared Responsibility Payment

This case addresses an interesting intersection of tax and bankruptcy law.  Specifically, it looks at the bankruptcy court’s treatment of claims made by the Internal Revenue Service (IRS) under §4980H of the Internal Revenue Code.  The specific issue addressed is whether or not such claim is entitled to priority status as an excise tax under §507(a)(8)(E) of the Bankruptcy Code.  Ultimately, the Court concluded that it is entitled to such priority status to the extent that such claim related to any payments required under the statute arising within three years from the petition date.

Section 4980H was added to the Internal Revenue Code by the Affordable Care Act (“ACA“), enacted on March 30, 2010.  Section 4980H applies to applicable “large employers” (generally, employers who employ at least 50 full-time employees, including full-time equivalent employees, on business days during the preceding calendar year).  Section 4980H generally provides that an applicable large employer is subject to an assessable payment if either (1) §4980H(a) applies because the employer fails to offer its full-time employees (and their dependents) the opportunity to enroll in minimum essential coverage under an eligible employer-sponsored plan and any full-time employee is certified to receive a premium tax credit or cost-sharing reduction; or (2) § 4980H(b) applies because the employer offers its full-time employees (and their dependents) the opportunity to enroll in minimum essential coverage and one or more full-time employees is certified to receive a premium tax credit or cost-sharing reduction.

In this case, the IRS asserted a priority claim against the Debtors for the employer shared responsibility payment (“ESRP“) under §4980H.  Specifically, the IRS sought priority status as an excise tax under 11 U.S.C. §507(a)(8)(E).  The Debtors objected, contending the ESRP is not an excise tax entitled to priority treatment, but is a nonpriority penalty. The parties also disputed when the “transaction occur[red]” that gave rise to the ESRP, as that phrase is used in 11 U.S.C. §507(a)(8)(E)(ii).

The Debtor was partially self-insured as defined by the ACA.  The Debtors qualified as an Applicable Large Employer under the ACA.  The Debtors offered minimum essential health insurance coverage to at least 95% of their employees, but some employees were allowed a tax credit or cost-sharing reduction for any of the following reasons: (a) the coverage did not provide minimum value; (b) the coverage was not affordable; or (c) the employee was not offered coverage. Under the ACA, if an employee receives a tax credit or cost-sharing reduction, then the IRS may charge the employer a shared responsibility payment under §4980H.

For the tax period ending December 31, 2016, the IRS charged the Debtors an ESRP for the employees that were allowed a tax credit or cost-sharing reduction under the ACA. For each month from January 2016 through November 2016, over 450 of the Debtors’ full-time employees were enrolled in a qualified health plan for which they were allowed a tax credit or cost-sharing reduction. On December 19, 2018, the IRS sent the Debtors a Letter 226-J with a proposed ESRP of $818,640.00 for tax year 2016, noting liability was applicable under 26 U.S.C. § 4980H(b). Ultimately, the amount was reduced to $778,050.00.

Beginning in 2017, the Debtors did not offer a health plan offering minimum essential coverage to salon employees. As a result, CHI accrued ESRP charges for 2017 and 2018. For each month of tax year 2017, over 350 of CHI’s full-time employees were allowed a tax credit or cost-sharing reduction by the IRS.  On October 3, 2019, the IRS sent the Debtors a Letter 226-J certifying that one or more employees were allowed a tax credit and proposing an ESRP of approximately $13,901,259.96, but later reduced to $1,311,930.00 upon a showing that the Debtors had offered minimum essential coverage to at least 95% of their full-time employees and their dependents.

Bankruptcy and the IRS’s Proof of Claim

The Debtors filed for bankruptcy in 2020.  The IRS filed a Proof of Claim against the Debtors asserting a liability of $2,094,029.28 and asserting priority status under §507(a)(8)(E).  In the Form 410 Summary, the IRS identified the tax as an “Excise” tax for the relevant periods.

The Court looked at two issues in relation to the IRS claims, as follows:

1. Whether  the ESRP was an excise tax entitled to priority under §507(a)(8)(E) of the Bankruptcy Code; and
2. if the ESRP was an excise tax, whether the amounts claimed by the IRS for 2016 and 2017 taxes were “on a transaction occurring within three years of the petition” as required by §507(a)(8)(E).

The Bankruptcy Code grants priority status to certain allowed claims. Section 507(a)(8) grants priority to “excise” taxes:

Section 507(a)(8)(E).

Is the ESRP an Excise Tax?

The Bankruptcy Code does not define the term “excise tax.” In United States v. Reorganized CF & I Fabricators of Utah, Inc.(“CF&I“), 518 U.S. 213, 224 (1996), the U.S. Supreme Court addressed whether an exaction was an excise tax entitled to priority under the statutory predecessor to §507(a)(8)(E) or a nonpriority penalty. The IRS asserted a claim against the debtor CF&I Steel Corporation for fees assessed for failing to make annual minimum funding contributions to a pension plan, as provided in 26 U.S.C. §§4971(a). Under §4971(a), an employer that failed to make its required contribution was assessed a tax of 10% on the accumulated funding deficiency. The debtor failed to pay $12.4 million of the required contribution into its pension plans for the tax year prior to filing bankruptcy. The amount due under 26 U.S.C. §§4971(a) was approximately $1.24 million.  The IRS similarly sought priority status for the exaction as an excise tax.  The bankruptcy court allowed the claim, but determined it was a noncompensatory penalty, not an excise tax, and denied priority. The district court and the Court of Appeals for the 10th Circuit affirmed.

In affirming, the Supreme Court focused on the operation—not the label—of the provision establishing the liability. CF&I, 518 U.S. at 224. It concluded that the Bankruptcy Act of 1978, which codified priority to several types of taxes, “reveals no congressional intent to reject generally the interpretive principle that characterizations in the Internal Revenue Code are not dispositive in the bankruptcy context, and no specific provision that would relieve us from making a functional examination of § 4971(a).” Id. The Court noted that a functional examination is supported by a long history of precedent in determining whether a tax is an “excise tax” for bankruptcy priority purposes. Id. ; see United States v. La Franca, 282 U.S. 568, 571-72 (1931) (a “tax” and a “penalty” “are not interchangeable one for the other. No mere exercise of the art of lexicography can alter the essential nature of an act or a thing; and if an exaction be clearly a penalty it cannot be converted into a tax by the simple expedient of calling it such.”); City of New York v. Feiring, 313 U.S. 283, 285 (1941) (determining whether a “tax” was entitled to priority treatment under §64 of the Bankruptcy Act of 1938); United States v. New York, 315 U.S. 510, 514-17 (1942) (relying on its decision in Feiring which examined the effect of the exaction).

The Court stated that “a tax is an enforced contribution to provide for the support of government; a penalty, as the word is here used, is an exaction imposed by statute as punishment for an unlawful act.” CF&I, 518 U.S. at 224 (citing to La Franca, 282 U.S. at 571-72). The Court concluded that the pension provision at issue was obviously penal in nature. The 10% exaction was not created to support the government. The legislative committee reports stated that the previous statutory penalties did not incentivize employers to fully fund their plans. Id. at 226. Instead, the new provision would penalize employers directly by requiring them not only to fund the deficiency but also pay the 10% exaction. Id. The Court highlighted that the 10% excise was in addition to the Pension Benefit Guaranty Corporation’s independent claim to the total amount of the pension contribution deficiency. Thus, the pension provision had a primarily punitive aim versus a goal to support the government.

The Supreme Court affirmed the use of this “functional approach” analysis of an exaction in Nat’l Fed’n of Independ. Bus. v. Sebelius (“NFIB”), 567 U.S. 519 (2012), which addressed whether the individual shared responsibility payment of the ACA passed Constitutional muster under the Taxing Clause.  At the time of the decision, the individual mandate required most Americans to maintain minimum essential health insurance coverage. Under the ACA, if an individual did not maintain minimum essential health insurance coverage, then the individual was required to make a shared responsibility payment to the IRS with their taxes and it was collected like a tax penalty.

After NFIB, many courts grappled with the question of whether the individual mandate was an excise tax under §507(a)(8)(E), with differing results.  The Court here focused on the Fourth Circuit’s opinion in Liberty Univ., Inc. v. Lew (“Liberty”), 733 F.3d 72 (4th Cir. 2013).   The Court in Liberty  relied on the Supreme Court’s analysis in NFIB to determine that ESRP is a tax under the “Taxing and Spending or General Welfare Clause.” Liberty , 733 F.3d at 95-96. The Fourth Circuit applied the “functional approach” and concluded that the ESRP functioned as a tax and not a penalty.  Turning to the case at bar, the Maryland Bankruptcy Court ultimately concluded that the employer shared responsibility payment is an excise tax entitled to priority.

Does the IRS have Priority?

Turning to the second issue, the Court noted that finding that the ESRP was an excise tax did not end the inquiry.  Section 507(a)(8)(E) provides that allowed unsecured government claims are entitled to priority only to the extent such claims are for an excise tax on “a transaction occurring during the three years immediately preceding the petition date.” §507(a)(8)(E). The parties disputed whether there was a “transaction” that imposed the ESRP and, if so, when the transaction “occur[ed]” under the ACA.  The Court determined that it is the underinsured or uninsured employee’s act of enrolling in a qualified health plan that triggers the ESRP, and therefore concluded that the “transaction occur[s]” under §507(a)(8)(E) when an employee who is not offered the minimum level of insurance coverage and who meets certain financial standards enrolls in a qualified health plan.

Ultimately, the Court determined that, based on the petition date of April 23, 2020, the three-year period of §507(a)(8)(E) began on April 23, 2017.  Any ESRP amounts arising from employee enrollments in a qualified plan prior to that date were excluded from priority, and would be deemed general unsecured claims.  Therefore, the court granted in part and denied in part the Debtors’ objection to the IRS claim.