Chapter 12 and the New Capital Gains Tax Rule: A Rosier Outlook for FSA Lenders in 2018?

Stuart A. Laven, Jr.

Amidst the seemingly endless downtrend in Chapter 11 bankruptcy filings in the era of cheap money and onerous Dodd-Frank regulations (business Chapter 11 filings are down some 43% nationwide from the last peak in 2010), there has been a notable counter-trend of late: the volume of agricultural bankruptcy filings has ballooned. While relatively scarce and unfamiliar to non-agricultural lenders, Chapter 12 bankruptcies—reorganizations of family farms and commercial fisheries—have increased almost 23% since 2015. Nationwide, there were 499 Chapter 12 filings for the 12-month period ended March 31, 2018, compared with 407 for calendar year 2015.

Upward Trend in Farm Bankruptcies

The upward trend in farm bankruptcies is undoubtedly tied to the ongoing depression in agricultural commodity prices, with dairy producers being among the hardest hit. In the dairy heartland of Wisconsin, for example, Chapter 12 filings nearly tripled, spiking from 22 in 2015 to 57 for the 12-month period ended March 31, 2018. And with a near record level ($6 billion) of USDA-subsidized farm debt outstanding (funded through a variety of Farm Service Agency (FSA) direct and guaranteed bank loan programs), both private FSA lenders and Uncle Sam have been bearing the lion’s share of the exposure from this soft market.

Chapter 12 Bankruptcy Filings Expected to Continue

Market experts are forecasting continued oversupply and difficult conditions for farmers through the end of 2018, with the pipeline of new Chapter 12 filings expected to continue unabated, especially for dairy and protein producers. But there’s at least a hypothetical light at the end of the tunnel for agricultural lenders: a recent revision to a key tax provision in Chapter 12 of the Bankruptcy Code.

In October 2017, the Family Farmer Bankruptcy Clarification Act of 2017 (H.R. 2266) was signed into law. Broadly, the Act expands the ability of Chapter 12 debtors to deal with capital gains taxes in Chapter 12 plans of reorganization.

Act Changes Increase Chance for Viable Exit from Bankruptcy

Specifically, the Act replaces Bankruptcy Code Section 1222(a)(2)(A) with new Section 1232, which now permits Chapter 12 debtors to treat capital gains taxes from post-bankruptcy asset sales as non-priority, general unsecured claims (i.e., a Chapter 12 plan can now be confirmed without paying 100% of post-petition capital gains taxes either in cash or over the life of the Chapter 12 plan).

Prior to this revision, under a Supreme Court ruling interpreting the 2005 version of Section 1222, only prepetition capital gains taxes could be classified as unsecured claims (and ultimately discharged under a Chapter 12 plan). This meant that some Chapter 12 debtors could not sell heavily depreciated assets post-bankruptcy without generating large, nondischargeble tax claims and effectively killing any chance for a viable exit from bankruptcy.

Theoretically, this revision could prove lucrative for secured lenders in Chapter 12 cases on two fronts. First, debtors will have the flexibility to sell/liquidate collateral under a plan without capital gains being an impediment to plan confirmation. Second, debtors who would otherwise be burdened with paying down 100% capital gains claims under a Chapter 12 plan will now have potentially greater free cash flow to support required plan payments to secured lenders and survive seasonal and/or unforeseen revenue swings.

The impact of the new Section 1232 remains to be seen, but the theoretical upside for lenders, servicers and the FSA itself lies in the opportunity for greater feasibility and flexibility as Chapter 12 debtors try to exit bankruptcy and stay in business. But at a minimum, the layered perils of rising interest rates and new barriers to international commodities trade should serve to generate a pretty robust data pool for future analysis.

Sources: Office of the United States Courts (bankruptcy filing data); “CoBank 2018 Year Ahead Report: Forces that Will Shape the Rural Economy” (CoBank, January 18, 2018); “Rising Interest Rates Add to Already Stressed Agricultural, Rural Economy” (CoBank, May 30, 2018).

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