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A federal judge has ruled that two retired partners of now-defunct Pennsylvania law firm LaBrum & Doak were properly ordered by the Bankruptcy Court to help pay off a $2 million “tax recapture” that stemmed from the firm’s office rental agreement. U.S. District Judge Jay C. Waldman, sitting as the appeals court to review rulings by U.S. Bankruptcy Judge David A. Scholl, found that Scholl correctly held that an “implied contract” existed under which partners were individually liable for recapture of the tax benefits which they received. The 23-page ruling in In Re: LaBrum & Doak rejected appeals brought by retired partners Perry S. Bechtle and Daniel J. Ryan. Waldman found that the tax recapture issue arose from a lease agreement that allowed the firm’s partners to take considerable deductions in the first few years of the lease with the expectation that they would then incur significant liabilities in the later years of the lease. But the firm dissolved before the second phase of the lease kicked in, and the firm found itself in Bankruptcy Court with the difficult problem of deciding how to pay off the $2 million tax recapture that became due all at once. Waldman found that the bankruptcy judge correctly held that 39 former partners should help pay off the tax debt. “Substantial tax benefits flowed to the former partners for four years. The expectation of all partners was that those who benefited would be responsible for their share of the corresponding liability through the end of the lease term,” Waldman wrote. “It would be inequitable to allow a partner to retain such benefit and then escape the corresponding cost or offsetting liability by forcing others to absorb it. Requiring partners to be responsible for liabilities proportional to the benefit each obtained is clearly just and equitable.” Focusing on the appeals brought by Bechtle and Ryan, Waldman said “appellants received a benefit, they reasonably should have expected to pay the cost associated with that benefit and their retention of the benefit without such payment would be unjust.” In the Bankruptcy Court, LaBrum & Doak, as debtor, instituted an adversary proceeding to obtain a declaratory judgment approving its proposed allocation of tax recapture liability to all of its partners and former partners who received the benefit of the recapture, as opposed to only the partners who remained at the time of the firm’s dissolution. The tax recapture liability issue stemmed from a 10-year lease the firm entered into in 1992 for office space with 1818 Market Partnership. The terms of the lease commenced Sept. 1, 1992, and extended through Aug. 31, 2002. As an incentive to the firm to enter the lease, the landlord abated the rent during the first year and for portions of the subsequent three years. TAX STRATEGY In order to take advantage of the tax benefits offered by the lease, the firm adopted in 1994 the “constant rental accrual method” of accounting provided in the tax code. That method allowed the firm to prorate for tax purposes the total rents due under the lease over the entire length of the lease, resulting in increased tax deductions for rental expenses for the first four years of the lease and permitting the partners to declare taxable income significantly less than actual income earned. Beginning in 1996, however, the firm was required to pay its rent in full, even though its rent expense deductions were limited to the constant rate previously established. That effectively increased the taxable income of the partners during that second period. Through 1995, the partners had received a cumulative tax benefit of $2,056,458, with Ryan receiving deductions of $110,407 and Bechtle receiving deductions of $64,721. To help provide for the tax liabilities upon recapture, the firm withheld significant sums from the partners’ cash distributions of profits and established a reserve fund as part of each partner’s capital account. The intention was to create a risk management device which would assist a departing or retiring partner to pay the accelerated tax liability upon his or her departure. When the firm experienced financial difficulty, however, the partners’ capital accounts were depleted. In 1995 and 1996, nine of the firm’s partners left, either by withdrawal or retirement. Bechtle and Ryan, the only partners who retired, did so effective Dec. 31, 1996. They entered into agreements with the partnership providing for post-retirement payouts beginning in January 1997 and extending for five years. The firm then operated under a 1989 “amended and restated partnership agreement,” which contained several provisions concerning liabilities of former partners for defined losses and pending claims. AMENDED AGREEMENT In January 1997, the remaining partners voted to adopt an amendment, to apply retroactively to Jan. 1, 1996, that expressly allocated to each present and former partner whose equity in the firm had not yet been completely liquidated a share of the tax recapture income that was to be recognized in the tax years 1996 to 2002. For those partners who had retired or otherwise terminated their interest in the partnership, however, the total amount of the tax recapture income that would be allocated to them throughout the 1996-to-2002 period would be accelerated and allocated to them in the years that they received returns of capital from the firm. A second amendment in April 1997 clarified that the allocations of additional income were for tax purposes only. But the Bankruptcy Court held that the amendment was not valid for lack of consideration. None of the partners appealed that decision. In June 1997, LaBrum & Doak’s remaining partners voted to dissolve the firm, effective July 31, 1997. The firm then negotiated with its landlord to vacate most of the space and reduce its rent. Consequently, all of the tax deductions which were meant to be recaptured through 2002 became due in 1997, resulting in an outstanding tax liability of $1,684,289. The firm allocated the tax liability to the present partners and those former partners who had left the firm but were partners at the time of inception of the lease and had received a tax benefit while partners, proportional to the tax benefits received by the partners in 1992-95. When some of the former partners challenged the validity of the allocations, the firm, as debtor, initiated the declaratory judgment action as an adversary proceeding in Bankruptcy Court, seeking approval of its proposed allocation of tax recapture liability among its existing and former partners who received the benefit of the recapture. Following a trial, Judge Scholl issued an opinion holding that the Bankruptcy Court had jurisdiction over the proceeding; that the proceeding was “core” to the bankruptcy case; that the amendments to the partnership agreement were not valid or enforceable against partners who had previously withdrawn; and that an implied contract existed, under which partners were individually liable for recapture of the tax benefits which they received. JURISDICTION QUESTIONED Bechtle and Ryan appealed, arguing that the Bankruptcy Court lacked jurisdiction over the adversary proceeding underlying the appeal and erred in finding an implied in fact contract. They also claimed that the Bankruptcy Court erred by failing to recognize as a defense a right of retiring partners to indemnification pursuant to the partnership agreement, although they admitted that they did not assert this defense before the Bankruptcy Court. Challenging Scholl’s jurisdiction ruling, they argued that a proceeding to determine the allocation of tax liabilities among the present and former partners of the firm does not affect the administration of the estate and therefore is not related to the bankruptcy because the parties ultimately liable for the taxes at issue are the individual partners. Scholl had ruled that the firm’s “obligation to allocate the tax liability of its partners and former partners on its returns, albeit that the ultimate payment responsibility lies with the partners, renders the matters at issue ‘related to’ the debtor’s bankruptcy … since it is not only conceivable but quite apparent that resolution of this issue is critical to the administration of the case.” Because affirmative obligations of the firm under the Internal Revenue Code could be affected by the proceeding, Scholl held that the Bankruptcy Court had jurisdiction. Waldman agreed, saying that “the reach of ‘related to’ jurisdiction is very broad, extending to any proceeding whose outcome could conceivably have any effect on the administration of the estate being administered in bankruptcy.” Although the firm was not ultimately responsible for payment of the taxes, Waldman found that the issue was nonetheless “related to” the bankruptcy. Scholl went further and held that the matter was a “core proceeding” because the firm’s proper filing of its tax returns is important to the administration of the estate. Waldman again agreed, saying the proceeding “involved a matter significant to the administration of the bankruptcy estate and is core.” IMPLIED CONTRACT Turning to the ultimate issue of whether there was an implied contract that held the former partners liable for the tax recapture, Waldman found that Scholl had determined as a fact that all of the partners who received a tax benefit agreed to accept the corresponding deferred tax liability. “A contract implied in fact is an enforceable contract which arises where an agreement, although not expressed in words, is inferred from the conduct of the parties in light of the surrounding circumstances,” Waldman wrote. In such an implied contract, Waldman said, “neither the offer and acceptance nor the moment of formation need be identifiable.” Waldman said Scholl’s findings on that point “are supported by the record and not clearly erroneous.” When the “constant rental accrual method” of accounting for the 1992 lease was first adopted by the firm, Waldman found that “the partners specifically discussed the effects of utilizing this method including the tax effect on each partner.” The partners, he said, “understood that each partner who obtained the tax benefit during the first four years of the lease would be responsible for the corresponding tax burden.” Bechtle and Ryan argued that it was inconsistent for the Bankruptcy Court to conclude that there was a lack of consideration for the amendments to the partnership agreement but nonetheless find the existence of consideration for an implied in fact contract. Waldman disagreed, saying, “The reason the Bankruptcy Court found no consideration for this amendment is that the partners had a pre-existing duty to pay their share of the tax recapture liability by virtue of an implied in fact contract. The receipt of tax benefits for the first four years of the lease is ample consideration for the obligation proportionately to absorb the offsetting tax liability in the later years.”

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