The Primary Purpose Test and SRP Chameleon: How the Obamacare “Penalty” Became a “Tax” Only to Become a “Penalty” Again
July 22, 2018
Authored by: Jacob Johnson
The Patient Protection and Affordable Care Act of 2010 (a/k/a “Obamacare” or the “ACA”), with its infamous “individual mandate” (and corresponding “shared responsibility payment” (which we’ll call the “SRP”)), is no stranger to controversy. Everyone is well aware of the legal challenges mounted against the individual mandate, and the seminal SCOTUS opinion upholding the mandate as a valid exercise of Congress’s taxing power – National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012). Don’t worry, we’re well aware that you, along with nearly every other American (including us here at the Bankruptcy Cave), are sick and tired of hearing about ACA squabbles. But this post will explore one side of the ACA that you’ve almost certainly not considered, but which is interesting (to us at least). It’s interesting because it provides the leading thought on which government exactions should and shouldn’t be entitled to priority under the Bankruptcy Code. But it’s also interesting because it allows us to highlight the bizarre, chameleon-like nature of the SRP – a “penalty” as drafted, then as a “tax” under the Taxing Clause of the Constitution (under Sebelius), and then a “penalty” again under Section 507 of Bankruptcy Code.
So far, we are aware of two reported decisions – In re Parrish, No. 17-02341-5-SWH, 2018 WL 1725385 (Bankr. E.D.N.C. Apr. 6, 2018), by Judge Humrickhouse of the Bankruptcy Court for the Eastern District of North Carolina and In re Chesteen, No. 17-11472, 2018 WL 878847 (Bankr. E.D. La. Feb. 9, 2018), by Judge Brown of the Bankruptcy Court for the Eastern District of Louisiana – addressing whether the SRP is entitled to priority under Section 507(a)(8) of the Bankruptcy Code (whether as a tax or, alternatively, a penalty in compensation for actual pecuniary loss). Both courts held that the SRP is not entitled to priority. These two decisions were rendered in a nearly identical procedural context: Chapter 13 debtors objecting to Internal Revenue Service (“IRS”) claims seeking excise tax priority treatment under Section 507(a)(8)(E) as to the debtors’ SRP liability. (Priority of claims is important in the Chapter 13 context because a Chapter 13 plan cannot be confirmed unless all priority claims are paid in full thereunder, or the holder thereof consents to a different treatment. 11 U.S.C. § 1322(a)(2).)
The starting point of both decisions was the so-called “functional analysis” mandated by the Supreme Court in United States v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213, 224 (1996), whereby courts examining the question of whether a claim is entitled to “tax” priority must look past the label of the exaction giving rise to the claim (whether “tax” or otherwise) to the exaction’s underlying characteristics and function. CF & I articulates this test as follows: “a tax is an enforced contribution to provide support for the government; a penalty, as the word is used [in Section 507(a)(8)], is an exaction imposed by statute as a punishment for an unlawful act” (emphasis added). While this test is simple enough where an exaction was imposed for the sole purpose of supporting the government fisc (clearly a tax entitled to priority) or where the exaction was imposed to punish an unlawful act (clearly a penalty not entitled to priority). But where the exaction falls in between these points, the analysis is mushy. While the IRS has successfully argued for a bright-line rule that any exaction not imposed to punish an unlawful act should be treated as a priority tax, more recent decisions have rejected this argument. However, until a recent decision out of the Bankruptcy Court for the Middle District of Georgia, Bradford v. U.S. Department of the Treasury (In re Bradford), 534 B.R. 839 (Bankr. M.D. Ga. 2015), there was no clear test to apply in this “grey area.” As formulated by Bradford (and as applied by Parrish and Chesteen), this “primary purpose” test provides that where an exaction has characteristics of both a tax and a penalty, the exaction will only be entitled to priority if it is shown, using the CF & I factors, that the exaction was levied with the primary purpose of supporting the government.
Both courts (relying on Bradford), rejected the IRS’s argument that Sebelius means the SRP functions as a tax for purposes of the functional analysis required by Section 507(a)(8). The courts’ reasoning here can be simplified as follows – Congress can create an imposition under its taxing power that is not a tax within the meaning of various portions of the U.S. Code. The courts, having rejected this argument that Sebelius controls, turned to examining, defending, and applying the primary purpose test.
In Parrish, the court adopted the primary purpose test without much explanation, simply declaring that: “[i]n order to determine whether the individual mandate of the ACA is a ‘tax’ granted priority in the context of § 507(a)(8) or a ‘penalty,’ the court must decide whether the primary, or dominant, purpose of the individual mandate or the ‘shared responsibility payment’ is to support the government or to punish or discourage certain conduct.”
On the other hand, in Chesteen, the court dealt more fully with the IRS’s attacks that the primary purpose test was unsound and not grounded in binding Circuit or Supreme Court precedent. The Chesteen court disagreed, reiterating that CF & I requires a functional analysis and the lawfulness of the act triggering the exaction was not determinative. The court reasoned that because “[m]any exactions have characteristics of both a tax and a penalty, . . . the court must use some test to determine whether an exaction is more like a tax or more like a penalty. For that reason, the ‘primary purpose’ of the exaction is informative if not determinative.” In other words, because the bright-line lawful = tax / unlawful = penalty distinction is unsound, and governments nearly always have some revenue capturing motive with respect to exactions, by logical necessity, the court must divine the government’s primary purpose for imposing the exaction.
Both courts, having examined the characteristics of the SRP, easily found that the individual mandate’s purpose was to encourage Americans to purchase health insurance coverage and, conversely, the SRP had the primary purpose of discouraging Americans from living without health insurance coverage. For that reason, the courts sustained the debtors’ objections and denied to accord priority treatment to the SRP.
While the narrow question of the priority of SRPs has a circumscribed impact following the passage of Tax Cuts and Jobs Act earlier this year, which eliminated the individual mandate as of 2019, these cases are important. First, these cases solidify that Sebelius did not alter the landscape of CF & I’s “functional analysis” used to determine what governmental exactions are entitled to priority under Section 507(a)(8). Second, and likely most importantly, these cases mark a new trend in favor of the “primary purpose test.” We look forward to seeing how the primary purpose test will develop as it is adopted and applied in future decisions.
 (a) Requirement to maintain minimum essential coverage.—An applicable individual shall for each month beginning after 2013 ensure that the individual, and any dependent of the individual who is an applicable individual, is covered under minimum essential coverage for such month.
 (b) Shared responsibility payment.—
(1) In general.—If a taxpayer who is an applicable individual, or an applicable individual for whom the taxpayer is liable under paragraph (3), fails to meet the requirement of subsection (a) for 1 or more months, then, except as provided in subsection (e), there is hereby imposed on the taxpayer a penalty with respect to such failures in the amount determined under subsection (c).
 United States v. Juvenile Shoe Corporation of America (In re Juvenile Shoe Corporation of America, 99 F.3d 898 (8th Cir. 1996) (holding that because the conduct triggering the exaction was lawful, the exaction could not be a penalty and was thus a tax).
 In Bradford, the court relied upon an older circuit case decided under the Bankruptcy Act of 1898 – Mahon v. IRS (In re Unified Control Systems, Inc.), 586 F.2d 1036, 1036 (5th Cir. 1978) – disallowing an exaction as a penalty because the exaction’s “sole substantial purpose was to penalize wrongful conduct.”
 “[W]here an exaction arguably serves more than one purpose, it is necessary to address the primary (or overriding) purpose of the exaction.”