EXECUTIVE SUMMARY
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Costs incurred in a bankruptcy filing can be categorized as either personal or business related. A taxpayer cannot deduct those categorized as personal expenses but can deduct those categorized as business expenses.
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Whether bankruptcy costs are treated as personal expenses or business expenses is determined under the origin-of-theclaim doctrine. This doctrine states that a taxpayer may deduct a legal expense if it arises out of a claim that is directly connected with or proximately caused by the taxpayer’s profit-seeking activities. In bankruptcy cases, this generally means that an expense will be treated as a deductible business expense if it is related to a taxpayer’s failed business.
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Bankruptcy expenses related to a failed business may be considered deductible business expenses even when the business failed in a year prior to the bankruptcy filing.
Between 1995 and 2005, the number of personal bankruptcies filed annually in the United States grew from approximately 900,000 to over 2 million.1 In 2005, in an effort to stem abuses of personal bankruptcy laws, the Bankruptcy Abuse Prevention and Consumer Protection Act2 (BAPCPA) was enacted, which increased bankruptcy filing costs and made debt discharge, including income taxes owed, more difficult. Therefore, maximizing bankruptcy filers’ tax deductions has become more important in facilitating the fresh start filers seek.
One category of income tax deductions that practitioners and taxpayers may overlook is the costs of the actual bankruptcy filing. Normally, costs of personal bankruptcy are not deductible on an individual’s tax return.3 However, in circumstances where the proximate cause of the personal bankruptcy is a prior business failure, the origin-of-the-claim doctrine supports the deduction of the portion of personal bankruptcy costs that relate to the business failure.4
A factor complicating the application of the origin-of-the-claim doctrine is that the relationship between business failure and personal bankruptcy may not be immediately apparent, especially in cases where the business failure occurred in a year prior to that of the bankruptcy filing. The taxpayer’s employment status (e.g., the taxpayer is employed by others at the time of filing) may also mask the underlying business cause of the bankruptcy. In addition, many small business owners use personal credit as a means of obtaining business funds, frequently commingling personal and business debts, which may also obscure the business origins of personal debts.
Overall, it is critical that a tax practitioner ascertain the origin of a personal bankruptcy filer’s debts in order to provide appropriate tax advice and maximize allowable deductions, particularly in light of the current economic turbulence.
BAPCPA and Bankruptcy Costs
Under BAPCPA, the costs of filing for bankruptcy have increased and the filer’s ability to discharge debts has decreased. The increased costs are due in part to the relatively higher percentage of individuals expected to file bankruptcy under chapter 13 rather than chapter 7. BAPCPA no longer allows individuals to select the chapter under which they file, but instead imposes a means test to determine whether a taxpayer may use the more favorable chapter 7. In addition, BAPCPA’s complexity is expected to increase the legal costs of bankruptcy filing. Other out-of-pocket costs for filers have also increased under BAPCPA, due to mandates that filers take financial management and credit counseling courses before their debts can be discharged. Finally, BAPCPA has reduced the ability of chapter 13 filers to receive a discharge of taxes assessed under an IRS substitute for return.5
Business versus Personal Expenses
Congress regards individuals as having two personas: One is personal while the other seeks profit through carrying on a business or the production of income. The ordinary and necessary expenses associated with seeking profits through a trade or business and/or investments are deductible under Sec. 162(a) and Secs. 212(1) and (2). Conversely, Sec. 262(a) disallows expenses for satisfying personal, living, or family needs.
The business versus personal distinction includes legal expenses and other costs related to bankruptcy. These costs are clearly tax deductible when they arise from business or investment transactions6 in which no restructuring or reorganization occurs,7 whereas costs related to personal bankruptcy are not deductible.8
While this dichotomy appears straightforward, the distinction between personal and business expenditures can be difficult to apply to bankruptcy fees. Specifically, it is not uncommon for individual entrepreneurs and small business owners to commingle their personal and business debts. Thus, the question becomes, what is the proper treatment of bankruptcy legal and other fees when an individual filing for personal bankruptcy has debts related to a failed business? To determine the deductibility of bankruptcy legal fees, case law relies on the origin-of-the-claim doctrine.
Origin-of-the-Claim Doctrine
The Supreme Court first addressed the treatment of an individual’s legal costs as business deductions in Kornhauser.9 In this case, the taxpayer incurred litigation costs to defend himself in a suit instigated by a former business partner. Even though the taxpayer was no longer a partner at the time of the suit, the Court ruled the legal costs were deductible business expenses. This finding introduced the concept that personally paid legal expenses are deductible if the suit or action against the taxpayer is directly connected with, or proximately resulted from, carrying on a business. Following Kornhauser, Deputy v. du Pont 10 explicitly stated that the origin from which the expense accrues is material in determining whether an expense is a business deduction. The “directly connected” test, derived from these cases, indicates that the characterization of an expense as “business” or “personal” is dependent on whether or not the claim arises in connection with the taxpayer’s profit-seeking activities.
The next important court decision, Lykes,11 discussed a limit of the originof- the-claim doctrine. Lykes argued that his legal fees for contesting a gift tax reassessment should be deductible because he incurred the fees to protect his personal investments from being liquidated to pay the reassessment. The Supreme Court held that the deductibility of legal expenses turns wholly upon the nature of the activities to which they relate. Since the dispute related to a personal gift, the origin of the legal fees was not directly connected with or a proximate result of a profit-seeking activity. Thus, the legal fees were not deductible.
The Supreme Court stated that allowing legal expenses to become deductible merely because of the potential consequences to profit or investment assets would result in too broad a determination of deductibility. Ultimately, the expense of defending almost any claim would be deductible by a taxpayer on the ground that the taxpayer made the defense to protect whatever income-producing property he or she owned. For example, consider the case of a taxpayer involved in a personal injury lawsuit related to the taxpayer’s negligence while driving for pleasure. If an unsuccessful outcome would result in the taxpayer’s losing income-producing assets to satisfy the action, the legal expenses would be deductible. The Supreme Court found this outcome to be contrary to the intent of the tax law.
The landmark case in the development of the origin-of-the-claim doctrine regarding legal expenditures is Gilmore.12 The Supreme Court granted certiorari for this case because of the importance of the issue and the conflicting decisions in the Court of Claims, the Courts of Appeals, and the Tax Court. Gilmore, as a result of a divorce proceeding, incurred legal fees in protecting his controlling interest in three franchised automobile dealerships. He feared losing his position as president and general manager of the corporations if his wife obtained a community property share in his holdings. Thus, Gilmore’s overriding concern in the divorce litigation was to protect his assets from claims by his wife.
The lower court held that 80% of Gilmore’s legal expenses were attributable to defending against his wife’s community claim to his stock holdings and hence were deductible as an investment expense. In overturning the lower court, the Supreme Court clarified the application of the origin-of-the-claim doctrine in the administration of income tax laws and laid the foundation for determining the tax treatment of litigation costs.
Specifically, the Court held that the deductibility of legal fees depends on whether the dispute arises from the taxpayer’s profit-seeking activities (e.g., in a bankruptcy case, the deductibility of the expenses depends on whether the bankruptcy occurred as a result of a failed business). Neither the consequences that might result to a taxpayer’s fortunes due to losing the lawsuit nor the taxpayer’s motivation for defending against the claims of others are relevant factors in determining deductibility. Since the origin of Gilmore’s litigation was his marriage and pending divorce, the costs of defending against his wife’s claims were not associated with a profit-seeking activity and thus were not deductible.
Applying the origin-of-the-claim doctrine to bankruptcy costs, the taxpayer can deduct the costs if the bankruptcy filing proximately resulted from business or investment activities. 13 The fact that there are business creditors involved in the bankruptcy does not automatically result in the origin of the claim being considered business,14 nor is the origin of the claim established by a taxpayer’s guaranteeing a company loan unless the dominant reason for doing so is to increase or protect his or her salary.15
Example 1: R is a self-employed individual with no medical insurance. He becomes very ill, eventually is hospitalized, and incurs $800,000 of medical bills. Upon his release from the hospital, R is unable to work and relies on both personal and business loans when attempting to pay his medical bills. After exhausting his available credit, and still being unable to pay $400,000 of his medical bills, R files for bankruptcy. R’s home and personal assets have a net value of $100,000 (before considering the medical bills), and the fair value of his business assets is $500,000 with $450,000 in liabilities. Even though R may incur legal expenses trying to protect his business assets from the medical creditors, because the origin of the claim for R’s bankruptcy is his personal medical expenses, the expenses will not be deductible.
Example 2: J owns a fast-food restaurant. Due to the construction of a new freeway, J’s business income falls dramatically. He initially tries to sell the business but finds no buyers. By the time J decides to file for bankruptcy, he has $500,000 of business debts in excess of business assets. He also has $100,000 of personal debts that he is unable to pay. Even though J has a mixture of business and personal debts, in this case the proximate cause of the bankruptcy was business failure, and J may therefore deduct a portion of the bankruptcy costs as a business expense.
Determining Deductible Amounts
Having determined that a bankruptcy has business origins, only those litigation costs that are directly related to the business portion of the bankruptcy are deductible.16 Therefore, an allocation of costs (bankruptcy filing fees, court costs, charges for attorney referrals, bankruptcy trustee charges, and attorneys’ fees)17 related to the business portion of the bankruptcy is necessary.
Allocation of costs between deductible and nondeductible items is common in the tax law. For example, taxpayers allocate expenses associated with taxable and tax-exempt income,18 vacation home expenses are allocated between personal use and rental,19 and costs related to tax advice in a divorce are deductible, as long as the taxpayer elects to itemize his or her deductions.20
However, expenses are deductible as a matter of legislative grace, and taxpayers bear the burden of proving that they are entitled to any deductions21 and providing a reasonable apportionment of the expenses between deductible and nondeductible.22 While apportionments based on the total time spent on accounting and litigation have been used in other situations,23 the IRS has been unsuccessful in arguing for allocation of bankruptcy costs based on time spent by the attorneys, accountants, and trustees dealing with each of the bankruptcy liabilities.24
Instead, for bankruptcies, the Tax Court has generally preferred to allocate costs based on the proportion of business creditor claims to total claims against the taxpayers.25 It should be noted that the Tax Court has not made an allocation between business and personal expenses in cases where the taxpayer made no attempt to provide a reasonable apportionment26 or allowed business deductions where there is no evidence to support the segregation between ordinary and necessary expenses of a business activity and personal expenses. 27 Where the taxpayer fails to show that debts were of business origin, costs related to those debts are not deductible. 28 Because courts are not obligated to speculate regarding business expenses, 29 they generally do not apply the Cohan rule to bankruptcy costs.30
Example 3: Several years ago, M began a retail western clothing business. She was unable to make a profit in the business and eventually discontinued operations. The proceeds from the sale of her business assets were used to satisfy business liabilities. However, M still has outstanding debts to her former business creditors of approximately $675,000. She also has unsecured personal debt of $450,000 that she is unable to pay. Although M has been trying to repay her creditors with earnings from her current employment, she realizes her efforts are futile and files for bankruptcy, incurring legal and filing fees of $15,000.
In this case, the origin of the claim for M’s bankruptcy is both business and personal. Her total debt is $1,125,000 ($675,000 owed to former business creditors plus $450,000 of personal debt). Because approximately 60% of M’s debts are related to her failed business ($675,000 ÷ $1,125,000), 60% of the proximate cause of her bankruptcy is business related. Thus, M may claim $9,000 of the bankruptcy costs as a business deduction.
Example 3 presents a bankruptcy with a straightforward delineation of business and personal debts. However, individual entrepreneurs and owners of small businesses often commingle some business and personal debts. According to the Federal Reserve Board, 47.6% of small businesses used personal credit cards in 2003.31 Similarly, members of the National Association of the Self Employed (NASE) cite personal credit cards as being second only to personal savings in financing both start-up costs and ongoing operations of small businesses (primarily due to these individuals’ inability to obtain other types of financing).32
Depending on the cashflows generated by their businesses, these individuals are also likely to concurrently use credit cards to finance their personal expenditures, charging food, clothing, and sometimes shelter. In addition, individuals may use home equity loans to raise additional cash to keep their businesses going and/or to consolidate business debts. In cases where this borrowing leads to bankruptcy, it may not be readily apparent which debts actually have business origins and may be particularly confusing if the individual, like M in the previous example, is currently employed by someone else at the time of the bankruptcy filing.
Example 4: Assume that a further analysis of M’s situation reveals that she used $405,000 of the $450,000 unsecured personal debt to try to keep her business afloat. As such, M’s business debts in excess of business assets would now be $1,080,000, rather than the $675,000 reported in Example 3. Business-related debts account for 96% of M’s outstanding debts ($1,080,000 ÷ $1,125,000), allowing her to deduct $14,400 of her bankruptcy costs.
According to Dowd,33 a taxpayer may deduct bankruptcy legal expenses with a business origin as business expenses in the year paid even though the business to which they pertain collapsed several years prior to the payment of the legal fees. Accordingly, even if M files for bankruptcy a few years after the close of her retail business, she will still be able to deduct those legal fees directly related to the business portion of the bankruptcy.
Bankruptcies arising from investments (Sec. 212 expenses) are treated similarly to those arising from business activities. Rather than being deductible on Schedule C, these bankruptcy costs are deductible on Schedule A, as miscellaneous itemized expenses subject to the 2% of adjusted gross income floor under Sec. 67,34 as are the costs of tax advice or return preparation fees.35 However, tax advice or return preparation fees associated with a trade or business (Schedule C), for rent or royalties (Schedule E), or for farming (Schedule F) are deductible from gross income in computing adjusted gross income.36 Based on the treatment of tax advice and return preparation fees, bankruptcies with origins of claims from rents, royalties, S corporations, or partnerships should also be deductible on Schedule E in arriving at adjusted gross income.
Example 5: T has rental properties that were severely damaged by flooding. After incurring substantial costs to repair the damage, T is unable to rent the properties. The mortgage holders foreclose on the properties. T still owes $400,000 for the repairs, which he cannot pay, and therefore he files for bankruptcy. Since the origin of the claim is from rental activities, the bankruptcy fees are deductible as a Schedule E expense.
Conclusion
The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act, with its stringent requirements, will likely increase the scope of work for legal and tax professionals and therefore the costs of bankruptcy for filers. If so, this increases the importance to filers of the potential deductibility of bankruptcy costs. As illustrated in this article, in order to maximize the tax deductions and minimize the amount of taxes owed by filers, it is important for a practitioner to fully understand the origin of the filers’ liabilities. Under the origin-ofthe- claim doctrine, personal bankruptcy fees, normally nondeductible for tax purposes, may be at least partially deductible for those individuals for whom a failed business is the proximate cause of the bankruptcy. Because entrepreneurs may finance their fledgling businesses though the use of personal credit cards and lines of credit, an analysis of the filers’ debts to determine the origin of the claim can increase tax deductions for bankruptcy costs.
Owners of failed businesses may not still be directly involved in the business at the time of the bankruptcy filing. In fact, they may be employed by others, with carryover debts from the business. Thus, it is critical that practitioners thoroughly question their clients regarding the nature and origin of their debts. If it is determined that some of what appear to be personal debts in fact are related to a failed business, the taxpayer must be able to substantiate that the charges arose from business and not personal activities. Once this has been accomplished, bankruptcy costs can be deducted proportionally based upon the ratio of business debt to total debt.
EditorNotes
Debra Sanders is a professor in the Department of Accounting at Washington State University in Vancouver, WA. Susan Gill is an associate professor and Jill Zuber is an assistant professor in the Department of Accounting at Washington State University in Pullman, WA. For more information about this article, please contact Prof. Sanders at dsanders@vancouver.wsu.edu.
Notes
1 American Bankruptcy Institute, Quarterly Non- Business Filings by Year (1994–2009).
2 Bankruptcy Abuse Prevention and Consumer Protection Act, P.L. 109-8.3 Sec. 262(a), which prohibits deductions for personal, living, or family expenses.
4 Sec. 162; Cox, T.C. Memo. 1981-552; Tabbi, T.C. Memo. 1995-463; Pierson, T.C. Memo. 1986-143.
5 For additional discussion of bankruptcy law changes under BAPCPA, see Parker and Nash, “Recognition of ‘Debt Modification Income’ Following Consumer Bankruptcy Reform,” 37 The Tax Adviser 658 (November 2006).
6 Secs. 162 and 212; Pierson, T.C. Memo. 1986-143.
7 Regs. Sec. 1.263(a)-5(a)(4).
8 Collins, 26 F.3d 116 (11th Cir. 1994); Mitchell, T.C. Memo. 1996-217; Cox, T.C. Memo. 1981-552; Dowd, 68 T.C. 294 (1977).
9 Kornhauser, 276 U.S. 145 (1928).
10 Deputy v. du Pont, 308 U.S. 488 (1940).
11 Lykes, 343 U.S. 118 (1952).
12 Gilmore, 372 U.S. 39 (1963).
13 Cox, T.C. Memo. 1981-552; Artstein, T.C. Memo. 1970-220. See Regs. Sec. 1.262-1(b)(7), indicating that the origin-of-the-claim doctrine is applicable to legal fees in divorce litigation.
14 Collins, 26 F.3d 116 (11th Cir. 1994).
15 Scofield, T.C. Memo. 1997-547.
16 Dowd, 68 T.C. 294 (1977).
17 Id.; Cox, T.C. Memo. 1981-552; Collins, 26 F.3d 116 (11th Cir. 1994); Tabbi, T.C. Memo. 1995-463; Scofield, T.C. Memo. 1997-547; Tarakci, T.C. Memo. 2000-358.
18 Sec. 265; Regs. Sec. 1.265-2; Fabens, 519 F.2d 1310 (1st Cir. 1975); Stocks, 98 T.C. 1 (1992).
19 Sec. 280A.
20 Davis, 287 F.2d 168 (1961); Rev. Rul. 72-545, 1972-2 C.B. 179.
21 Tabbi, T.C. Memo. 1995-463; French, T.C. Memo. 1990-314; Tarakci, T.C. Memo. 2000-358; New Colonial Ice Co., 292 U.S. 435 (1934); Deputy v. du Pont, 308 U.S. 488 (1940).
22 Strauss, PH TCM ¶43217 (1943); Mallinckrodt, 2 T.C. 1128 (1943); Jamison, 8 T.C. 173 (1947); Martin, 50 T.C. 341 (1968).
23 Estate of Morgan, 332 F.2d 144 (5th Cir. 1964).
24 Catalano, T.C. Memo. 2000-82.
25 Dowd, 68 T.C. 294 (1977); Cox, T.C. Memo. 1981-552; Scofield, T.C. Memo. 1997-547.
26 Mitchell, T.C. Memo. 1996-217.
27 Gagnon, T.C. Memo. 1996-430.
28 Dowd, 68 T.C. 294 (1977); Mitchell, T.C. Memo. 1996-217.
29 Williams, 245 F.2d 559 (5th Cir. 1957).
30 The Cohan rule is based on Cohan, 39 F.2d 540 (2d Cir. 1930), where the taxpayer was unable to substantiate travel and entertainment deductions through receipts or other proof. The Second Circuit determined that disallowing all costs when the taxpayer has no records is not necessary and “the court may estimate the deductible amount, bearing heavily, if it chooses, upon the taxpayer whose inexactitude is of his own making.”
31 Federal Reserve Board, “Report to the Congress on the Availability of Credit to Small Business,” Table 4 (October 2007)..
32 See testimony of Kristie Darien, Executive Director, National Association for the Self-Employed, “SBA’s Micro-Loan Program,” before House Committee on Small Business (July 12, 2007).
33 Dowd, 68 T.C. 294 (1977). The IRS nonacquiesced (AOD 1978-80) based on the allowance of the legal expenses. The nonacquiescence does not address the timing or the allocation of the expenses.
34 Scofield, T.C. Memo. 1997-547.
35 Temp. Regs. Sec. 1.67-1T(a)(iii).
36 Rev. Rul. 92-29, 1992-1 C.B. 20; IRS Letter Ruling 9234009 (5/20/92).
