Common tax issues are encountered in Chapter 7 and Chapter 11 bankruptcy cases. Failure to fully understand the application of tax laws in the context of a Chapter 7 or Chapter 11 bankruptcy case can undermine the success of the bankruptcy proceedings, result in unanticipated adverse tax consequences, and even expose a party to personal liability.
A Chapter 7 bankruptcy is a liquidation proceeding in which the debtor's nonexempt assets, if any, are sold by the Chapter 7 trustee, and the proceeds are distributed to creditors according to the priorities established in the Bankruptcy Code. A Chapter 11 bankruptcy is a reorganization proceeding in which the debtor repays creditors through a court-approved plan of reorganization. Chapter 11 is ordinarily used by business debtors; however, individual consumers may be eligible to file for Chapter 11 bankruptcy under certain circumstances (see Toibb v. Radloff, 501 U.S. 157 (1991)). A Chapter 11 case is typically pursued by individuals who continue to have substantial personal earning power but whose debts exceed the Chapter 7 and Chapter 13 limits.
Role of Tax Considerations in Bankruptcy: In General
A fundamental goal of the federal bankruptcy laws is to give debtors a financial "fresh start" from burdensome debts (e.g., Local Loan Co. v. Hunt, 292 U.S. 234 (1934)). The U.S. Bankruptcy Code operates in conjunction with the Internal Revenue Code (IRC) and defers to the IRC for purposes of determining tax consequences of the bankruptcy process (11 U.S.C. §346(k)).
However, unlike the Bankruptcy Code, the IRC is not primarily concerned with fairness, equity, or a fresh start for the debtor (e.g., In re Olson, 121 B.R. 346 (Bankr. N.D. Iowa 1990); In re McGowen, 95 B.R. 104 (N.D. Iowa 1988); In re Nevin, 135 B.R. 652 (Bankr. D. Hawaii 1991)). In addition, Congress itself acknowledged this tension between the IRC and bankruptcy laws in connection with the enactment of the Bankruptcy Act of 1978 (seeS. Rep't No.95-989, 95th Cong., 2d Sess., at 13-14 (1978): "A three-way tension thus exists among (1) general creditors, who should not have the funds available for payment of debts exhausted by an excessive accumulation of taxes for past years; (2) the debtor, whose 'fresh start' should likewise not be burdened with such an accumulation; and (3) the tax collector, who should not lose taxes which he has not had reasonable time to collect or which the law has restrained him from collecting").
As such, a debtor in Chapter 7 or Chapter 11 bankruptcy generally continues to be subject to applicable federal income tax laws despite the bankruptcy and must continue to timely file federal income tax returns and pay federal income tax due (see Secs. 6012 and 6151; 11 U.S.C. §346; 28 U.S.C. §960). (It should be noted that the IRC contains some statutory provisions that specifically address Chapter 7 and Chapter 11 bankruptcies; however, these provisions generally address specific, narrow tax issues in bankruptcy and are limited in scope (see, e.g.,Secs. 108, 368(a)(1)(G), 382(l), 1017, 1398, and 6658).) In addition, the debtor generally continues to be subject to state and local tax laws (such as sales and use, property, and franchise taxes), as well as other federal tax laws (such as payroll and employment taxes) during the bankruptcy process (see, e.g., Holywell Corp. v. Smith,503 U.S. 47 (1992); Raleigh v. Illinois Dept. of Revenue,530 U.S. 15 (2000); California State Board of Equalization v. Sierra Summit, Inc., 490 U.S. 844 (1989)).
Following are highlights of some of the common tax issues encountered by individual debtors and bankruptcy trustees at each stage of the bankruptcy process.
Prepetition and Filing Tax Issues
The first set of tax issues arises in connection with the bankruptcy filing itself. Under bankruptcy law, when an individual debtor files a bankruptcy petition under Chapter 7 or Chapter 11, a separately taxable bankruptcy estate that consists of property formerly belonging to the debtor is created (11 U.S.C. §541(a)). The bankruptcy estate is administered by a trustee or by a debtor in possession for the benefit of creditors, and the estate may derive its own income and incur expenditures during the course of the bankruptcy process (11 U.S.C. §541). The term "debtor in possession" refers to a debtor that keeps possession and control of its assets while undergoing a reorganization under Chapter 11 without the appointment of a case trustee (11 U.S.C. §§1101, 1107).
Common Prefiling Tax Issues for Bankruptcy Estate
Upon the creation of the bankruptcy estate, the trustee or debtor in possession, as the case may be, becomes responsible for computing tax due and filing all required federal and state income tax returns on behalf of the bankruptcy estate during the bankruptcy case (Sec. 1398(c)(1); 11 U.S.C. §1107). The trustee or debtor in possession also becomes liable to pay any federal and state income tax due on the bankruptcy estate's taxable income (see, e.g., Holywell Corporation v. Smith, 503U.S.47, 52 (1992) (citing Sec. 6151(a), which provides, in relevant part, "[W]hen a return of tax is required . . . the person required to make such return shall . . . pay such tax."). Failure to timely file income tax returns and pay income tax due exposes the bankruptcy estate to IRS penalties and interest and could potentially expose the trustee or debtor in possession to personal liability.
A somewhat related prefiling issue for a trustee relates to prepetition federal income tax refunds to which the debtor might be entitled. A Chapter 7 debtor's unreceived prepetition tax refund becomes property of the bankruptcy estate upon the filing of the bankruptcy petition (Internal Revenue Manual (IRM) §18.104.22.168.3(1)). As such, the debtor's prepetition tax refunds are subject to "turnover" to the trustee. To obtain turnover of the debtor's tax refund for the benefit of the bankruptcy estate, the trustee must follow specific procedural and notice requirements (see IRM §22.214.171.124.3(2)). The IRS will deny invalid or incomplete requests (IRM §126.96.36.199.3(4)). Accordingly, it is important for the trustee to consult a tax adviser to ensure timely compliance with all applicable procedural requirements for obtaining turnover of the debtor's prepetition tax refund.
Common Prefiling Tax Issues for Individual Debtors
The individual debtor is required to file individual income tax returns during a bankruptcy case (Secs. 6012(a)(1) and 1398(e)(2)). The debtor is required to report income received, gains and losses recognized, and deductions paid other than income, gains, losses, and deductions that belong to the bankruptcy estate (id.). One of the most important prepetition debtor tax considerations that is often overlooked relates to the individual debtor's ability to make an election to close his or her tax year as of the day before the date on which the bankruptcy case begins (Sec. 1398(d)(2)). If this election is made, the debtor's tax year, which otherwise would be a full-year period unaffected by the bankruptcy filing, is divided into two "short" tax years of less than 12 months, with the first tax year ending on the day before the commencement of the bankruptcy case, and the second tax year beginning on the commencement date and ending at year end (Secs. 1398(d)(2)(A)(i)-(ii)). Depending on the individual debtor's particular facts and circumstances, this election can result in substantial federal income tax savings to the debtor. Conversely, making the election under the wrong facts and circumstances might be disadvantageous to the debtor.
To properly compute individual tax liability during the bankruptcy case and avoid exposure to accuracy-related IRS penalties and interest, the debtor must know the items that are properly included on the tax returns filed by the bankruptcy estate and the items that are properly included on the debtor's individual tax returns. In addition, the debtor must understand how the creation of a separately taxable bankruptcy estate affects tax attributes carried forward from prior periods, such as net operating loss (NOL) carryovers, credit carryovers, and charitable contribution carryovers.
Significantly, the debtor's tax attribute carryovers from tax years ending prior to the commencement of the bankruptcy case can be used only by the bankruptcy estate while the bankruptcy estate is in existence (Sec. 1398(i); Benton, 122 T.C. 353 (2004); Linsenmeyer, No. 03-1172 (6th Cir. 2003)). Thus, the debtor loses its tax attribute carryovers upon the filing of the bankruptcy petition. Depending on the debtor's individual tax situation and the nature and extent of the debtor's tax attribute carryovers, it might be appropriate to consider tax strategies to minimize the reduction or loss of tax attributes upon filing for bankruptcy.
An additional prefiling consideration for debtors relates to prior-year overpayments of tax carried forward from a prepetition tax year. Significantly, a federal or state tax overpayment carried forward from a prepetition tax year may become the property of the bankruptcy estate upon the filing of a petition for relief under Chapter 7 or Chapter 11 (Nichols v. Birdsell, 491 F.3d 987 (9th Cir. 2007)). This means that the prior-year overpayment of tax will become available for credit against the bankruptcy estate's tax liability (as opposed to available for credit against the debtor's individual tax liability). If a debtor previously has elected to carry forward a prior-year overpayment, it might affect the timing of the bankruptcy filing. Similarly, if an individual debtor is considering filing for bankruptcy, it might affect the decision to request a refund of overpaid taxes (as opposed to electing to apply the overpayment to a later tax year).
A somewhat related prefiling consideration for the debtor and his or her bankruptcy counsel relates to prepetition federal income tax refunds to which the debtor is entitled. As previously noted, an individual debtor's prepetition tax refunds are subject to turnover to the bankruptcy estate, which might affect the timing of the bankruptcy filing for debtors who are entitled to receive a refund of overpaid federal income taxes from the IRS. Similarly, the timing of the bankruptcy filing might also be affected if the debtor owes taxes from a prior period, because certain taxes are nondischargeable in bankruptcy. Nondischargeable taxes include income and gross receipts taxes that are assessed within 240 days of the filing of the bankruptcy petition or that are assessed after the bankruptcy petition is filed (11 U.S.C. §507(a)(8)). If a debtor owes income taxes from a prior tax period, it might be necessary to consider when the tax was assessed, as this might affect the timing of the bankruptcy filing in some cases. Significantly, the concept of assessment is a tax term of art. In addition, special rules might apply for counting the number of days that have elapsed since a prior assessment of tax (see In re Williams, 188 B.R. 331 (Bankr. E.D.N.Y. 1995); In re Blank, 137 B.R. 671 (Bankr. N.D. Ohio 1992); In re Frary, 117 B.R. 541 (Bankr. D. Alaska 1990)).
Tax Issues During the Bankruptcy Case
While a bankruptcy filing does not relieve the debtor of his or her usual duty to file income tax returns, it can markedly shift the nature, timing, and extent of the debtor's obligations to pay taxes. In addition, the actions and financial activities of the trustee or debtor in possession during the bankruptcy case can create unanticipated adverse tax consequences for both the debtor and the bankruptcy estate.
Common Tax Issues Encountered by the Chapter 11 Bankruptcy Estate
Post-petition income: Property acquired by the debtor after the bankruptcy petition date (after-acquired property) becomes the property of the bankruptcy estate (11 U.S.C. §1115; IRM §188.8.131.52(3)). Specifically, Section 1115 of the Bankruptcy Code defines property of the bankruptcy estate to include (1) the debtor's gross earnings from performance of services after the commencement of the bankruptcy case (post-petition services); and (2) the gross income from property acquired by the debtor after the commencement of the bankruptcy case (post-petition property). As a result, the bankruptcy estate, rather than the individual debtor, is required to include in its taxable income the debtor's gross earnings from post-petition services and gross income generated by the debtor's post-petition property.
This significantly affects how the individual debtor and the debtor's bankruptcy estate are taxed during the Chapter 11 bankruptcy case. In addition, this might potentially affect the debtor's employer and persons filing Forms W-2, 1099, and other information returns that report payments to the debtor. IRS Notice 2006-83 provides guidance for debtors in possession or trustees relative to the tax filing obligations and procedural requirements for ensuring proper reporting of the debtor's income from post-petition services and post-petition property during a Chapter 11 bankruptcy case.
Alternative minimum tax (AMT) considerations: As previously noted, tax attribute carryovers from tax years ending before the commencement of bankruptcy can be used only by the bankruptcy estate while it is in existence (Sec. 1398(g); Benton, 122 T.C. 353 (2004); Linsenmeyer, No. 03-1172 (6th Cir. 2003); Kahle, T.C. Memo. 1997-91 (1997)). Therefore, the debtor's tax attribute carryovers from prior tax periods become available to offset the federal income tax liability of the bankruptcy estate during the bankruptcy case. In considering asset transactions, bankruptcy professionals often assume that if there are enough NOLs or other tax attributes to offset taxable income generated by the bankruptcy estate, there will be no federal or state income tax liability for the estate.
However, under the alternative tax NOL rules (Sec. 56(d)(1)), the ability to use NOLs and other tax attributes to offset the estate's taxable income may be limited for AMT purposes. The amount of the NOLs available for AMT purposes (ATNOLs) may differ from the amount of the regular tax NOLs, and generally only 90% of a taxpayer's computed alternative minimum taxable income can be offset with ATNOLs. Thus, even though available regular tax NOLs might exceed the regular taxable income of the bankruptcy estate, the bankruptcy estate may not be able to fully use the estate's ATNOLs, resulting in an AMT liability.
If the bankruptcy estate incurs an AMT liability, the estate may be entitled to a minimum tax credit that it can carry forward to offset regular federal income tax liability in a subsequent tax year when AMT does not apply (Sec. 53(a)). Although the debtor's tax attributes become the property of the bankruptcy estate upon the filing of the petition, any unused tax attributes remaining when the case is closed by the Bankruptcy Court revert back to the debtor in that year (Sec. 1398(i)). Since the trustee is a fiduciary, it is important for him or her to properly track and carry forward any minimum tax credit generated by the bankruptcy estate to preserve those credits for use by the bankruptcy estate in subsequent tax years or by the debtor after the bankruptcy estate is closed.
Common Tax Issues Encountered by the Debtor
Cancellation of debt is perhaps one of the most common tax issues encountered by debtors during bankruptcy and relates to the cancellation or modification of indebtedness and the attendant tax consequences to the debtor. Generally, a debtor is required to recognize cancellation-of-debt (COD) income to the extent that a debt is discharged for less than the amount owed (e.g., Kirby Lumber Co.,284 U.S. 1 (1931); Sec. 61(a)(12)). While the concept may seem straightforward in theory, its application to a debtor's particular facts is rarely straightforward, especially in a bankruptcy. Another potentially complicating factor in considering COD income relates to situations where a debtor transfers collateralized property to a creditor in exchange for discharge of the debt that the property secures. In this situation, the transaction's tax consequences differ significantly depending on whether the underlying debt is recourse or nonrecourse.
In addition to the threshold challenges associated with identifying a debt discharge event and determining whether a debtor has realized COD income for federal income tax purposes, the general rule requiring recognition of COD income is subject to numerous exceptions, exclusions, and modifications that may provide some relief for the debtor. The most relevant of these are the exclusions of COD income for bankrupt (Sec. 108(a)(1)(A)) and insolvent (Sec. 108(a)(1)(B)) taxpayers.
Understanding and navigating the tax implications associated with common transactions and procedures that occur before and during a Chapter 7 or Chapter 11 bankruptcy case can be complex, requiring an intricate analysis and understanding of the particular facts and circumstances of the bankruptcy case. A failure of a debtor or trustee to fully understand the application of tax laws in the context of a Chapter 7 or Chapter 11 bankruptcy can result in unanticipated adverse tax consequences and potentially expose a fiduciary, such as a debtor's bankruptcy counsel or the trustee of the bankruptcy estate, to personal liability. The addition of a tax adviser who understands the tax consequences of a Chapter 7 or Chapter 11 bankruptcy to the team of advisers can add tremendous value for debtors, their bankruptcy counsel, and trustees.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.