Providing services to a partnership in bankruptcy

The Bankruptcy Code provides relief to, and governs the affairs of, debtors, which includes individuals, partnerships, and corporations. Therefore, a partnership can file for bankruptcy, despite the fact that, for federal income tax purposes, it is considered a nontaxpaying entity. (Even though a partnership is not liable for entity-level federal income taxes, it may be subject to a variety of employment, excise, and property taxes.) The bankruptcy estate of an individual is treated as a separate entity for federal income tax purposes if the individual’s case is filed under Chapter 7 of the Bankruptcy Code (liquidation) or Chapter 11 of the Bankruptcy Code (reorganization) (Sec. 1398(a)). On the other hand, a partnership’s bankruptcy filing does not create a separate taxable entity (Sec. 1399).

For purposes of the separate entity rules, a partnership is not treated as an individual, but the interest in a partnership of a bankrupt individual is taken into account in the same manner as any other interest (Sec. 1398(b)(2)). Thus, where an individual filed a Chapter 7 bankruptcy petition (which created a separate bankruptcy estate) and the partnership’s tax year ended after the bankruptcy filing, partnership items for that tax year were treated as distributed on the last day of the partnership’s tax year to the bankruptcy estate, and not to the individual (Gulley, T.C. Memo. 2000-190).

Planning tip: Partners who want to take advantage of their share of a partnership’s losses should delay filing the bankruptcy petition until after the close of the partnership’s loss year, or accelerate the closing of their partnership’s tax year by selling the partnership interest.

Helping a troubled partnership make the decision to file

If the practitioner and management determine that an informal workout cannot succeed, they must decide whether to reorganize or liquidate the partnership in a bankruptcy proceeding.

Advantages of filing for bankruptcy

The major advantage of filing for bankruptcy is the automatic stay or halt against creditor action to foreclose or collect debts during the bankruptcy proceeding. This stay protects the debtor partnership against harassment by creditors and gives the partnership time to reorganize or liquidate the business and develop a plan of debt settlement that is fairest to all creditors. The automatic stay also protects creditors against other creditors’ rush to collect debts first. However, this automatic stay does not necessarily protect the partners from legal action if, for example, they have guaranteed the partnership’s debts.

Another important advantage of bankruptcy to the debtor partnership is the avoidance powers it gives. With these powers, the partnership can reject unfavorable contracts and leases and overturn certain transactions deemed to have given an unfair preference to one creditor over other creditors. This maximizes the value of the debtor business to the creditors under the plan of reorganization or liquidation.

Disadvantages of filing for bankruptcy

The most serious disadvantage of a bankruptcy is a loss of control by management. In a Chapter 7 liquidation, management loses control to a trustee. Since the trustee’s purpose is to liquidate the partnership, this may not be a critical issue. In a Chapter 11 reorganization, even though the debtor partnership’s management typically remains in place as a debtor in possession, some operating control is lost. For instance, the court must approve administrative expenses and actions outside the normal course of business, such as asset sales. Another disadvantage of a bankruptcy proceeding is that reporting requirements are more burdensome.

Furthermore, a partnership in Chapter 11 is unlikely to react as quickly to the changing business environment due to the administrative requirements imposed by the bankruptcy and the general reluctance of most debtors in possession to take any risk. Other disadvantages include significantly higher legal and administrative costs, a loss of customers because of the stigma attached to filing bankruptcy, and the physical and psychological toll on the partners and management resulting from a legal proceeding.

Finally, and perhaps more importantly, it is common for one or more partners to personally guarantee the partnership’s debt. If the debt is not paid off or arrangements made to liquidate the debt in bankruptcy, the creditors will look to the partners’ personal assets to satisfy the obligation. The partners may be left with a larger personal liability than if they had negotiated with the creditors themselves in an informal workout, and one or more may be forced into personal bankruptcy. Since partners often have no idea whether they have guaranteed one or more debts, it is worthwhile reviewing credit card, line of credit, and other loan applications to determine whether any such guarantees exist.

Common bankruptcy misconceptions

Partners may not realize that prebankruptcy transactions can be affected by the bankruptcy filing. A major concern of creditors is that a business facing bankruptcy will repay favored creditors, leaving fewer assets to be distributed to the remaining creditors. Under the Bankruptcy Code, payments made 90 days prior to filing the bankruptcy petition may be preferential transfers that must be repaid to the bankruptcy estate by the creditor. Not all payments made during the 90-day period are preferential transfers, however. Routine transfers may be permitted if the debt was incurred in the ordinary course of business and the payment was made in accordance with ordinary business terms.

Another misconception is that bankruptcy wipes out all of the partnership’s debts. While the Bankruptcy Court can enter an order discharging the debtor from liability for debts, including taxes, some debts are not dischargeable. The scope of the bankruptcy discharge depends on the chapter under which the case is filed and the nature of the debt. Even if a tax is discharged, it is still collectible from the debtor’s prebankruptcy property if the IRS filed a Notice of Federal Tax Lien before the bankruptcy petition was filed. Perfected liens generally pass through bankruptcy proceedings unaffected, even if the debtor’s personal liability for the debt is discharged.

A final misconception is that bankruptcy will equally affect all partners, or will affect them to the extent of their pro rata ownership interest in the entity. When partnership debt is canceled, the amount and timing of the income realized by the partnership is determined at the partnership level. However, the tax consequences of the partnership’s income realization are determined at the partner level. For example, to the extent a partner is insolvent after a discharge of indebtedness, the discharge is a tax-free event. Insolvent partners (who remain insolvent after the partnership debt discharge) can exclude their share of the partnership’s cancellation-of-debt income, while other partners will have to recognize their share of such income to the extent they are solvent or made solvent by the partnership’s debt discharge.

Prebankruptcy planning

Prebankruptcy planning should begin with a realistic assessment of why the partnership is not doing well. This is arguably the most important service the practitioner can provide. To the extent the problems stem from bad contracts, temporary cash flow problems, or other nonsystemic problems, a reorganization gives the partnership time to get its affairs back in order. Furthermore, the automatic stay prevents creditors from suing the partnership or enforcing a judgment, which would further compound the partnership’s financial problems.

If reorganizing and not liquidating, the partnership should try to accumulate as much prebankruptcy cash as possible. Once the bankruptcy petition is filed, creditors are often reluctant to extend credit, which can make it difficult to continue operations. If the partnership has cash in banks to which money is owed, the bank will freeze the funds once the bankruptcy petition is filed, then offset the cash against amounts due to the bank. The partnership should consider moving the cash to one or more banks that are not creditors.

Another important prebankruptcy planning step is to create a schedule of all debts owed, all third parties affected (i.e., cosigners, guarantors, etc.), and the secured or unsecured nature of the debt. This illustrates which debts should be paid and which can be ignored. Generally speaking, the partnership should consider paying secured debt for property that will be kept since repossession can occur for even one delinquent payment. When third parties have cosigned for or guaranteed partnership debt, failing to make payment can cause the creditor to look to them for payment.

The partnership should consider stopping payments on debts that will be discharged. A reorganization will require some sort of payment, but the specifics can be negotiated once the bankruptcy petition is filed. Whether to continue paying debts may depend on other factors, such as whether the partners or others have guaranteed the debts or whether the creditor is a key supplier whose assistance will be needed during the bankruptcy.

A final step is to prepare or obtain a detailed schedule of all assets and liabilities. It is important to go beyond a listing of the assets and liabilities and actually obtain the underlying legal documents to verify title, what liens, if any, exist, and whether any guarantors or others will be affected. Reviewing the documents supporting all debts is equally important for the same reasons. In many cases, these reviews uncover guarantors, collateral agreements, and other transactions that have been forgotten.

Services provided by a practitioner in a bankruptcy proceeding

Prefiling bankruptcy services can include (1) preparation of delinquent tax returns; (2) analysis of which type of bankruptcy would best suit the business’s needs; (3) analysis of taxes due to determine priority and whether any personal liability may exist (e.g., the trust fund recovery penalty); (4) asset analysis to determine whether assets are exempt or should be abandoned; and (5) preparation of the bankruptcy schedules and required financial statements.

During bankruptcy, the practitioner can (1) help formulate the plan of reorganization; (2) provide tax advice; (3) prepare court reports (the operating statements of the debtor); (4) prepare the tax returns due; and (5) review creditor claims for accuracy. In a Chapter 7 liquidation, there is less need for services other than accounting and tax compliance since the partnership will go out of business.

To assist creditors, the practitioner can (1) review the debtor’s schedules to be sure all assets and liabilities have been included; (2) monitor the debtor’s financial activity during the bankruptcy; (3) evaluate the debtor’s proposed reorganization; (4) provide an alternative reorganization plan when appropriate; (5) conduct special investigations for the creditors; (6) provide tax advice on proposed transactions; and (7) prepare or review various valuations.

Administering the engagement

A practitioner who wishes to provide services to a bankrupt partnership must obtain court approval to be retained by the debtor. Detailed affidavits and applications for retention must be filed with the court, stating the practitioner’s experience, relationship to the debtor, and services to be provided. In approving retention, the court considers whether the practitioner has experience in bankruptcy matters and is a disinterested party. To have fees approved by the court for payment, detailed time and expense records must be maintained, which can delay the payment of the fees in bankruptcy cases.

Frequently, creditors object to the amount of accounting or other professional fees charged to a bankrupt entity. In such cases, the court conducts a hearing to determine the reasonableness of the charges, which usually delays payment of the disputed fees. Many bankruptcy courts are also reluctant to allow a professional to charge a standard hourly rate, insisting on a lower rate for bankruptcy work.

This case study has been adapted from PPC’s Tax Planning Guide — Partnerships, 31st Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, Twila A. Bollinger, and Larry N. Bland Jr., published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).