Tax Aspects of Bankruptcy
| Publication year | 1988 |
| Pages | 619 |
| Citation | Vol. 17 No. 4 Pg. 619 |
1988, April, Pg. 619. Tax Aspects of Bankruptcy
It is critical to approach the woes of a financially troubled client with a comprehensive bankruptcy/tax strategy. Otherwise, while avoiding known creditors, a client may unknowingly incur devastating tax liabilities. This article reviews tax issues and strategies to avoid adverse tax consequences in bankruptcy cases.
When a client walks into the office, he or she may already have structured a workout plan. It is vitally important that the practitioner immediately determine the tax consequences of the workout and inform the client prior to creating a taxable event.
Should the client sell assets to pay debts, any gain from the sale of property (the amount realized over the adjusted basis) constitutes taxable income.(fn1) If the purchaser assumes any liabilities, they are also included in the amount realized.
In the event of foreclosure, gain or loss is determined in the same manner as an ordinary sale of the property. Any deficiency resulting from the difference between the amount of the debt and the bid amount remains a liability of the debtor.
If a client is able to negotiate a deed in lieu of foreclosure, remember that the surrender of property is also a taxable event. Capital gain or loss will be recognized as the difference between the adjusted basis and the amount realized upon surrender. The amount realized will be the fair market value of the property, plus any obligations assumed by the mortgagee.
A sale taking place outside of bankruptcy may create capital gain tax liability which will not be dischargeable upon filing. If this tax exposure is significant, consideration must be given to holding the assets, filing bankruptcy and letting the bankruptcy estate create the taxable event.
In addition to capital gain, an important consideration outside of bankruptcy is discharge of indebtedness income. Gross income includes income realized from the debt forgiveness.(fn2) The measure of income realized is the amount of debt discharged, but no income is realized to the extent that payment of the liability would have given rise to a deduction.(fn3) Thus, if a client owes a party $100,000 plus accrued interest of $15,000, and deeds back a property worth $80,000, the client will have discharge of indebtedness income of $20,000.
An exception to the discharge of indebtedness rule excludes from income of an insolvent taxpayer the amount of debt relief to the extent of the debtor's insolvency.(fn4) The amount excluded from income is applied to reduce tax attributes unless an IRC § 108(b)(5) election is first made to apply the reduction to depreciable property. An additional exception is IRC § 108(g), which treats the discharge of certain "qualified farm indebtedness" by solvent farmers as though the discharge occurred while the farmer was insolvent.
Although the Tax Reform Act of 1986(fn5) made the characterization of capital gain income versus discharge of indebtedness income less dramatic, this distinction may still be important economically and with respect to offsetting capital losses. The characterization may further be affected by whether the "one step" or "two step" approach is used, or whether the debt discharged is recourse or nonrecourse.(fn6)
Finally, even though a client may have sufficient tax attributes such as net operating loss ("NOL") or investment tax credit ("ITC") to offset the recognition of income, potential applicability of the alternative minimum tax must be computed. A transfer may also trigger recapture of investment credit.(fn7)
The tax exposure resulting from the above taxable events will be nondis-chargeable in bankruptcy. If possible, the tax burden should be shifted to the bankruptcy estate. A calculation of estimated tax liabilities is required before taking any action. Assets may need to be appraised, depreciation schedules updated and past returns analyzed for tax attribute status. The hazards presented by capital gain income, discharge of indebtedness income, and the alternative minimum tax calculation may combine to make a workout situation much less desirable than a bankruptcy proceeding. If so, the next task is to determine a bankruptcy strategy.
Pursuant to IRC § 1398(a), an individual filing for either Chapter 7 or Chapter 11 bankruptcy creates a separate taxable entity. No separate taxable entity will be created as a result of a Chapter 13 proceeding (adjustment of debts of an individual with regular income) or a Chapter 12 (family farmer) proceeding for federal income tax purposes.(fn8) The effect of a separate entity is to shift the tax liability to the estate for transactions occurring post-petition.
1. Dischargeability. Section 523(a)(1)(A) of the Bankruptcy Reform Act of 1978 ("Bankruptcy Code")(fn9) provides for non-dischargeability of liability for prepeti-tion taxes specified in the priority provisions of Bankruptcy Code § 507(a)(7). Simplified, this section establishes a seventh priority for:
A. Taxes measured by income or gross receipts:
1) for which a return was due within...
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