Tax Land Mines That Await the Unwary Bankruptcy Practitioner
| Publication year | 1994 |
| Pages | 31 |
| Citation | Vol. 23 No. 1 Pg. 31 |
1994, January, Pg. 31. Tax Land Mines That Await the Unwary Bankruptcy Practitioner
Bankruptcy petitioners inevitably face a variety of tax issues, some of them uniquely affected by the insolvency or bankruptcy of a particular taxpayer. Tax issues also can dramatically affect the dynamics of Chapter 11 reorganizations. Nevertheless, many bankruptcy attorneys overlook tax issues, unaware of the tax planning opportunities and traps bankruptcy may create. Therefore, this article surveys the basic tax issues that arise in the context of bankruptcy or insolvency.
The Internal Revenue Code ("Code") treats the Chapter 7 or 11 bankruptcy estate of an individual debtor as a separate taxable entity for federal income tax purposes.(fn1) However, such an individual debtor may irrevocably elect to close his or her taxable year as of the day before the filing of a bankruptcy case. This election divides the debtor's taxable year into two short taxable years. The first short period ends on the day before the commencement date of the bankruptcy case, the second on the commencement date.(fn2) If the election is not made, the bankruptcy filing does not affect the taxable year of an individual debtor.(fn3)
Whether to make a short-year election should be carefully considered. The election effectively causes the debtor's federal income tax liability for the pre-petition period to become an allowable claim against the bankruptcy estate. This tax liability will be paid by the estate to the extent estate assets are available and remains a liability of the individual debtor only to the extent the tax claim is nondischargeable.(fn4) If the individual debtor does not make the election, no part of the debtor's tax liability for the year of the bankruptcy is collectible from the estate. Instead, it is collectible from the individual debtor. Importantly, if the debtor has no pre-petition tax liability, deciding not to make the election in order to offset expected post-petition income against pre-petition losses often makes the most sense.
Income tax attributes (including net operating loss carryovers) of an individual debtor are deemed transferred to the bankruptcy estate on the filing of the bankruptcy petition.(fn5) On termination of the case, these attributes are returned to the debtor to the extent they are not used by the bankruptcy estate.(fn6) Moreover, the individual debtor receives any income tax attributes created but not used by the estate.
For individual debtors, the disposition of estate property is recognized by the estate, not the individual debtor. Thus, sales and exchanges of estate property usually create taxable gain for the estate. Further, involuntary sales of estate property, such as foreclosures and deeds in lieu of foreclosure, are treated as deemed sales and may generate so-called "phantom gain," resulting in tax liability even though the estate receives no cash benefit from the disposition.(fn7) Given this tax result, and particularly where property is subject to debts in excess of its value, a bankruptcy trustee will likely abandon the property as burdensome to the estate.(fn8)
Abandonment by a trustee can be devastating to a debtor. Despite a debtor's expectation that bankruptcy operates to discharge all debt, once property has been abandoned, any tax liability associated with foreclosure shifts back to the debtor.(fn9) Thus, a taxpayer who declares bankruptcy in expectation of a foreclosure may be saddled with the resulting tax liability regardless of the bankruptcy and without cash to pay it. This result has spawned a great deal of controversy since it runs contrary to the bankruptcy policy of giving debtors a fresh start.(fn10) Nevertheless, bankruptcy practitioners must be wary of the potential tax consequences of abandonment and advise their clients accordingly.
Another confusing area in the world of bankruptcy taxation concerns cancellation-of-debt income ("COD income"). COD income is generated when debt is satisfied for less than its face amount.(fn11) It can arise in cash for debt, debt for debt, stock for debt or property for debt transactions. Each form of transaction is subject to special tax rules.(fn12) In general, because forgiveness of debt enriches the debtor, COD income is taxed just like any other form of income.
Consistent with the policies of bankruptcy law, however, debtors who are either insolvent or in bankruptcy are afforded special treatment. In particular, COD income may be excluded if the forgiveness of debt occurs pursuant to a discharge in a Title 11 case.(fn13) In addition, COD income may be excluded if the taxpayer is insolvent, even though not in bankruptcy, but this exclusion is limited to the amount by which the taxpayer is insolvent (that is, the amount by which liabilities exceed assets).(fn14)
The insolvency exception then, unlike the bankruptcy exception, is often only a partial exclusion. Further, calculating insolvency involves some...
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