Chapter XI Bankruptcy Taxation

• Jurisdiction: United States

XI. Bankruptcy Taxation

A. Introduction

Bankruptcy and tax law have a lot of overlap. The government appears as tax collector (where it may get favorable treatment via bankruptcy priority or statutory lien rights). The debtor may get to discharge some tax debt (not much) or string out the payments. He may be able to manage tax-loss deductions, or he may find himself faced with liability for "gains" via debt relief. The fields of tax and bankruptcy have substantial interaction and, as a result, substantial potential for conflict. Both individual and corporate debtors must be concerned about the treatment of pre-petition tax liabilities.

B. Entities in Bankruptcy

Bankruptcy taxation rules differ markedly depending on the nature of the party filing for bankruptcy: individual, corporation or partnership.

When an individual files for bankruptcy, a separate entity, the bankruptcy estate, is created as of the date of filing. When an individual debtor files for relief under chapter 7 or 11 of the Bankruptcy Code (BC), the bankruptcy estate is treated as a separate taxable entity [IRC § 1398(a)].⁵⁴ This furthers the "fresh start" policy of the BC by shifting tax liability from the individual debtor to the bankruptcy estate. The transfer of property from the debtor to the estate is not deemed to be a taxable event.

A separate taxable entity is not created in chapters 12 or 13 or in any case where the debtor is not an individual [IRC § 1399]. If a case is converted from chapter 12 or 13 to chapter 7 or 11, then the separate-entity rules are applied on the date of the conversion. Conversion of a case from chapter 11 to chapter 7 or vice versa has no tax significance. If the case is dismissed, then the bankruptcy estate ceases to exist and is treated as if it never had existed [§ 1398(b)(1)]. If a chapter 7 or 11 case is subsequently converted to chapter 12 or 13, then the separate taxable-entity rules no longer apply and the entity ceases to exist.⁵⁵

As with all "new" entities, a tax identification number must be obtained and the tax year selected. Generally, all of the debtor's pre-petition property becomes a part of the estate, subject to the exemption of specific property granted under federal or state law. Exempt property transferred back to the debtor, other than by sale or exchange, is not treated as a taxable disposition. The estate succeeds to the debtor's tax attributes: capital loss carryovers, tax basis, holding periods, character of assets, method of accounting, etc., on the first day of the taxable year in which the bankruptcy case commences [IRC § 1398(g)].

The bankruptcy trustee must file the estate's income tax return when the bankruptcy estate's gross income equals or exceeds the amount of the debtor's exemption plus the standard deduction [IRC § 6012(a)(9)]. Post-petition administrative expenses allowed by the bankruptcy court are allowable as tax deductions, usually as ordinary and necessary business expenses, to the extent they are not disallowed [IRC § 1398(h)(1)]. In other words, administrative expenses of the taxable estate are not subject to capitalization under the IRC. These deductions are allowed only to the estate and may be carried backward or forward only to the taxable years of the estate [IRC § 1398(h)]. On the termination of the estate, the debtor succeeds to the estate's remaining tax attributes [IRC § 1398(i)].

An individual debtor's tax year may be divided in two through an irrevocable "short-year election" [IRC § 1398(d)(2)]. When the election is made, the debtor's first short year terminates as of the day before the commencement of the bankruptcy case. The second short year covers the balance of the debtor's taxable year. The significance of the election is that tax liabilities for the first short year become pre-petition priority claims that will be paid out of assets otherwise available for unsecured creditors. In effect, this forces the unsecured creditors to pay all or a portion of the first short-year priority claim. A debtor or nondebtor spouse may choose to join in the election [IRC § 1398(d)(2)(B)]. Absent the short-year election, the individual debtor has an unbroken taxable year in the year in which the bankruptcy occurs.

When a corporation files for bankruptcy, a bankruptcy estate is also created. However, this separate estate has no significance for tax purposes. No new or separate taxable entity is created; the debtor corporation continues unchanged as the taxable entity. Corporations operating as DIPs continue to have a duty to file tax returns using the same identification number, reflecting both pre- and post-petition income and deductions. If a trustee is appointed, the burden to file tax returns shifts to the trustee.

The corporation's tax year does not change. Pre-petition tax attributes, such as net operating losses, tax credit carryovers, and the character and carrying value of assets, remain unchanged. Most post-petition costs allowed by the court, or otherwise associated with the bankruptcy, are deductible as ordinary and necessary business expenses, subject to the capitalization requirements found in the IRC and the Treasury Regulations.⁵⁶

Subchapter "S" corporations also continue to file their returns as they did before bankruptcy. The amount and nature of income continues to "pass through" to the stockholders and is taxed individually rather than at the corporate level. Status as a subchapter "S" corporation can be terminated if the requirements for that status do not continue to be met post-petition. For instance, if a plan calls for stock to be issued to creditors, thereby creating more than 100 shareholders, the "S" corporation would terminate at the date of confirmation.

A separate taxable estate is not established for tax purposes when a partnership...