Chapter 13 Bankruptcy Taxation Fundamentals

• Jurisdiction: United States

13. Bankruptcy Taxation Fundamentals

Written by:

Thomas M. Horan

Womble Carlyle Sandridge & Rice LLP

Wilmington, Del.

Georgiana I. Nertea

EisnerAmper LLP; New York

Ira Spiegel

EisnerAmper LLP; New York

Taxes are always in the headlines, a political hot potato, and an issue that we deal with daily in our personal and business lives. There are significant issues in bankruptcy taxation that are necessary to a basic understanding of the issues found at the intersection of bankruptcy and tax law. These issues include the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005's (BAPCPA) elimination of § 728 of the Bankruptcy Code and its implementation of the "prompt determination" request under § 505 of the Code, along with a discussion of certain critical foundational tax issues in bankruptcy cases.

A. The End of § 728

BAPCPA affected the work required in many areas of our professions. Specifically, it eliminated § 728's "special tax provisions" and rewrote § 346 of the Code, which, in certain sections, had previously deferred to § 728. This changed the requirements regarding the filing of tax returns and, by implication, the paying of the related taxes. It also impacted cases filed under or converted to chapter 7 and the accountants retained by the chapter 7 trustees.

Until BAPCPA became effective on Oct. 17, 2005, § 728 allowed a trustee to forego the annual filing of state and local tax returns as measured by income for the entire period during which the trustee's case was pending, subject to a final determination as to whether there was net taxable income for the estate for the case beginning with the order for relief through to the pending closure of the case. If it was determined that the estate resulted in net taxable income, state and local returns would be required to be filed.

The elimination of § 728 equalized the treatment regarding the annual filing of state and local tax returns for cases under chapter 11 and 7. Therefore, under the BAPCPA revisions to the Bankruptcy Code, all business and individual debtor tax returns measured by income (federal, state and local) must be timely filed. Please note that cases under chapter 11 were and still are required to timely file all income/franchise tax returns, but also such returns as, but not limited to, sales tax and payroll tax.

As many states' annual business tax returns are identified as "franchise" tax returns in lieu of income tax returns, they require an annual franchise tax and/or minimum income tax payment even in the absence of net taxable income. The same can be said for states identifying their returns as income tax returns. Prior to BAPCPA, in estates with no net taxable income, chapter 7 trustees usually filed only a final federal tax return to demonstrate no outstanding tax issues. Under BAPCPA, state and local returns are filed and accompanied by the required franchise tax and/or minimum income tax payment annually. While these minimum payments may not adversely affect individual estates, the accumulated impact for an individual state may have sparked the end of § 728.

Additionally, as each year of an individual's or business' estate must now stand alone, taxes may have to be remitted one year and then require an amended return in a future year resulting from a loss that can be carried back to recover the earlier income tax payment. The end result, possibly already felt by trustees, is that professional fees increase, tax payments increase, and distributions to creditors decrease.

B. Prompt Determination under § 505(b)(2)

A key tool for all trustees—but primarily chapter 7 trustees—as they seek to file their closing reports with a final tax statement is provided by § 505(b)(2) of the Code. As revised by BAPCPA,¹ § 505(b)(2) permits a trustee to request a prompt determination by mailing a request to proper taxing authorities at a special address designated for service of requests under § 505(b)(2), or, if the taxing authorities do not designate such an address, to their regular address for filing of a tax return.²

The Internal Revenue Service (IRS) requests that each return requesting § 505(b)(2) status be...