Chapter 7 and chapter 11 bankruptcy: tax considerations.

• Author: DeSellier, Brianne N.

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Common tax issues are encountered in Chapter 7 and Chapter 11 bankruptcy cases. Failure to hilly understand the application of tax laws in the context of a Chapter 7 or Chapter 11 bankruptcy case can undermine the success of the bankruptcy proceedings, result in unanticipated adverse tax consequences, and even expose a party to personal liability'.

A Chapter 7 bankruptcy is a liquidation proceeding in which the debtors nonexempt assets, if any, are sold by the Chapter 7 trustee, and the proceeds are distributed to creditors according to the priorities established in the Bankruptcy Code. A Chapter 11 bankruptcy is a reorganization proceeding in which the debtor repays creditors through a court-approved plan of reorganization. Chapter 11 is ordinarily used by business debtors; however, individual consumers may be eligible to file for Chapter 11 bankruptcy under certain circumstances (see Toibb v. Radloff, 501 U.S. 157 (1991)). A Chapter 11 case is typically pursued by individuals who continue to have substantial personal earning power but whose debts exceed the Chapter 7 and Chapter 13 limits.

Role of Tax Considerations in Bankruptcy: In General

A fundamental goal of the federal bankruptcy laws is to give debtors a financial "fresh start" from burdensome debts (e.g., Local Loan Co. v. Hunt, 292 U.S. 234 (1934)). The U.S. Bankruptcy Code operates in conjunction with the Internal Revenue Code (IRC) and defers to the IRC for purposes of determining tax consequences of the bankruptcy process (11 U.S.C. [section]346(k)).

However, unlike the Bankruptcy Code, the IRC is not primarily concerned with fairness, equity, or a fresh start for the debtor (e.g., In re Olson, 121 B.R. 346 (Bankr. N.D. Iowa 1990); In re McGowen, 95 B.R. 104 (N.D. Iowa 1988); In re Nevin, 135 B.R. 652 (Bankr. D. Hawaii 1991)). In addition, Congress itself acknowledged this tension between the IRC and bankruptcy laws in connection with the enactment of the Bankruptcy Act of 1978 (see S. Rep't No. 95-989,95th Cong., 2d Sess., at 13-14 (1978): "A three-way tension thus exists among (1) general creditors, who should not have the funds available for payment of debts exhausted by an excessive accumulation of taxes for past years; (2) the debtor, whose 'fresh start' should likewise not be burdened with such an accumulation; and (3) the tax collector, who should not lose taxes which he has not had reasonable time to collect or which the law has restrained him from collecting").

As such, a debtor in Chapter 7 or Chapter 11 bankruptcy generally continues to be subject to applicable federal income tax laws despite the bankruptcy and must continue to timely file federal income tax returns and pay federal income tax due (see Secs. 6012 and 6151; 11 U.S.C. [section]346; 28 U.S.C. [section]960). (It should be noted that the IRC contains some statutory provisions that specifically address Chapter 7 and Chapter 11 bankruptcies; however, these provisions generally address specific, narrow tax issues in bankruptcy and are limited in scope (see, e.g., Secs. 108,368(a)(1)(G), 382(1), 1017,1398, and 6658).) In addition, the debtor generally continues to be subject to state and local tax laws (such as sales and use, property, and franchise taxes), as well as other federal tax laws (such as payroll and employment taxes) during the bankruptcy process (see, e.g., Holywell Corp. v. Smith, 503 U.S. 47 (1992); Raleigh v. Illinois Dept, of Revenue, 530 U.S. 15 (2000); California State Board of Equalization v. Sierra Summit, Inc., 490 U.S. 844 (1989)).

Following are highlights of some of the common tax issues encountered by individual debtors and bankruptcy trustees at each stage of the bankruptcy process.

Prepetition and Filing Tax Issues

The first set of tax issues arises in connection with the bankruptcy filing itself. Under bankruptcy law, when an...