Deductibility of bankruptcy costs and the origin of the claim.

• Author: Sanders, Debra

EXECUTIVE SUMMARY

* Costs incurred in a bankruptcy-filing can be categorized as either personal or business related. A taxpayer cannot deduct those categorized as personal expenses but can deduct those categorized as business expenses.

* Whether bankruptcy costs are treated as personal expenses or business expenses is determined under the origin-of-the-claim doctrine. This doctrine states that a taxpayer may deduct a legal expense if it arises out of a claim that is directly connected with or proximately caused by the taxpayer's profit-seeking activities. In bankruptcy cases, this generally means that an expense will be treated as a deductible business expense if it is related to a taxpayer's failed business.

* Bankruptcy expenses related to a failed business may be considered deductible business expenses even when the business failed in a year prior to the bankruptcy filing.

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Between 1995 and 2005, the number of personal bankruptcies filed annually in the United States grew from approximately 900,000 to over 2 million. (1) In 2005, in an effort to stem abuses of personal bankruptcy laws, the Bankruptcy Abuse Prevention and Consumer Protection Act (2) (BAPCPA) was enacted, which increased bankruptcy filing costs and made debt discharge, including income taxes owed, more difficult. Therefore, maximizing bankruptcy filers' tax deductions has become more important in facilitating the fresh start filers seek.

One category of income tax deductions that practitioners and taxpayers may overlook is the costs of the actual bankruptcy filing. Normally, costs of personal bankruptcy are not deductible on an individual's tax return. (3) However, in circumstances where the proximate cause of the personal bankruptcy is a prior business failure, the origin-of-the-claim doctrine supports the deduction of the portion of personal bankruptcy costs that relate to the business failure. (4)

A factor complicating the application of the origin-of-the-claim doctrine is that the relationship between business failure and personal bankruptcy may not be immediately apparent, especially in cases where the business failure occurred in a year prior to that of the bankruptcy filing. The taxpayer's employment status (e.g., the taxpayer is employed by others at the time of filing) may also mask the underlying business cause of the bankruptcy. In addition, many small business owners use personal credit as a means of obtaining business funds, frequently commingling personal and business debts, which may also obscure the business origins of personal debts.

Overall, it is critical that a tax practitioner ascertain the origin of a personal bankruptcy flier's debts in order to provide appropriate tax advice and maximize allowable deductions, particularly in light of the current economic turbulence.

BAPCPA and Bankruptcy Costs

Under BAPCPA, the costs of filing for bankruptcy have increased and the flier's ability to discharge debts has decreased. The increased costs are due in part to the relatively higher percentage of individuals expected to file bankruptcy under chapter 13 rather than chapter 7. BAPCPA no longer allows individuals to select the chapter under which they file, but instead imposes a means test to determine whether a taxpayer may use the more favorable chapter 7. In addition, BAPCPA's complexity is expected to increase the legal costs of bankruptcy filing. Other out-of-pocket costs for fliers have also increased under BAPCPA, due to mandates that filers take financial management and credit counseling courses before their debts can be discharged. Finally, BAPCPA has reduced the ability of chapter 13 fliers to receive a discharge of taxes assessed under an IRS substitute for return. (5)

Business versus Personal Expenses

Congress regards individuals as having two personas: One is personal while the other seeks profit through carrying on a business or the production of income. The ordinary and necessary expenses associated with seeking profits through a trade or business and/or investments are deductible under Sec. 162(a) and Sees. 212(1) and (2). Conversely, Sec. 262(a) disallows expenses for satisfying personal, living, or family needs.

The business versus personal distinction includes legal expenses and other costs related to bankruptcy. These costs are clearly tax deductible when they arise from business or investment transactions (6) in which no restructuring or reorganization occurs, (7) whereas costs related to personal bankruptcy are not deductible. (8)

While this dichotomy appears straightforward, the distinction between personal and business expenditures can be difficult to apply to bankruptcy fees. Specifically, it is not uncommon for individual entrepreneurs and small business owners to commingle their personal and business debts. Thus, the question becomes, what is the proper treatment of bankruptcy legal and other fees when an individual filing for personal bankruptcy has debts related to a failed business? To determine the deductibility of bankruptcy legal fees, case law relies on the origin-of-the-claim doctrine.

Origin-of-the-Claim Doctrine

The Supreme Court first addressed the treatment of an individual's legal costs as business deductions in Kornhauser. (9) In this case, the taxpayer incurred litigation costs to defend...