Individual bankruptcy - state and local income tax treatment can greatly differ from federal.

• Author: Scott, Don E.

The Internal Revenue Code (Code) and the Bankruptcy Code (BC) govern the income tax treatment of bankrupt debtors. To the extent the Code and BC do not provide parallel treatment, the Code takes precedence. However, for determining the state and local tax treatment of bankrupt debtors, the BC takes precedence. Therefore, the state/local tax treatment of a bankrupt debtor can vary significantly from the Federal income tax treatment.

The Bankruptcy Reform Act of 1978 made substantial changes to the BC. As originally drafted, it contained many tax provisions relating to the treatment of can-cellation-of-debt (COD) income, tax-attribute carryovers, the commencement and termination of bankruptcy estates and the responsibility for filing income tax returns. However, during the legislative process, language was inserted to give the Code precedence over the BC with respect to Federal income taxes. Hence, bankrupt taxpayers find themselves with one set of rules for Federal tax purposes (contained in the Code) and another set of rules for state/local tax purposes (contained in the BC).

Several of the most important differences between the Code and BC for individual bankruptcy are summarized in the comparison chart on pages 680-682. It should not be used, however, as a substitute for a thorough reading of the Code, BC and applicable state/local tax laws.

Comparison of Federal With State/Local Individual Bankruptcy Tax Rules

Item

Reduction of tax attributes

Code/Federal

To the extent COD income is excluded under Sec. 108(a)(1)(A), (B) or (C) in a tax year beginning before Jan. 1, 1994, five tax attributes are reduced in the following order:

* Net operating losses (NOLs) (including any NOL for the year of discharge and any NOL carryover to such year).

* General business credits.

* Capital loss carryovers.

* Basis.

* Foreign tax credit carryovers.

For tax years beginning after Dec. 31, 1993, the Revenue Reconciliation Act of 1993 added minimum tax credit carryovers and passive activity loss and credit carryovers to the attributes subject to reduction. Attribute reduction takes place after computing tax for the year of discharge (i.e., on the first day following the end of the year that includes the date of discharge). If basis is reduced, the regulations under Sec. 1017 indicate the order in which the reduction is applied against 'different types of assets. Debtors may elect to reduce basis in depreciable property before reducing the other attributes...