Providing services to a partnership in bankruptcy.

• Author: Ellentuck, Albert B.

The Bankruptcy Code provides relief to, and governs the affairs of, debtors, which includes individuals, partnerships, and corporations. Therefore, a partnership can file for bankruptcy, despite the fact that, for federal income tax purposes, it is considered a nontaxpaying entity. (Even though a partnership is not liable for entity-level federal income taxes, it may be subject to a variety of employment, excise, and property taxes.) The bankruptcy estate of an individual is treated as a separate entity for federal income tax purposes if the individual's case is filed under Chapter 7 of the Bankruptcy Code (liquidation) or Chapter 11 of the Bankruptcy Code (reorganization) (Sec. 1398(a)). On the other hand, a partnership's bankruptcy filing does not create a separate taxable entity (Sec. 1399).

For purposes of the separate entity rules, a partnership is not treated as an individual, but the interest in a partnership of a bankrupt individual is taken into account in the same manner as any other interest (Sec. 1398(b)(2)). Thus, where an individual filed a Chapter 7 bankruptcy petition (which created a separate bankruptcy estate) and the partnership's tax year ended after the bankruptcy filing, partnership items for that tax year were treated as distributed on the last day of the partnership's tax year to the bankruptcy estate, and not to the individual (Gulley, T.C. Memo. 2000-190).

Planning tip: Partners who want to take advantage of their share of a partnership's losses should delay filing the bankruptcy petition until after the close of the partnership's loss year, or accelerate the closing of their partnership's tax year by selling the partnership interest.

Helping a troubled partnership make the decision to file

If the practitioner and management determine that an informal workout cannot succeed, they must decide whether to reorganize or liquidate the partnership in a bankruptcy proceeding.

Advantages of filing for bankruptcy

The major advantage of filing for bankruptcy is the automatic stay or halt against creditor action to foreclose or collect debts during the bankruptcy proceeding. This stay protects the debtor partnership against harassment by creditors and gives the partnership time to reorganize or liquidate the business and develop a plan of debt settlement that is fairest to all creditors. The automatic stay also protects creditors against other creditors' rush to collect debts first. However, this automatic stay does not necessarily protect the partners from legal action if, for example, they have guaranteed the partnership's debts.

Another important advantage of bankruptcy to the debtor partnership is the avoidance powers it gives. With...