Tax issues for bankruptcy trustees.

• Author: Morrison, Donald G.

A joint petition filed with the U.S. Bankruptcy Court by a husband and wife does not result in a single taxable estate for income tax purposes, according to Knobel, 167 B.R. 436 (1994). This case, decided by the U.S. Bankruptcy Court for Texas, was a case of first impression.

James and Leigh Knobel filed a joint petition under Chapter 7 of the U.S. Bankruptcy Code on Sept. 19, 1991. In so filing, they paid one filing fee, their case was assigned a single case number, one trustee was appointed, and the Service issued only one employer identification number. When it came time for filing the income tax returns, the trustee computed the tax liability using a standard deduction and one personal exemption for the bankruptcy estate of James Knobel and also a standard deduction and one personal exemption for the bankruptcy estate of Leigh Knobel. The trustee filed one Form 1041, U.S. Fiduciary Income Tax Return, and two Form 1040s to report the income of the estates and compute their tax liabilities. On examination, the IRS disallowed one of the exemptions and one of the standard deductions taken on the original returns filed. The Service's position was that there was only one taxable estate; therefore, only one standard deduction and one exemption were allowable. The IRS contended that, because a joint petition was filed with the Bankruptcy Court and one trustee was appointed to administer the case, the case was in substance handled as one estate (although an order to consolidate the estates was never entered by the court).

The trustee asserted that although the estates were jointly administered and a joint petition was filed with the court, Section 302 of the Bankruptcy Code indicates that a joint filing creates two estates that remain separate and distinct (taxable) entities until the estates are consolidated pursuant to court order.

The court agreed with the trustee, and allowed an exemption and standard deduction for each estate. It refuted the Service's argument that Bankruptcy Code Section 541(a)(2) and Sec. 1398 indicated that only one estate and one taxable entity are created on the filing of a joint petition to the bankruptcy court. The court also disagreed with the IRS's argument of substance over form; even though the estates were substantively handled as one, that did not override Bankruptcy Code Section 302.

This decision by the Bankruptcy Court could provide tax savings opportunities to some trustees. However, many bankrupt estates...