Vol. 4, No. 1, Pg. 32. Look Before You Leap: Bankruptcy Tax Planning.

• Author: By George W. DuRant and Robert F. Anderson

South Carolina Lawyer

1992.

Vol. 4, No. 1, Pg. 32.

Look Before You Leap: Bankruptcy Tax Planning

32Look Before You Leap: Bankruptcy Tax PlanningBy George W. DuRant and Robert F. AndersonAll professionals are at least familiar with the needs of estate planning to provide for distribution of the estates of their more substantial clients. Equally as critical, however, is the tax planning that should go on when those same clients face the prospects of bankruptcy.

Income tax planning for a debtor's transactions immediately before and during the pendency of a bankruptcy proceeding can play a crucial role in assuring that the debtor meet the financial objective of obtaining a fresh start. The filing of a petition for relief under one of the chapters of the Bankruptcy Code triggers application of several key sections of the Internal Revenue Code (IRC) that can substantially impede a debtor's ability to obtain a fresh start.

This article explores the election by an individual contemplating a Chapter 7 or Chapter 11 proceeding under the Bankruptcy Code (11 U.S.C. § 101 et seq.) to file a short period income tax return for the period before the bankruptcy as allowed under IRC § 1398(d). In the authors' opinion, this election should routinely be considered by bankruptcy counsel.

33 IRC Section 1398(d)

When an individual files a the bankruptcy petition under Chapter 7 or Chapter 11, two significant events occur:

1. An estate is created under 11 U.S.C. § 541 which is taxable separate and distinct from the individual debtor; and

2. All non-exempt assets formerly owned by the debtor, wherever located, are transferred tax-free to the estate. In addition to the assets, the estate succeeds to all of the debtor's tax attributes existing "as of the first day of the debtor's taxable year in which the case commences." 26 U.S.C. § 1398(g).

Tax attributes to which the estate succeeds include net operating loss carryforwards, charitable contribution carryforwards, tax credit carryovers, capital loss carryovers, suspended passive activity losses and the taxable basis in any assets "inherited" by the bankruptcy estate.

As a separate taxable entity, the Chapter 7 or 11 individual bankruptcy estate reports its income on a fiduciary income tax return. For example, if a trustee in bankruptcy, or a debtor in possession, sells an estate asset, any taxable gain...