James R. Balmforth: Tax Aspects Of Bankruptcy

It’s a common misconception that you can’t discharge tax debts in bankruptcy. It’s possible, but discharge is subject to a good many rules. Income tax debts might be eligible for discharge under Chapter 7 or Chapter 13 of the Bankruptcy Code, depending on how old they are and some other criteria.

Chapter 7 versus Chapter 13

Chapter 7 is sometimes called a “straight” bankruptcy because it provides for the full discharge of allowable debts. The bankruptcy court effectively takes control of your assets and liquidates them as necessary to pay off as much of your debt as possible. If you don’t have sufficient assets to cover all your debts, you’re no longer responsible for those unpaid balances after your bankruptcy is discharged.

Chapter 13 involves a multiyear, court-approved payment plan to repay your debts to the extent possible. The goal is to pay them off in full, but some unpaid balances can be discharged.

Tax debts are typically considered “priority” debts in both Chapter 7 and Chapter 13 bankruptcies. This means that they’re addressed and paid first when assets are liquidated in Chapter 7, and they must be included and paid in full in a Chapter 13 payment plan. Priority tax debts are not dischargeable in Chapter 13.

Rules to Discharge Tax Debts

Tax debts are associated with a particular tax return and tax year. The bankruptcy law lays out specific criteria for how old a tax debt must be before it can be discharged, as well as a couple of additional rules. If the income tax debt meets all five of these rules, the tax debt is dischargeable in Chapter 7 bankruptcies:

• The due date for filing the tax return in question was at least three years ago.

• The tax return was filed at least two years ago.

• The tax assessment is at least 240 days old.

• The tax return was not fraudulent.

• The taxpayer is not guilty of tax evasion.

Apply these criteria to each year’s tax debt to determine if that year’s unpaid balance is dischargeable through bankruptcy. Some of your debts might be while others might not. Tax debts that arise from unfiled tax returns are not dischargeable. This is an important distinction because the IRS routinely assesses tax on unfiled returns. These tax liabilities cannot be discharged unless and until the taxpayer files a tax return for the year in question. Again, this often covers the same ground as the first two rules. The IRS must assess the tax at least 240 days before the taxpayer files for bankruptcy. The IRS assessment can arise from a self-reported balance due such as your filed tax return, an IRS final determination in an audit or an IRS proposed assessment that has become final. The tax return cannot be fraudulent or frivolous. In other words, you can’t try to claim your dog as a dependent and then file for bankruptcy when the IRS calls you on it.

You cannot be guilty of any intentional act of evading the tax laws. The bankruptcy petitioner is required to prove that the previous four years’ tax returns have been filed with the IRS before a bankruptcy can be granted. These four previous tax returns must be filed no later than the date of the first creditors’ meeting in a bankruptcy case. Additionally, bankruptcy petitioners are required to provide a copy of their most recent tax return to the bankruptcy court. Creditors can also request a copy of the tax return, and petitioners must provide a copy to them if asked. Common tax issues are encountered in Chapter 7 and Chapter 11 bankruptcy cases. Failure to fully understand the application of tax laws in the context of a Chapter 7 or Chapter 11 bankruptcy case can undermine the success of the bankruptcy proceedings, result in unanticipated adverse tax consequences, and even expose a party to personal liability.

A Chapter 7 bankruptcy is a liquidation proceeding in which the debtor’s nonexempt assets, if any, are sold by the Chapter 7 trustee, and the proceeds are distributed to creditors according to the priorities established in the Bankruptcy Code. A Chapter 11 bankruptcy is a reorganization proceeding in which the debtor repays creditors through a court-approved plan of reorganization. Chapter 11 is ordinarily used by business debtors; however, individual consumers may be eligible to file for Chapter 11 bankruptcy under certain circumstances. A Chapter 11 case is typically pursued by individuals who continue to have substantial personal earning power but whose debts exceed the Chapter 7 and Chapter 13 limits.
A fundamental goal of the federal bankruptcy laws is to give debtors a financial “fresh start” from burdensome.

The U.S. Bankruptcy Code operates in conjunction with the Internal Revenue Code (IRC) and defers to the IRC for purposes of determining tax consequences of the bankruptcy process. However, unlike the Bankruptcy Code, the IRC is not primarily concerned with fairness, equity, or a fresh start for the). In addition, Congress itself acknowledged this tension between the IRC and bankruptcy laws in connection with the enactment of the Bankruptcy Act of 1978. “A three-way tension thus exists among general creditors, who should not have the funds available for payment of debts exhausted by an excessive accumulation of taxes for past years; the debtor, whose ‘fresh start’ should likewise not be burdened with such an accumulation; and the tax collector, who should not lose taxes which he has not had reasonable time to collect or which the law has restrained him from collecting”.

As such, a debtor in Chapter 7 or Chapter 11 bankruptcy generally continues to be subject to applicable federal income tax laws despite the bankruptcy and must continue to timely file federal income tax returns and pay federal income tax due. (It should be noted that the IRC contains some statutory provisions that specifically address Chapter 7 and Chapter 11 bankruptcies; however, these provisions generally address specific, narrow tax issues in bankruptcy and are limited in scope. In addition, the debtor generally continues to be subject to state and local tax laws (such as sales and use, property, and franchise taxes), as well as other federal tax laws (such as payroll and employment taxes) during the bankruptcy process

Prepetition and Filing Tax Issues

The first set of tax issues arises in connection with the bankruptcy filing itself. Under bankruptcy law, when an individual debtor files a bankruptcy petition under Chapter 7 or Chapter 11, a separately taxable bankruptcy estate that consists of property formerly belonging to the debtor is created. The bankruptcy estate is administered by a trustee or by a debtor in possession for the benefit of creditors, and the estate may derive its own income and incur expenditures during the course of the bankruptcy process. The term “debtor in possession” refers to a debtor that keeps possession and control of its assets while undergoing reorganization under Chapter 11 without the appointment of a case trustee.

Common Profiling Tax Issues for Bankruptcy Estate

Upon the creation of the bankruptcy estate, the trustee or debtor in possession, as the case may be, becomes responsible for computing tax due and filing all required federal and state income tax returns on behalf of the bankruptcy estate during the bankruptcy case. A somewhat related profiling issue for a trustee relates to prepetition federal income tax refunds to which the debtor might be entitled. A Chapter 7 debtor’s undeceived prepetition tax refund becomes property of the bankruptcy estate upon the filing of the bankruptcy. As such, the debtor’s prepetition tax refunds are subject to “turnover” to the trustee. To obtain turnover of the debtor’s tax refund for the benefit of the bankruptcy estate, the trustee must follow specific procedural and notice requirements. The IRS will deny invalid or incomplete requests. Accordingly, it is important for the trustee to consult a tax adviser to ensure timely compliance with all applicable procedural requirements for obtaining turnover of the debtor’s prepetition tax refund.

Common Profiling Tax Issues for Individual Debtors

The individual debtor is required to file individual income tax returns during a bankruptcy case. The debtor is required to report income received, gains and losses recognized, and deductions paid other than income, gains, losses, and deductions that belong to the bankruptcy estate. One of the most important prepetition debtor tax considerations that is often overlooked relates to the individual debtor’s ability to make an election to close his or her tax year as of the day before the date on which the bankruptcy case begins. If this election is made, the debtor’s tax year, which otherwise would be a full-year period unaffected by the bankruptcy filing, is divided into two “short” tax years of less than 12 months, with the first tax year ending on the day before the commencement of the bankruptcy case, and the second tax year beginning on the commencement date and ending at year end. Depending on the individual debtor’s particular facts and circumstances, this election can result in substantial federal income tax savings to the debtor. Conversely, making the election under the wrong facts and circumstances might be disadvantageous to the debtor. To properly compute individual tax liability during the bankruptcy case and avoid exposure to accuracy-related IRS penalties and interest, the debtor must know the items that are properly included on the tax returns filed by the bankruptcy estate and the items that are properly included on the debtor’s individual tax returns.

In addition, the debtor must understand how the creation of a separately taxable bankruptcy estate affects tax attributes carried forward from prior periods, such as net operating loss (NOL) carryovers, credit carryovers, and charitable contribution carryovers. Significantly, the debtor’s tax attribute carryovers from tax years ending prior to the commencement of the bankruptcy case can be used only by the bankruptcy estate while the bankruptcy estate is in existence. Thus, the debtor loses its tax attribute carryovers upon the filing of the bankruptcy petition. Depending on the debtor’s individual tax situation and the nature and extent of the debtor’s tax attribute carryovers, it might be appropriate to consider tax strategies to minimize the reduction or loss of tax attributes upon filing for bankruptcy. An additional profiling consideration for debtors relates to prior-year overpayments of tax carried forward from a prepetition tax year. Significantly, a federal or state tax overpayment carried forward from a prepetition tax year may become the property of the bankruptcy estate upon the filing of a petition for relief under Chapter 7 or Chapter 11. This means that the prior-year overpayment of tax will become available for credit against the bankruptcy estate’s tax liability (as opposed to available for credit against the debtor’s individual tax liability). If a debtor previously has elected to carry forward a prior-year overpayment, it might affect the timing of the bankruptcy filing.

Similarly, if an individual debtor is considering filing for bankruptcy, it might affect the decision to request a refund of overpaid taxes (as opposed to electing to apply the overpayment to a later tax year). A somewhat related profiling consideration for the debtor and his or her bankruptcy counsel relates to prepetition federal income tax refunds to which the debtor is entitled. As previously noted, an individual debtor’s prepetition tax refunds are subject to turnover to the bankruptcy estate, which might affect the timing of the bankruptcy filing for debtors who are entitled to receive a refund of overpaid federal income taxes from the IRS. Similarly, the timing of the bankruptcy filing might also be affected if the debtor owes taxes from a prior period, because certain taxes are no dischargeable in bankruptcy. No dischargeable taxes include income and gross receipts taxes that are assessed within 240 days of the filing of the bankruptcy petition or that are assessed after the bankruptcy petition is filed. If a debtor owes income taxes from a prior tax period, it might be necessary to consider when the tax was assessed, as this might affect the timing of the bankruptcy filing in some cases. Significantly, the concept of assessment is a tax term of art. In addition, special rules might apply for counting the number of days that have elapsed since a prior assessment of tax.

Tax Issues During the Bankruptcy Case

While a bankruptcy filing does not relieve the debtor of his or her usual duty to file income tax returns, it can markedly shift the nature, timing, and extent of the debtor’s obligations to pay taxes. In addition, the actions and financial activities of the trustee or debtor in possession during the bankruptcy case can create unanticipated adverse tax consequences for both the debtor and the bankruptcy estate.

Common Tax Issues Encountered by the Chapter 11 Bankruptcy Estate
Post-petition income: Property acquired by the debtor after the bankruptcy petition date (after-acquired property) becomes the property of the bankruptcy estate. Specifically, Section 1115 of the Bankruptcy Code defines property of the bankruptcy estate to include the debtor’s gross earnings from performance of services after the commencement of the bankruptcy case (post-petition services); and the gross income from property acquired by the debtor after the commencement of the bankruptcy case (post-petition property). As a result, the bankruptcy estate, rather than the individual debtor, is required to include in its taxable income the debtor’s gross earnings from post-petition services and gross income generated by the debtor’s post-petition property. This significantly affects how the individual debtor and the debtor’s bankruptcy estate are taxed during the Chapter 11 bankruptcy case. In addition, this might potentially affect the debtor’s employer and persons filing Forms W-2, 1099, and other information returns that report payments to the debtor. IRS Notice 2006-83 provides guidance for debtors in possession or trustees relative to the tax filing obligations and procedural requirements for ensuring proper reporting of the debtor’s income from post-petition services and post-petition property during a Chapter 11 bankruptcy case. Alternative minimum tax (AMT) considerations: As previously noted, tax attribute carryovers from tax years ending before the commencement of bankruptcy can be used only by the bankruptcy estate while it is in existence.

Therefore, the debtor’s tax attribute carryovers from prior tax periods become available to offset the federal income tax liability of the bankruptcy estate during the bankruptcy case. In considering asset transactions, bankruptcy professionals often assume that if there are enough NOLs or other tax attributes to offset taxable income generated by the bankruptcy estate, there will be no federal or state income tax liability for the estate. However, under the alternative tax NOL rules the ability to use NOLs and other tax attributes to offset the estate’s taxable income may be limited for AMT purposes. The amount of the NOLs available for AMT purposes (ATNOLs) may differ from the amount of the regular tax NOLs, and generally only 90% of a taxpayer’s computed alternative minimum taxable income can be offset with ATNOLs. Thus, even though available regular tax NOLs might exceed the regular taxable income of the bankruptcy estate, the bankruptcy estate may not be able to fully use the estate’s ATNOLs, resulting in an AMT liability. If the bankruptcy estate incurs an AMT liability, the estate may be entitled to a minimum tax credit that it can carry forward to offset regular federal income tax liability in a subsequent tax year when AMT does not apply. Although the debtor’s tax attributes become the property of the bankruptcy estate upon the filing of the petition, any unused tax attributes remaining when the case is closed by the Bankruptcy Court revert back to the debtor in that year. Since the trustee is a fiduciary, it is important for him or her to properly track and carry forward any minimum tax credit generated by the bankruptcy estate to preserve those credits for use by the bankruptcy estate in subsequent tax years or by the debtor after the bankruptcy estate is closed.

Common Tax Issues Encountered by the Debtor

Cancellation of debt is perhaps one of the most common tax issues encountered by debtors during bankruptcy and relates to the cancellation or modification of indebtedness and the attendant tax consequences to the debtor. Generally, a debtor is required to recognize cancellation-of-debt (COD) income to the extent that a debt is discharged for less than the amount owed. While the concept may seem straightforward in theory, its application to a debtor’s particular facts is rarely straightforward, especially in a bankruptcy. Another potentially complicating factor in considering COD income relates to situations where a debtor transfers collateralized property to a creditor in exchange for discharge of the debt that the property secures. In this situation, the transaction’s tax consequences differ significantly depending on whether the underlying debt is recourse or nonrecourse.

In addition to the threshold challenges associated with identifying a debt discharge event and determining whether a debtor has realized COD income for federal income tax purposes, the general rule requiring recognition of COD income is subject to numerous exceptions, exclusions, and modifications that may provide some relief for the debtor. The most relevant of these are the exclusions of COD income for and insolvent taxpayers.