A case brought under Chapter 11 of the Bankruptcy Code is often referred to as a “reorganization.”. People whose debt exceeds the Chapter 13 ceiling also file Chapter 11. Common tax problems are found in Chapter 7 and Chapter 11 bankruptcy cases. Not fully understanding the application of tax laws in the context of a Chapter 7 or Chapter 11 bankruptcy case can undermine the success of the bankruptcy proceeding, have unforeseen adverse tax consequences, and even expose a party to personal liability. A Chapter 7 bankruptcy is a liquidation procedure in which the Chapter 7 trustee sells the debtor's non-exempt assets, if any, and the revenues are distributed to creditors in accordance with the priorities set forth in the Bankruptcy Code.
A Chapter 11 bankruptcy is a reorganization procedure in which the debtor reimburses creditors through a court-approved reorganization plan. Commercial debtors typically use Chapter 11; however, individual consumers may be eligible to file for Chapter 11 bankruptcy under certain circumstances (see Toibb v. A Chapter 11 case is usually brought by individuals who continue to have substantial personal purchasing power, but whose debts exceed the limits of Chapter 7 and Chapter 13. A fundamental objective of federal bankruptcy laws is to provide debtors with a fresh financial start from onerous debts (for example,.
The Bankruptcy Code works in conjunction with the Internal Revenue Code (IRC) and refers to the IRC for the purpose of determining the tax consequences of the bankruptcy process (11 U, S, C. As such, a debtor bankrupt under Chapter 7 or 11 generally remains subject to applicable federal income tax laws despite the bankruptcy and must continue to timely file federal income tax returns and pay the federal income tax due (see Secs. It should be noted that the IRC contains some legal provisions that specifically address Chapter 7 and Chapter 11 bankruptcies; however, these provisions generally address specific and limited tax issues in the event of bankruptcy and are limited in scope (see, p. The following highlights some of the common tax problems that individual debtors and bankruptcy trustees face at each stage of the bankruptcy process.
The first set of tax issues arise in connection with the bankruptcy filing itself. Under bankruptcy law, when an individual debtor files a bankruptcy application under Chapter 7 or Chapter 11, a separately taxable bankruptcy estate is created consisting of assets that previously belonged to the debtor (11 U, S, C. The bankruptcy estate is managed by a trustee or by a debtor in possession for the benefit of creditors, and the estate can obtain its own revenues and incur expenses during the course of the bankruptcy process (11 U, S, C. The term debtor in possession refers to a debtor who maintains possession and control of his assets while undergoing a reorganization under Chapter 11 without the appointment of a judicial administrator (11 U, S, C.
The individual debtor is required to file individual income tax returns during a bankruptcy case (Secs. The debtor is required to declare the income received, the profits and losses recognized and the deductions paid other than the income, profits, losses and deductions that belong to the bankruptcy estate (id. One of the most important and often overlooked pre-petition tax considerations concerns the individual debtor's ability to make the decision to close their tax year the day before the date the bankruptcy case begins (sec. If this choice is made, the debtor's tax year, which would otherwise be a full-year period not affected by the bankruptcy filing, is divided into two short tax years of less than 12 months, the first tax year ends the day before the bankruptcy case begins, and the second tax year begins on the start date and ends at the end of the year (Secs.
Depending on the individual debtor's particular facts and circumstances, this choice can result in substantial federal income tax savings for the debtor. On the contrary, making the choice under the wrong circumstances and facts may be disadvantageous for the debtor. To correctly calculate individual tax liability during the bankruptcy case and to avoid being exposed to accurately related IRS penalties and interest, the debtor must know the items that are correctly included in the tax returns filed by the bankruptcy estate and the items that are correctly included in the debtor's individual tax returns. In addition, the debtor must understand how the creation of a separately taxable bankruptcy estate affects tax attributes transferred from previous periods, such as net operating loss (NOL) transfers, credit transfers, and charitable contribution transfers.
Significantly, transfers of the debtor's tax attributes from tax years that ended before the start of the bankruptcy case can only be used by the bankruptcy estate as long as the bankruptcy estate exists (sec. Therefore, the debtor loses the transfers of tax attributes when filing the bankruptcy petition. Depending on the debtor's individual tax situation and the nature and extent of the debtor's transfers of tax attributes, it might be appropriate to consider tax strategies to minimize the reduction or loss of tax attributes upon filing for bankruptcy. Additional consideration for debtors refers to prior year tax overpayments carried over from a tax year prior to the request.
Significantly, a federal or state tax overpayment carried over from a tax year prior to the petition may become the property of the bankruptcy estate upon filing a request for relief under Chapter 7 or Chapter 11 (Nichols v. Birdsell, 491 F, 3d 987 (19th century). This means that the tax overpayment from the previous year will become available as a credit against the bankruptcy estate's tax debt (instead of being available for the credit against the debtor's individual tax liability). If a debtor has previously chosen to transfer an overpayment from the previous year, this could affect the timing of the bankruptcy filing.
Likewise, if an individual debtor is considering filing for bankruptcy, this could affect the decision to request a refund of overpaid taxes (instead of choosing to apply the overpayment to a later tax year). Pre-filing consideration, somewhat related for the debtor and his bankruptcy attorney, refers to the federal income tax refunds to which the debtor is entitled. As noted above, tax refunds prior to an individual debtor's request are subject to bankruptcy estate billing, which could affect the time of filing for bankruptcy for debtors who are entitled to receive a refund of overpaid federal income taxes from the IRS. Likewise, the timing of the bankruptcy filing could also be affected if the debtor owes taxes from a previous period, because certain taxes are not cancellable in the event of bankruptcy.
Non-refundable taxes include income and gross income taxes that are calculated within 240 days of the filing of the bankruptcy application or that are assessed after the filing of the bankruptcy application (11 U, S, C). If a debtor owes income tax from a previous tax period, it may be necessary to consider when the tax was assessed, as this could affect the timing of the bankruptcy filing in some cases. Significantly, the concept of valuation is a technical tax term. In addition, special rules could be applied to count the number of days elapsed since the previous tax settlement (see In re Williams, 188 B, R.
Ohio, 1999; In Red Fray, 117 BC, R. While filing for bankruptcy does not exempt the debtor from his usual obligation to file income tax returns, it can significantly change the nature, schedule, 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 may result in unforeseen adverse tax consequences for both the debtor and the bankruptcy estate. However, under Alternative Tax Rules (NOL) (Sec.
The amount of NOLs available for AMT (ATNOL) purposes may differ from the amount of regular tax NOLs and, generally, only 90% of the taxpayer's calculated alternative minimum taxable income can be offset by ATNOL. Therefore, even if the available ordinary tax NOLs may exceed the bankruptcy estate's regular taxable income, the bankruptcy estate may not be able to fully utilize the estate's ATNOL, resulting in an AMT obligation. Debt cancellation is perhaps one of the most common tax problems faced by debtors during bankruptcy and refers to the cancellation or modification of the debt and the consequent tax consequences for the debtor. Generally, the debtor is required to recognize debt cancellation income (COD) to the extent that the debt is settled for less than the amount due (for example,.
While the concept may seem simple in theory, its application to the debtor's particular facts is rarely simple, especially in a bankruptcy case. Another factor that may complicate the consideration of cash on delivery income relates to situations in which a debtor transfers secured property to a creditor in exchange for the forgiveness of the debt that the property guarantees. In this situation, the tax consequences of the transaction differ significantly depending on whether the underlying debt is recourse or non-recourse. In addition to the minimal challenges associated with identifying a case of debt forgiveness and determining whether a debtor has earned cash on delivery for federal income tax purposes, the general rule requiring the recognition of cash on delivery income is subject to numerous exceptions, exclusions, and modifications that may provide some relief to the debtor.
The most relevant of these are the exclusions from COD income for bankrupt individuals (Sec. Understanding and exploring the tax implications associated with common transactions and procedures that occur before and during a Chapter 7 or Chapter 11 bankruptcy case can be complex, as it requires an intricate analysis and understanding of the particular facts and circumstances of the bankruptcy case. A debtor or trustee's failure to fully understand the application of tax laws in the context of a Chapter 7 or Chapter 11 bankruptcy can have unforeseen adverse tax consequences and potentially expose a trustee, such as the debtor's bankruptcy attorney or the bankruptcy trustee, to personal liability. Adding a tax advisor who understands the tax consequences of a Chapter 7 or Chapter 11 bankruptcy to the advisory team can add enormous value to debtors, their bankruptcy attorneys, and trustees.
Howard Wagner is a director of Crowe Horwath LLP in Louisville, Kentucky. Unless otherwise stated, contributors are members of or associated with Crowe Horwath LLP. Business lunch deductions after the peculiarities of the TCJA driven by the COVID-19 tax relief Don't get lost in the fog of legislative changes, evolving tax issues, and evolving tax planning strategies. Tax Section membership will help you keep up to date and make your office more efficient.
The Bankruptcy Code works in conjunction with the Internal Revenue Code (IRC) and refers to the IRC for the purpose of determining the tax consequences of the bankruptcy process (11 U...