Discussion Questions for Tax Basics: What Every Bankruptcy Attorney Should Know
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- Georgiana Morrison
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1 Discussion Questions for Tax Basics: What Every Bankruptcy Attorney Should Know 1. Individual Debtor s Liability for Corporate Tax Debt Are officers and directors responsible person[s] within the meaning of 26 U.S.C so as to make them liable for their corporation s tax debt? Yes. See In re Carpenter, 540 B.R. 691 (B.A.P. 9th Cir. 2015) (holding that an individual chapter 11 debtor and former corporate officer is a responsible officer with respect to unemployment insurance contributions and that such debt is a nondischargeable priority claim under 11 U.S.C. 507(a)(8)(E)). Section 6672 of the Internal Revenue Code states that [a]ny person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. 2. Deeds in Lieu of Foreclosure Can a trustee give a creditor a deed in lieu of foreclosure, and, if so, is it advisable from a tax perspective? Court approval is required for a trustee to provide a creditor with a deed in lieu of foreclosure. 11 U.S.C. 363(b)(1). Foreclosure, a deed in lieu of foreclosure, or any other transfer from the debtor to the lender in full satisfaction of the debt is treated, for federal income tax purposes, as a sale of property which may give rise to gain or loss to the mortgagor. Restructuring debt on distressed real estate, ss049 ALI ABA 407, 433. Thus, a deed in lieu of foreclosure, like a foreclosure, would make the estate liable for any gain or COD income with respect to the transaction. The debtor would be liable for the gain and COD income in cases in which the estate is not a separate taxable entity. 1
2 Example: The debtor owes creditor $500 of recourse indebtedness secured by property with a value of $300. When the debtor transfers the property to creditor (through a deed in lieu of foreclosure, for example) in exchange for complete forgiveness of of the indebtedness, the debtor recognizes $200 of COD income. 3. Abandonment In cases in which the estate is a separate taxable entity, should a trustee abandon property rather than permitting foreclosure or a deed in lieu of foreclosure? Probably. Abandoning the property would effectively make the debtor liable for any gain and COD income with respect to the transaction. Otherwise, the gain and COD income would become administrative expense tax claims which would have to be funded through the plan. 4. Failure of the Internal Revenue Service to File a Claim in the Bankruptcy What happens if the IRS forgets to file a proof of claim? In Chapter 13 cases in which the debtor proposes to pay priority tax claims in full, and the entities to whom the obligations are owed fail to file proofs of claim, the priority tax claims are discharged unless the claims are entitled to nondischargeablility. See In re Richards, 50 B.R. 339 (E.D. Tenn 1985) and In re Rothman, 76 B.R. 38 (Bankr. E.D.N.Y. 1987). In individual debtor cases under Chapter 7 or Chapter 11, the failure of the IRS to file a proof of claim does not affect the dischargeability of the underlying tax debt. In re Grynberg, 986 F.2d 367 (10th Cir. 1993). The debtor should file a proof of claim on behalf of the IRS. 5. Sale of Property with a Low Adjusted Basis If the trustee plans to sell low basis estate property, what tax mitigation techniques may the trustee employ? Where the estate is not a separate taxable entity, the estate cannot incur administrative expense claims. Hall v. United States, 132 S. Ct. 1882, 1883 (2012). The debtor would be liable for the gain. In such a case, the tax on the gain will not be included in the plan. The debtor could, however, convert 2
3 its case to a proceeding under Chapter 7. The tax on the gain would then be treated as prepetition debt. 11 U.S.C. 348(d). A claim against the estate or the debtor that arises after the order for relief but before conversion in a case that is converted under section 1112 or 1307 of this title, other than a claim specified in section 503(b) of this title, shall be treated for all purposes as if such claim had arisen immediately before the date of the filing of the petition. In re Hotel Nevada Corp., 75 B.R. 174, 176 (Bankr. D. Nev. 1987). If the estate is a separate taxable entity, the gain from the sale of the property will be an administrative expense tax claim. 6. Priority of Administrative Expense Tax Claims Upon Conversion Which claims have priority when the estate has incurred administrative expense tax claims before and after conversion? Tax claims incurred during Chapter XI proceedings are therefore in fact junior to claims for expenses incurred in subsequent bankruptcy proceedings. Nicholas v. United States, 384 U.S. 678, 688, 86 S. Ct. 1674, 1682, 16 L. Ed. 2d 853 (1966). 7. The Short Year Election When should the short year election be made? When the election is not made, the debtor s tax liability for the taxable year in which the bankruptcy case commences will be a postpetition claim. Thus, any tax attributes of the debtor will not be able to offset the claim unless the estate does not utilize the attributes and they later go back to the debtor. When the election is made, the debtor can transform its tax liability up to the date of the bankruptcy filing into a prepetition (albeit nondischargeable) claim under 11 U.S.C. 507(a)(8). If any amount of the claim remains unpaid, tax attributes of the debtor can be used to further reduce the claim. For example, a NOL from the first short year might be used to reduce the nondischargeable tax debt. The following examples illustrate these principles. 3
4 Example 1: Make the election. Debtor has gross income as of August 16, Debtor has generated NOLs in previous tax years that may be carried forward or backward to other tax years. Debtor files for Chapter 7 on August 17, Without the election, the tax owed is due on April 15, 2014 for the period January 1 through December 31. The NOL attributes will pass to the bankruptcy estate, and the trustee can use them to reduce the estate s tax liability. Any unused losses would then pass back to the Debtor upon termination of the bankruptcy case. Example 2: Do not make the election. The Debtor has had no income from January 1 through August 16, and NOLS have arisen during this time period (not in previous years). Debtor files for Chapter 7 relief on August 17, The Debtor expects to receive a substantial income from September through December. Without the election, the debtor will be able to use the NOLs against postpetition income. With the election, the bankruptcy trustee gets to use the NOLS (because the NOLS become carryovers) and the debtor s income cannot be offset by the NOLS. Any unused portion of the NOLS would pass back to the debtor upon termination of the case. Note: If the NOLs had arisen in previous tax years, they would pass to the estate absent the election. If the debtor makes the election, the debtor may utilize the NOLS. 8. Cancellation of Indebtedness What are the tax consequences of the following transactions? Facts: The Taxpayer owes $500 to bank, secured by property with a fair market value of $300. The taxpayer has an adjusted basis of $400 in the property. a. If the bank writes down the value of the debt, the taxpayer will have COD income in the amount of the write down whether the indebtedness is recourse or nonrecourse.. No COD income would be recognized if one of the exceptions under 11 U.S.C. 108 applies. b. If the indebtedness is recourse, a transfer of the property by the taxpayer to the creditor in full satisfaction of the indebtedness will result in $100 of gain and $200 of COD income. No COD income would be recognized if one of the exceptions under 11 U.S.C. 108 applies. 4
5 c. If the indebtedness is nonrecourse, a transfer of the property by the taxpayer to the creditor in full satisfaction of the indebtedness will result in in $100 of gain and $0 of COD income. No COD income would be recognized if one of the exceptions under 11 U.S.C. 108 applies. 9. Circuit Split: The Definition of Return for Purposes of 11 U.S.C. 523(a) When is a tax return a return for purposes of 11 U.S.C. 523(a)? The hanging paragraph in 523(a) defines a return for purposes of determining nondischargeability of tax debt under 523(a) as a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements). Such term includes a return prepared pursuant to section 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a return made pursuant to section 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law (emphasis added). The First, Fifth, and Tenth Circuits, guided by the language of the hanging paragraph, have defined return to exclude any return that was filed late. See Fahey v. Massachusetts Department of Revenue (In re Fahey), 779 F.3d 1 (1st Cir. 2015); In re Mallo, 774 F.3d 1321 (10th Cir. 2014); and McCoy v. Mississippi State Tax Commission (In re McCoy), 666 F.3d 924 (5th Cir. 2012). Thus, under 523(a)(1)(B) relating to the nondischargeability of tax debt associated with returns that are fraudulent, never filed, or delinquent and filed within two years of the bankruptcy petition, tax debt relating to a delinquent return is never dischargeable. The Ninth Circuit Bankruptcy Appellate Panel recently rejected the Circuit Courts literal definition of return in favor of a less formalistic, pre BAPCA definition. In re Martin, WL at 10 (B.A.P. 9th Cir. Dec. 17, 2015). The Court stated that a return is a return if it meets the following requirements: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law. Id. The BAP pointed out that the circuit courts strict definition of return leads to an odd result: under the literal construction of the hanging paragraph, a debtor taxpayer who is one month or one day or even one hour late in filing his or her return will have his associated tax debt excepted from discharge, whereas a debtor taxpayer who never bothers to file his or her own return can discharge his or her associated tax debt if the IRS fortuitously prepares a return on that person's behalf. Id. at 8. It also pointed out that the circuit courts definition of return also makes 523(a)(1)(B)(ii) largely superfluous (aside from returns prepared by the IRS) because its reference to 5
6 delinquent returns which are filed within two years of the bankruptcy petition is unnecessary given the view that a return can never be delinquent at all. Id. at 9. Notably, the Eighth Circuit addressed the meaning of the term return for purposes of 523(a) roughly one year after the hanging paragraph was added. In re Colsen, 446 F.3d 836 (8th Cir. 2006). The Court did not apply the language of the hanging paragraph because the debtor s bankruptcy petition was filed before the language took effect. Id. at 839. Instead, the 8 th Circuit affirmed the test applied by the bankruptcy court and the Eighth Circuit Bankruptcy Appellate Panel the same test that the Ninth Circuit BAP applied in Martin. 6
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