Tax Basics: What Every Bankruptcy Attorney Should Know

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1 Tax Basics: What Every Bankruptcy Attorney Should Know 1

2 Areas of Focus 1. Secured tax claims and tax claims entitled to priority 2. Nondischargeable tax claims 3. The short tax year election 4. Cancellation of indebtedness income in bankruptcy 2

3 Preliminary Matters: Always Obtain a Transcript and Previous Returns Previous Returns. Provided by the Internal Revenue Service (IRS) for a small fee. Tax Transcript. The tax transcript is a document which lists each transaction between the taxpayer and the IRS. It displays matters of both substantive importance and those that are of only administrative significance. The transcript is free to request from the IRS. Transaction Codes Pocket Guide. A reference to aid in understanding the transcript. Tax Transcript is Frequently Dispositive. The transcript may be introduced into evidence, and courts may rely on it to resolve factual disagreements among the parties. See Roberts v. C.I.R., 87 T.C.M. (CCH) 1228 (T.C. 2004), Schroeder v. C.I.R., 84 T.C.M. (CCH) 141 (T.C. 2002). 3

4 Secured Tax Claims and Tax Claims Entitled to Priority 4

5 Secured Tax Claims Attachment. A lien attaches under IRC 6321 when the tax is assessed and the amount remains unpaid after payment is demanded. The lien attaches to all of the debtor s pre-petition property. See U.S. v. Rogers, 103 S. Ct (1983). It is generally unenforceable after 10 years. 26 U.S.C Perfection. Occurs when a Notice of Federal Tax Lien is filed with the appropriate state entity. 26 U.S.C Absent pre-petition perfection, the IRS will be treated as an unsecured creditor. United States v. TM Bldg. Products, Ltd., 231 B.R. 364, 370 (S.D. Fla. 1998) Competing Liens. First in time, first in right governs, and federal tax liens generally do not prime existing liens. See I.R.S. v. McDermott, 507 U.S. 447, 449 (1993). Some liens may also have priority over a previously perfected federal tax lien. See 26 U.S.C. 6323(b)(1)-(10). Secured Tax Claims and Tax Claims Entitled to Priority 5

6 Pre-Petition Income Tax Claims Entitled to Priority Under 11 U.S.C. 507(a)(8)(A) 3 Year Rule. Taxes associated with a return that was filed within 3 years of the bankruptcy Filing. 240 Day Rule. Taxes assessed within 240 days before the bankruptcy filing. Extended to include 30 days plus the time period in which an offer in compromise was pending. Assessible but not Assessed. Taxes assessible after the bankruptcy is filed, but not yet assessed. Secured Tax Claims and Tax Claims Entitled to Priority 6

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8 Pre-Petition Non-Income Tax Claims Entitled to Priority Under 11 U.S.C. 507(a)(8)(B)-(G) Property Taxes. Pre-petition property taxes last payable within one year of the bankruptcy filing. Trust Fund Taxes. Taxes which must be collected and paid over to the IRS. Employment Taxes. Taxes associated with wages, salaries, or commissions for which a return is last due after three years before the bankruptcy filing. Pecuniary Penalties. Includes only non-punitive penalties that are related to priority tax claims and which serve as compensation for actual pecuniary loss. (Punitive penalties are paid after general unsecured creditors pursuant to 11 U.S.C. 726(a)(4)). Excise Taxes. Customs Duties. Secured Tax Claims and Tax Claims Entitled to Priority 8

9 Post-Petition Tax Claims Entitled to Priority: Administrative Expense Tax Claims Under 11 U.S.C. 507(a)(2) and 503(b)(1)(B)-(C) Administrative Expense Tax Claims. The actual, necessary costs and expenses of preserving the estate including Any secured or unsecured tax incurred by the estate except a tax of the kind specified in 507(a)(8) [pre-petition tax claims] (including property taxes and taxes attributable to an excessive allowance of a tentative carryback adjustment), together with any associated fine, penalty, or reduction in credit. Administrative Expense Treatment Only Available When Estate is Separate Taxable Entity. A tax incurred by the estate is a tax for which the estate itself is liable. Hall v. United States, 132 S. Ct. 1882, 1883 (2012). Where the estate is not a separate taxable entity, the tax is the liability of the debtor alone. Id. at Secured Tax Claims and Tax Claims Entitled to Priority 9

10 Post-Petition Tax Claims Entitled to Priority: Tax Claims on Certain Wages, Salaries, and Commissions Under 11 U.S.C. 507(a)(4) Priority for Certain Wages, Salaries, or Commissions Earned Within 180 Days Before the Bankruptcy Includes Associated Taxes. Any corresponding income taxes or social security taxes withheld from employees wages are included. Only Applies to Post-Petition Tax Withholdings. Payroll tax withholdings do not occur until the wage, salary, or commission is actually paid as part of the claims distribution process. Therefore, all tax withholdings effectively occur post-petition. See Otte v. United States, 419 U.S. 43, (1974). Nondischargeable Tax Claims 10

11 Plan Confirmation Requires Payment of Priority Tax Claims in Full Chapter 13 Plan Confirmation. A plan must provide for payment in full, in deferred cash payments, of all priority tax claims in order to be confirmed. 11 U.S.C. 1322(a)(2). Chapter 11 Plan Confirmation. In order for a Chapter 11 plan to be confirmed, it must provide for full payment in cash on the effective date of the plan of all administrative tax claims under 11 U.S.C. 507(a)(2). 11 U.S.C. 1129(a)(9). It must also provide deferred cash payments totaling the full amount of any priority tax claim under 11 U.S.C. 507(a)(4) whose holder has accepted the plan, and full payment in cash on the effective date of the plan for any priority tax claim under 11 U.S.C. 507(a)(4) whose holder has not accepted the plan. Id. Finally, the plan must provide cash installments totaling the full amount of any priority tax claim under 11 U.S.C. 507(a)(8). Id. Secured Tax Claims and Tax Claims Entitled to Priority 11

12 Nondischargeable Tax Claims 12

13 Nondischargeable Tax Claims Under 11 U.S.C. 523(a)(1) and 523(a)(7) in Chapter 7 and Chapter 11 Individual Debtor Cases Prepetition Priority Taxes. All taxes entitled to priority under 11 U.S.C. 507(a)(8). Unfiled or Delinquent Return. Includes any tax for which a return was required and was not filed or was filed late and within two years from the bankruptcy filing. Fraudulent Return or Tax Evasion. Evasion is defined as a willful attempt to evade or defeat a tax. Punitive Tax Penalties. Unless the non-pecuniary penalty relates to a transaction or event that is more than 3 years old. Nondischargeable Tax Claims 13

14 Nondischargeable Tax Claims in Chapter 13 Under 11 U.S.C. 1328(a)(2) Unfiled or Delinquent Return. Includes any tax for which a return was required and was not filed or was filed late and within two years from the bankruptcy filing. The associated post-petition interest is also not dischargeable. Fraudulent Return or Tax Evasion. Evasion is defined as a willful attempt to evade or defeat a tax. The associated post-petition interest is also not dischargeable. Assessible but not Assessed. Taxes assessible after the bankruptcy filing, but not yet assessed. Trust Fund Taxes. Taxes which must be collected and paid over to the IRS. The associated postpetition interest is also not dischargeable. Nondischargeable Tax Claims 14

15 Post-Petition and Post-Confirmation Interest Secured Tax Claims. Post-petition and post-confirmation interest accrues on oversecured claims. Administrative Tax Claims. Interest accrues and is likely also an administrative priority. See, e.g., In re Weinstein, 272 F.3d 39, 47 (1st Cir. 2001) and In re Colortex Indus., Inc., 19F.3d1371(11th Cir. 1994). Other Priority Tax Claims in Chapter 11 and Chapter 13. Post-petition interest accrues where the debtor is solvent under 11 U.S.C. 726(a)(5), and with respect to the time between the filing of the petition and plan confirmation. Post-confirmation interest accrues on priority tax claims in Chapter 11, but not in Chapter 13 cases. Nondischargeable Tax Claims 15

16 16

17 The Short Tax Year Election 17

18 Bankruptcy May Create a Separate Taxable Entity Individual Debtor Chapter 7 and 11 Cases. The bankruptcy filing makes the estate a separate taxable entity from the debtor. Chapter 13 Cases and Commercial Cases. The bankruptcy filing does not create a separate taxable entity. The Short Tax Year Election 18

19 Succession of Tax Attributes Estate s Tax Attributes. The estate receives the same tax attributes to which the debtor had been entitled before bankruptcy. 26 U.S.C. 1398(g). When Succession Occurs. The succession occurs upon the filing of the bankruptcy petition. The estate succeeds to the attributes of the debtor as they existed on the first day of the debtor s taxable year in which the case commences. These attributes include, for instance, deductions, NOLS, carrybacks, carryforwards, and the same basis, holding period, and character of any transferred asset as that asset held in the debtor s prepetition hands. The Short Tax Year Election 19

20 Determining the Estate s Taxable Income Generally. The estate calculates its taxable income like any other taxpayer. 26 U.S.C. 1398(c)(1) No Double Counting. Income is reported by the debtor or the estate, but not both. Amounts Included and Excluded from Gross Income. Estate s gross income includes that which is, or is derived from, property of the estate. See 11 U.S.C. 541(a)(1), (7). The estate s gross income excludes amounts received or accrued by the debtor pre-petition. 26 U.S.C. 1398(e)(1). Tax Free Disposition of Assets from Debtor to Estate. No gain, loss, recapture, or acceleration of income or deductions occurs upon the transfer of assets from the debtor to the estate, or from the estate to the debtor upon termination of the estate. The Short Tax Year Election 20

21 The Short-Year Election Under 26 U.S.C. 1398(d) Generally. The election allows a debtor with non-exempt assets to split his or her tax year into two, shorter taxable years. Absent the election, the bankruptcy filing does not affect the debtor s tax year. First Tax Year. Ends on the day before the day the bankruptcy petition is filed. Second Tax Year. Begins on the day the petition is filed, and ends on the same day that the debtor s tax year would have ended absent the election. The Short Tax Year Election 21

22 Making the Short-Year Election - Treas. Reg T How and When. The election is made when the taxpayer files its return for the first short taxable year on or before the 15th day of the fourth full month following the end of the first short taxable year. The taxpayer should write Section 1398 Election at the top of the return. Making the Election While Requesting an Extension of Time to File a Return. The election may also be made by attaching a statement of election to an application for extension of time for filing a return that satisfies the extension of time requirements for filing a return under 26 U.S.C for the first short taxable year. The Short Tax Year Election 22

23 Benefits of Making the Short-Year Election Tax Liability for First Short Year. The tax liability for the first short year becomes a prepetition, albeit nondischargeable, priority claim under 11 U.S.C. 507(a)(8). Utilization of Valuable Tax Attributes. The election permits the debtor to utilize valuable tax attributes before they would otherwise pass to the estate. The Short Tax Year Election 23

24 Cancellation of Indebtedness Income in Bankruptcy 24

25 Cancellation of Indebtedness Included in Gross Income. Gross income includes income from the discharge of indebtedness unless an exception or an exclusion under 108 applies. See 26 U.S.C. 61(a)(12). Defined. (1) whether at the inception of the loan transaction, the borrowed funds were excluded from the taxpayer s income upon receipt because of the offsetting obligation to repay; and (2) if so, whether the taxpayer s obligation to repay has been cancelled, forgiven, or reduced. American Bar Association Section of Taxation, Report of the Section 108 Real Estate and Partnership Task Force, Part 1, 46 TAX LAW. 209, 224 (1992). Cancellation of Indebtedness Income in Bankruptcy 25

26 Exceptions to the Realization of Cancellation of Indebtedness Income Gift. The cancellation of the debt was intended as a gift. Disputed Debt. The amount of the debt, not the collectibility, is disputed. Lost Deduction. Where the payment of the discharged liability would have otherwise permitted a deduction. Purchase Price Adjustment. Discharge may be treated as a reduction of the purchase price of an asset (and corresponding decrease in basis) where the debt arises out of the asset s purchase. 26 U.S.C. 108(e)(5). Cancellation of Indebtedness Income in Bankruptcy 26

27 Exceptions to the Recognition of Income Realized from the Cancellation of Indebtedness Under 26 U.S.C. 108 Bankruptcy. Discharge Occurs in a Title 11 Case. 26 U.S.C. 108(a)(1)(A). The taxpayer must be under the court s jurisdiction, and the discharge must be either granted by the court or effectuated pursuant to a court-approved plan. 26 U.S.C. 108(d)(2). Insolvency. The debtor is insolvent immediately preceding the discharge. 26 U.S.C. 108(a)(1)(B). The amount of cancellation of indebtedness income excluded from gross income may not exceed the amount by the which the taxpayer is insolvent immediately preceding the discharge. 26 U.S.C. 108(a)(3). A taxpayer is insolvent to the extent that its liabilities exceed the fair market value of its assets immediately preceding the discharge. 26 U.S.C. 108(d)(3). Cancellation of Indebtedness Income in Bankruptcy 27

28 Attribute and Basis Reduction Rule for Cancellation of Indebtedness Income Excluded Under 26 U.S.C. 108(a) Generally. A taxpayer must reduce certain tax attributes, or first elect to reduce his or her basis in depreciable property, by the amount of excluded cancellation of indebtedness income. 26 U.S.C. 108(b). Any remaining amount is excluded forever. Treas. Reg (a)(2). Cancellation of Indebtedness Income in Bankruptcy 28

29 Reduction in Tax Attributes Absent Election to Reduce Basis in Depreciable Property Reduction in Tax Attributes. Absent a basis reduction election, 108(b)(2) requires tax attributes to be reduced in the following order: 1. NOLs 2. General business credits 3. Minimum tax credits 4. Capital loss carryovers 5. Basis in the taxpayer s property. See 26 U.S.C and Treas. Reg Passive activity loss and credit carryovers 7. Foreign tax credit carryovers Cancellation of Indebtedness Income in Bankruptcy 29

30 Reduction in Tax Attributes with Election to First Reduce Basis in Depreciable Property When Basis Reduction Takes Effect. Reduction occurs at the beginning of the tax year after the tax year in which the discharge occurs. Mechanics. If the election is made, tax attributes are reduced under 26 U.S.C. 108 in the following manner: 1. Basis in Depreciable Property (but not below zero) 2. Carryovers and credits except foreign tax credits 3. Basis in nondepreciable property 4. Foreign tax credit carryovers Cancellation of Indebtedness Income in Bankruptcy 30

31 Questions 31

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