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1 Bankruptcy Questions Answered! Attorney to Non- Attorney Robert McKenzie, EA, Esq. Types of Bankruptcies This is not an easy subject, but our goal is to distill it to key issues you need to know as a return preparer. Hopefully at the end of the session you will know what questions to ask to know when you re in trouble 1

2 Chapter 7 All of the debtor's nonexempt property is liquidated id d and the proceeds distributed to creditors. A Trustee is appointed to do the liquidation; the trustee works on a percentage of assets liquidated. After about six months, most debts are discharged. Text Page 1 Chapter 13 Eligible individuals pay part or all of their debts over a three to five year period. Debtor keeps their assets Debtor repays a portion of their dischargeable debt, and all of their nondischargeable debt. Simplest reorganization Under about $340,000 Unsecured Debt 2

3 Chapter 12 Eligible farmers pay part or all of their debts over a three to five year period. Text Page 1 Chapter 11 The debtor proposes a reorganization plan and seeks approval of creditors. Debtor keeps their assets Debtor repays a portion of dischargeable debt. Expensive: Large legal fees, monthly fees and very complicated. 3

4 Plain Language Practice Tip! How to remember what the categories mean Once a debtor files a petition with the USBC, the law prohibits creditors (including the IRS) from taking certain collection actions and protects certain assets from liquidation. This prohibition on collection is known as the automatic stay. Before the Process Begins Why is it that we get clients in a panic, saying they need to file prior year returns ASAP just because they are contemplating bankruptcy? Text Page 2 4

5 Creation of the Bankruptcy Estate I m having trouble with this concept but if I try to relate it to my experience with regular trusts and estates, I think I can better grasp it. Bankruptcy proceedings begin with the filing of a petition that filing creates the bankruptcy estate. t Typically an individual id debtor files either a Chapter 7 or Chapter 11 Petition. In no-asset 7 s,, the debtor continues to file income tax returns as though there were no bankruptcy and there were no separate taxable bankruptcy estate. Text Page 2 5

6 When a separate taxable bankruptcy estate is created, the estate inherits and takes into account the following income attributes of the debtor: 1. Net operating loss carryovers 2. Charitable contribution ti carryover 3. Recovery of tax benefit items 4. Carryovers of any credit 5. Capital loss carryovers 6. The debtor's basis, holding period, and character of any asset 7. The debtor's accounting method. 8. Other tax attributes of the debtor. Text Page 3 Caution! You may need to talk to the client s bankruptcy lawyer to confirm the status they are in but watch out before you use any tax attribute while the t/p is in this process. 6

7 Background and general legal principals The commencement of a bankruptcy case creates an estate, t which h generally includes all legal or equitable interests of the debtor in property as of the commencement of the case. Property excluded from the estate is never included in the estate Text Page 3 We need some plain language Come on Bob what what s really going on here? 7

8 Here s what s going on: The bankruptcy estate property will be used to pay the debtor's creditors. The bankruptcy estate is treated as a separate taxable entity from the debtor. The trustee or debtor-in-possession is responsible for preparing and filing the estate's tax returns and paying its taxes. The debtor remains responsible for filing his or her own returns and paying taxes on income that does not belong to the estate. When the bankruptcy estate is terminated or dissolved, any resulting transfer of the estate's assets back to the debtor is also not treated as a disposition. The transfer does not result in gain or loss, recapture of deductions or credits, or acceleration of income or deductions to the estate. The abandonment of property by the estate to the debtor is a nontaxable disposition of property. If the debtor received abandoned property from the estate, the debtor has the same basis in the property that the estate had. 8

9 Trustee or Debtor in Possession When a trustee is appointed, the debtor generally must turn over to the trustee control over the assets of the bankruptcy estate. In most Chapter 11 cases, a trustee is not appointed and the debtor (referred to as the debtor in possession) remains in control of the property of the bankruptcy estate. The debtor in possession must perform all the functions and duties of a trustee. Attribution of Income If there is a separate taxable entity, the trustee or DIP will need to obtain an EIN. IRC Section 1398(e)(1) provides that the gross income of the estate includes the gross income of the debtor to which the estate is entitled under the Bankruptcy Code. IRC Section 1398(e)(2) provides that the gross income of the debtor does not include any item to the extent the item is included d in the gross income of the bankruptcy estate. Text Page 5 9

10 Ask what type of bankruptcy your client has entered so you know the filing requirements. The bankruptcy estate is not treated as a separate entity for tax purposes when an individual files a petition under Chapter 12 or 13. The individual should continue to file the same federal income tax returns that were filed prior to the bankruptcy petition but don t use the attributes! Individuals in Chapter 7 or 11 The bankruptcy estate is treated as a new taxable entity, separate from the individual taxpayer. The estate in a Chapter 7 case is represented by a trustee. In Chapter 11, the debtor often remains in control of the assets (DIP) and acts as the bankruptcy trustee. The debtor files a Form 1040; the bankruptcy trustee files a Form 1041 for the estate. If the debtor remain as the DIP, the debtor must file both Form 1040 & 1041 for the bankruptcy estate 10

11 Taxation of Bankruptcy Estate The estate is entitled to one personal exemption and to the standard deduction for a married person filing separately (if the estate does not itemize deduction). Income tax rates are those for "Married Persons Filing Separately. The bankruptcy estate can adopt either a calendar year or a fiscal year since it is taxed as a separate new entity. Caution! Responsibility for filing Form 1041 lies with the fiduciary of the estate. That person may be your client, because it is either the trustee (if one is appointed), or the debtor in possession (your client, if one is not). 11

12 Gross Income of the Estate The gross income of the estate includes all gross income of the debtor that is received or accrued after commencement of the bankruptcy proceedings and to which the estate is entitled. Amounts paid or incurred by the bankruptcy estate will be allowed as a credit, deduction, administrative expense. Net Operating Losses Carry backs and carry forwards originating from the estate are only available to the estate, not the debtor. However, a net operating loss incurred by the estate can be carried back to the debtor's pre- bankruptcy tax years, as well as to previous tax years of the estate. 12

13 Exhibits Notice Statement for Ch.11 cases in allocation of individual/estate income Example: Tax return for the bankruptcy estate Requests for Prompt Determination of Liability Because the debtor is responsible for any unpaid tax liability of the bankruptcy estate, the debtor should urge the trustee to make the request. Tax returns filed by the trustee are open for inspection by the debtor. The trustee of the estate is responsible for paying the income tax liability of the estate. However, the debtor can be liable for the tax if the assets of the estate are not sufficient to pay the tax. 13

14 Abandonment of Property The trustee can abandon any property of the estate that is burdensome or inconsequential. Abandonment of the property does not include abandonment of proceeds after a taxable sale or exchange. Yikes! Couldn t this toss the troubled, underwater asset back to the debtor to face any tax consequences personally? The miracle of washing recourse to non-recourse. Text Page 10 Taxation of the Individual Debtors When no separate taxable bankruptcy is created, the debtor must file tax returns as though there was no bankruptcy proceeding. When a separate bankruptcy estate is created under the individual Chapter 7 or Chapter 11 proceeding, the debtor can elect to close his or her tax year on the day before the bankruptcy proceeding commences. The debtor must have property other than exempt property to make the election. 14

15 When to Elect Short Years An individual debtor who has taxable income for the short tax year ending the day before the bankruptcy petition is filed, should make the election. The debtor should not make the election if he or she has a loss for the first short year tax year because the loss would be carried over to the bankruptcy estate. Conclusion of Bankruptcy At the end of the bankruptcy proceedings the debtor inherits the tax attributes of the bankruptcy estate that were not reduced by debt discharge. The debtor may not carry back a NOL occurring on a tax year ending after commencement of the bankruptcy to any pre- bankruptcy tax year. Just how long can a bankruptcy proceeding last? Text Page 12 15

16 Income from Discharge of Indebtedness Although no income is realized from a debt discharged in bankruptcy, the excluded amount must be reflected in one of two ways. The debtor, or estate in a Chapter 7 or 11 case can either: Reduce tax attributes by that amount, or Elect to reduce basis in depreciable property by the excluded amount. Income from Discharge of Indebtedness Any part of the excluded amount that does not go to reduce basis is then applied to reduce other tax attributes. The bankruptcy exclusion for discharged debt is closely related to exclusions for debts discharged when: The taxpayer is insolvent, or A solvent farmer's discharge of "qualified, farm indebtedness." A solvent taxpayer's discharge of debt on qualified depreciable real property. 16

17 Discharge of an Insolvent Debtor An insolvent debtor can exclude from gross income discharged debt up to the amount of his insolvency. Insolvency equals the excess of liabilities over the fair market value of assets immediately before the debt discharge. An insolvent debtor who is solvent following the debt discharge realizes income to the extent t post-discharge assets exceed post-discharged liabilities. Excluded amounts can either reduce tax attributes or reduce depreciable assets in the same manner as in bankruptcy. Caution! Beware of property transferred to satisfy creditors. The insolvency exception only applies to debt cancellation income and only to the extent of the debtor's insolvency. In a bankruptcy case, a property transfer to creditors that results in forgiveness or discharge will not create income. 17

18 No Debt Discharge Income on Some Real Estate Debt The excluded COD income reduces the taxpayer's basis in depreciable real property. Applies to the forgiveness of debt on trade or business realty. The excluded COD income is limited to the amount by which the debt exceeds the property's FMV, and can not be more than the taxpayer's total basis in depreciable realty. The debt must have been incurred by the taxpayer in connection with real property used in a trade or business, and must be secured by that property. Coordination of Exclusions Bankruptcy rules take precedence over insolvency rules Insolvency take precedence over qualified farm debt and qualified real property business exclusion Insolvency, qualified farm debt, and qualified real property do not apply to a discharge that occurs in bankruptcy Insolvency exclusion is applied first before applying the qualified debt exclusion. The principal residence exclusion takes precedence over insolvency. 18

19 Reduction of Debtor s Tax Attributes Unless the debtor chooses to use all or a part of the amount of canceled debt to first reduce the basis of depreciable property, use the amount of canceled debt to reduce the tax attributes in the order listed below: Net operating loss General business credit carryovers Minimum tax credit Capital losses Basis Passive activity loss and credit carryovers Foreign tax credit Practice Tip Attributes or Basis? If taxable income is anticipated in the near future, it is usually best to reduce depreciable property and preserve operating loss and credit carryovers so as to offset taxable income and taxes while increasing cash flow. If NOL carryovers and net credit carryovers are going to expire on you, it is usually best to reduce these tax attributes instead of losing them. If depreciable property that might be reduced will be held for a long period of time, it is usually best to reduce depreciable property p and defer any tax consequences. State and local taxes should be tested under each alternative 19

20 Caution! Tax Attribute Reduction Example Discussion Example Tax Tools: Computing Insolvency Insolvency Worksheet Form 982 IRS Procedures for Nondischargeable and Dischargeable Tax Debts Post- Bankruptcy Generally, once a bankruptcy petition is filed, all collection against the debtor stops until the automatic stay is lifted, i.e., the bankruptcy case is closed, dismissed, or a discharge is granted or denied. When the proceeding is complete, the IRS separates out collection activity into two functions one for dischargeable debts and one for nondischargeable debts. 20

21 Post-Bankruptcy Nondischarged debts are returned to the normal collection stream. Discharged tax debts go through a separate process that includes screening of both real and personal property for the possibility of collecting from assets exempted, excluded, or abandoned from the bankruptcy proceeding, if certain dollar thresholds are met Tax Liabilities & Bankruptcy See Exhibits & Checklists: Classifying i Your Tax Debt Dischargeability at a Glance 21

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