Tax Issues for Bankruptcy & Insolvency By David S. De Jong, Esquire, CPA Stein, Sperling, Bennett, De Jong, Driscoll & Greenfeig, PC 25 West Middle Lane Rockville, Maryland 20850 301-838-3204 ddejong@steinsperling.com Background on Cancellation of Indebtedness In United States v. Kirby Lumber Company, 284 U.S. 1 (1931), the U.S. Supreme Court first established the principal that the benefit to a debtor on partial or complete discharge of a liability is taxable income. Prior case law had held to the contrary. The principal is now codified. 1
Under Internal Revenue Code Section 61, except as otherwise provided, gross income means all income from whatever source derived including specifically income from discharge of indebtedness. Code Section 108(e)(1) reaffirms this principal in the absence of an applicable exception. Nontaxable Debt Discharge Under Section 108(a) Section 108(a)(1) sets forth many of the exceptions to the general rule that income from discharge of indebtedness is taxable. These exceptions include: Discharge in a Title 11 case; 2
Discharge when the taxpayer is insolvent (liabilities including exempt assets such as pensions exceed assets); Qualified farm indebtedness (trade or business of farming, at least 50 percent of gross receipts for 3 previous years were from farming and loan was from business or governmental lender); In the case of a taxpayer other than a C corporation, qualified real property business indebtedness (real estate used in trade or business, debt is secured by property and, if incurred after 1992, is acquisition indebtedness); and Qualified principal residence indebtedness (2007-2012) (acquisition indebtedness secured by principal residence) and limited to $2 million ($1 M on MFS return). 3
In a Title 11 or insolvency case, the taxpayer may elect to first reduce the basis of depreciable property (but not below zero) or may reduce attributes in this order: Net operating loss General business credit Minimum tax credit Capital loss Basis Passive activity loss or credit Foreign tax credit Credits are reduced at the rate of 33 1/3 cents for each dollar excluded from income requiring a credit reduction. Under (C), a taxpayer not eligible for an insolvency exception or one who has used up the insolvency exception may reduce tax attributes discussed above in lieu of recognizing income on discharge by a qualified person, an unrelated party regularly engaged in the business of lending money. This exception applies only to the extent of basis and tax attributes available for reduction; any excess cancellation of indebtedness is taxable. The attributes that are reduced are generally the same and in the same order as in an insolvency or Title 11 case. Under (D), only basis may be reduced. Under (E), a taxpayer is required only to reduce the basis of the residence (but not below zero) by the amount of the cancelled indebtedness excluded from income. 4
Nontaxable Debt Discharge Under Section 108(e) Under Internal Revenue Code Section 108(e)(2), income does not arise on cancellation of indebtedness if payment would have given rise to a deduction the tax penalty is the loss of a deduction. Thus, a cash basis taxpayer with an account payable that is forgiven picks up no income. A similar taxpayer using accrual basis accounting picks up income on discharge of the payable because of the inapplicability of Section 108(e)(2) to accrual basis taxpayers and the applicability of the tax benefit rule of Section 111. Under Internal Revenue Code Section 108(e)(5), a reduction in a purchaser s debt to a seller is not taxable. This statutory exception is not applicable to third-party debt such as obligations to a bank incurred to acquire the property; however, Revenue Ruling 92-99 contemplates that the exception applies where the relief from a third party ties back to the original sale such as in the case of seller fraud. Under Internal Revenue Code Section 108(e)(6), exchanges of debt for stock or other equity capital do not cause discharge from indebtedness income under the corporate reorganization provisions of Subchapter C. 5
Under Internal Revenue Code 108(f), student loans by a government or educational institution that self-cancel upon provision of service in certain professions allow high need areas (but not if the service is for the educational institution). Nontaxable Debt Discharge Not Under Section 108 Because Internal Revenue Code Section 102 excludes gifts from income, discharge from indebtedness in a gift context involving a creditor s disinterested generosity is not taxable. This will normally arise in a family and not a business context; in fact, legislative history says there will not be any gift exception in a commercial context. Cancellation of contingent indebtedness is not taxable as there is no accretion to wealth as established by case law. This may apply in the case of a guarantor or co-obligor with at least one remaining liable party. 6
Where debt forgiveness is part of a larger loss transaction, the discharge of indebtedness is not in and of itself taxable. Any gain serves to reduce the overall loss of the taxpayer. See, e.g., Bowers v. Kerbaugh Empire Company, 271 U.S. 170 (1926). Where no increase in a debtor s assets arises from discharge of indebtedness, no taxable event occurs. For example, the holder of a note issued without consideration does not pick up taxable income on discharge of a portion of that indebtedness. See, e.g., Bradford v. Commissioner, 233 F.2d 751 (2nd Cir. 1932). Where a disputed debt is settled, there is considered to be no discharge from indebtedness as the resolution arguably fixed the proper amount of the debt. See, e.g., Sobel v. Commissioner, 40 B.T.A. 1263 (1939). The dispute must be bona fide. See, e.g., Rood v. Commissioner, 80 AFTR2d 97-5239 (11th Cir. 1997). The Courts of Appeal are divided as to whether the disputed debt exception applies when the existence itself of the debt as opposed to the amount is in issue. See Zarin v. Commissioner, 916 F.2d 110 (3rd Cir. 1990) rev g 92 T.C. 1084 (1989) (unpaid gambling debt not enforceable under state law does not cause taxable income); contra, Preslar v. Commissioner, 167 F.3d 1323 (10th Cir. 1999) (amount not in dispute only whether bank was in breach). Acquisition of Indebtedness by Debtor 7
If a debtor or a party related to a debtor acquires an outstanding debt from the creditor at a discount, discharge of indebtedness income arises. Related parties include: a member of the same controlled group of corporations under Internal Revenue Code Section 1563 with control determined by more than 50 percent vote and value; a partnership controlled by the debtor within the meaning of Internal Revenue Code Section 707(b)(1); a trade or business under common control under Internal Revenue Code Section 414(b) and (c); or a spouse, child, grandchild or parent of the debtor, or a spouse of the debtor, child or grandchild. Pursuant to the American Recovery and Reinvestment Act of 2009, relief from indebtedness income on reacquisition by a business of its debt instruments in 2009 and 2010 may be reported ratably over five years beginning in 2014 if the exclusions on bankruptcy, insolvency, qualified real property and qualified farm indebtedness are waived for all years; acceleration applies on death and liquidation or redemption of an interest. Timing of Cancellation of Indebtedness Income When cash changes hands, income is realized at the time the debt is satisfied for less than the amount owed. When cash does not exchange hands because there is no partial repayment, income is realized when it is clear that the debt will not be repaid. Cozzi v. Commissioner, 88 T.C. 435 (1987). This may occur as the result of court decision, agreement, expiration of a statute of limitations or otherwise. 8
Reporting of Cancellation of Indebtedness Income In the case of discharge from indebtedness in excess of $600 by a financial institution, governmental agency or other lender, a Form 1099 must be issued to show discharged principal pursuant to Regulation 1.6050P. No reporting is required in the case of guarantors or co-debtors as at least one additional party remains liable. In the case of multiple debtors owing $10,000 or more, each must receive a Form 1099 for the full amount and reports a pro rata portion with an explanation. A debtor excluding discharge from indebtedness income from a tax return under Section 108(a) including one reducing basis or tax attributes must attach Form 982 to the return. Bankruptcy Tax Issues Filing Bankruptcy Code Section 1398 creates a separate taxpayer for the assets of an individual in a Chapter 7 or 11 case that is not dismissed under which the bankruptcy estate succeeds to most tax attributes of the individual including net operating loss and capital loss carryovers, passive activity and at risk losses, as well as basis, accounting method. These attributes are denied to the individual who pays taxes on wage income and any other income not belonging to the estate. The estate must file a tax return if its gross income exceeds the sum of one personal exemption plus the standard deduction for married individuals filing separately. A bankrupt individual with non-exempt assets may elect to commence a new individual tax year with the bankruptcy by filing a tax return for the short year within the non-extendable 3 ½ month period following the bankruptcy. If the debtor has a tax liability for the short period, there is no personal liability if the estate has sufficient assets to pay the tax and the election is made. 9
Bankruptcy Tax Issues Collection Bankruptcy Code Section 362(e) stays IRS collection activity and shifts issues related to the legality of a tax into the Bankruptcy Court (which is generally considered as the most favorable forum for taxpayers). An individual may discharge certain tax obligations in bankruptcy but, among others, may not discharge trust fund (payroll and sales tax) obligations as well as income taxes where three years have not passed from the extended due date of the return and two years have not passed from the date of filing the return. In the case of tax deficiencies, at least 240 days must have passed from the date of assessment. Liabilities out of fraud are nondischargeable as are liabilities arising from an IRS-prepared substitute for return. Most courts including the Fourth Circuit deny discharge even if an actual return is filed after a substitute for return. IRS will challenge discharge of tax liabilities (generally with success) of individuals who lead extravagant lifestyles. It appears as if moderate and upper income individuals (beginning typically in upper 5 figures) required to pay a portion of consumer indebtedness over a 5-year period with disposable income pursuant to the Bankruptcy Abuse Prevention and Consumer Protection Act are not required to repay a portion of tax debts as they are not consumer in nature. A lien by IRS against exempt property is unaffected by a bankruptcy as the discharge is only of the person. In Wadleigh v. Commissioner, 134 TC No. 14, the Tax Court determined that IRS could levy on a pension post-bankruptcy as it was not an asset of the bankruptcy estate. 10
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