Last month we looked at Internal Revenue Code (“IRC”) Section 108(a)(1) and the effect of a bankruptcy discharge on taxable income. This month we will examine collateral tax issues arising from a bankruptcy filing.
IRC Section 1398 lists several rules that are applicable to individual Title 11 bankruptcy cases, including filings under both Chapter 7 (liquidations) and Chapter 11 (reorganizations). In general, Section 1398(d)(1) provides that the taxable year of the debtor shall be determined without regard to the bankruptcy case. However, Section 1398(d)(2) allows a taxpayer to make an irrevocable election to treat the debtor’s taxable year which includes the commencement date as two short taxable years: the first short year ends on the day before the commencement date, and the second taxable year begins on the commencement date. The “commencement date” generally means the date a voluntary bankruptcy petition is filed, or the later date when the court enters an order for relief adjudicating the debtor as bankrupt in the event the bankruptcy was involuntary. Internal Revenue Manual (“IRM”) Section 18.104.22.168 (4-17-2013) explains that the “two short years” election is not common, and sets forth the procedural steps to make the election.
Nevertheless, taxpayers should consult with their tax professionals and bankruptcy attorneys to determine whether the election would provide a benefit in their case. A recent opinion explains: “Under the statutory scheme, the consequences of a debtor making the §1398(d)(2) election is to allow the taxing authority to make a claim against the bankruptcy estate for any tax liability arising in the first short year. If, however, the debtor does not make the election, the tax liability for the entire tax year is considered a post-bankruptcy debt for which the taxing authority has no claim against the bankruptcy estate.” In re Medley, 2016 WL 3003642, at *2 (Bankr. M.D. Ala. May 17, 2016).
The estate, on the other hand, may initially choose its own taxable period (i.e., when its first tax year ends), as long as the initial period does not exceed one year.
TAX FORMS & FILING REQUIREMENTS
When an individual debtor files bankruptcy, two taxpayers exist post-petition: (i) the trustee or “Debtor in Possession” (“DIP”), who must file a return (Form 1041) for all income which belongs to the bankruptcy estate, and (ii) the individual debtor, who must file a return (Form 1040) for all income of the debtor which is not part of the estate. IRC § 1398(e) & IRM 22.214.171.124 ¶1. The bankruptcy estate is therefore a separate taxable entity for which a separate Tax Identification Number must be obtained. See also Williams v. Commissioner, 123 T.C. 144, 147-48 (2004). Because the bankruptcy results in two separate taxpayers, losses and deductions generated by one taxpayer may generally not be used to offset income from the other taxpayer. (See below for more details and exceptions.)
Further, when a married couple files a bankruptcy petition jointly, the petition actually creates two separate bankruptcy estates, requiring two Form 1041s. However, the court may substantively consolidate the estates, which would result in only one Form 1041 needing to be filed.
If a bankruptcy debtor’s petition gets dismissed, the effect is as if the bankruptcy petition was never filed. In such a case, the debtor must file amended returns to replace any short year returns already filed or Form 1041s previously filed. IRM 126.96.36.199 ¶4g.
Section 1398 applies only to individual debtors. Partnerships and corporations are governed by IRC Section 1399, which provides that no separate taxable entity shall result from a bankruptcy petition filing when Section 1398 does not apply.
IRC Section 1398(E)(1) addresses how income is allocated between an individual debtor and the bankruptcy estate. Specifically, the bankruptcy estate is entitled to the individual debtor’s income or loss from the bankruptcy commencement date while any items of income or loss received or accrued before the bankruptcy filing remain with the debtor. For example, if a debtor owns S corporation stock and files bankruptcy before the end of the S corporation’s taxable year, gains or losses of the S corporation flow through in their entirety to the bankruptcy estate (generally from the date of the petition to the date the debtor is dismissed or discharged), and K-1s should be issued to the bankruptcy trustee. See Medley, supra at *2.
In general, the bankruptcy estate succeeds to the tax attributes of the debtor determined on the first day of the debtor’s taxable year in which the case commences, and any transfers of assets from the debtor to the estate (or vice versa) are not treated as a disposition. IRC §1398(f). The tax attributes will become part of the estate when the petition is filed. The estate will thus succeed to and must report income from the following sources on Form 1041 (generally from the date of the petition to the date the debtor is dismissed or discharged): (a) wages and other compensation earned as an employee, (b) independent contractor income, (c) self-employment income, and (d) rental income from assets transferred to the estate or from property purchased with income of the estate after filing of the bankruptcy petition. IRM 188.8.131.52 ¶5. Thus, it is vital to determine the source and nature of any income when deciding whether the income is attributed to the estate or the individual debtor.
Additionally, the individual debtor must report the following income sources on his Form 1040 (again, generally from the date of the petition to the date the debtor is dismissed or discharged): (i) rental income from real property purchased using excluded, exempt, or abandoned assets, (ii) rental income from real property using funds obtained from gifts, inheritance, or insurance proceeds received more than 180 days after the bankruptcy petition date, (iii) income from excluded property, such as an ERISA retirement plan, and (iv) self-employment tax on self-employment income earned by the bankruptcy estate and reported on the Form 1041 filed by the estate. In a recent case, the Tax Court held that, where an individual debtor filed for bankruptcy in 2006 and earned self-employment income in 2007, the income would be included on the estate’s Form 1041 and the estate would be liable for income taxes on the income, but the individual debtor would remain responsible for the self-employment taxes on the income and must report self-employment tax (but not self-employment income) on Form 1040. Sisson v. Commissioner, T.C. Memo. 2016-143, at *4-5 (Aug. 1, 2016).
Similarly, the estate will succeed to a number of credits and deductions, including net operating loss carryovers, charitable contribution carryovers, capital loss carryovers, basis in assets, and many other tax attributes of the debtor. IRS §1398(g). When the estate terminates, any remaining tax attributes will revert back to the individual, but first any net operating losses must be reduced by the amount of any discharged debt.
In conclusion, the rules governing taxation of bankruptcy estates and debtors are quite complex. The IRS generally sends Letter 4914, Notice to Individual Chapter 11 Debtor Regarding Income Tax Filing Responsibilities to individual debtors and trustees advising them of their tax responsibilities. However, when a question arises that is not answered by IRS guidance, a debtor should seek assistance as needed. The debtor, trustee, and their respective attorneys and tax professionals should work closely to ensure that all tax obligations are met and that any opportunities for beneficial tax treatment are utilized.
Prepared by: Sandra D. Mertens, Esq. of Dale & Gensburg, P.C., 200 West Adams Street, Suite 2425, Chicago, IL 60606 Phone: 312-263-2200