Bankruptcy
IMPORTANT: A
bankruptcy may not discharge your tax liability.
AN
OFFER IN COMPROMISE WILL DISCHARGE ALL OF THE TAX LIABILITY YOU
CANNOT AFFORD TO PAY!
Call Alvin Brown at
(888) 712-7690 immediately if you are considering bankruptcy.
Publication 908
(7/1996), Bankruptcy
Tax Guide
Revised:
7/1996
Table of Contents
Introduction
This publication covers the federal income tax aspects of bankruptcy.
Bankruptcy proceedings begin with the filing of a petition with the
bankruptcy court. The filing of the petition creates a bankruptcy
estate, which generally consists of all the assets of the person filing
the bankruptcy petition. A separate taxable entity is created if the
bankruptcy petition is filed by an individual under chapter 7 or chapter
11 of the Bankruptcy Code. These chapters are explained later. The tax
obligations of taxable estates are discussed later under The
Bankruptcy Estate.
The tax obligations of the person filing a bankruptcy petition (the debtor)
vary depending on the bankruptcy chapter under which the petition was
filed. For individuals, these are also explained in the first part of
this publication. For other entities, see Partnerships
and Corporations , later.
Generally, when a debt owed to another is canceled the amount canceled or
forgiven is considered income that is taxed to the person owing the
debt. If a debt is canceled under a bankruptcy proceeding, the amount
canceled is not income. However, the canceled debt reduces the amount of
other tax benefits the debtor would otherwise be entitled to. See Debt
Cancellation, later.
This publication is not intended to cover bankruptcy law in general, or to
provide detailed discussions of the tax rules for the more complex
corporate bankruptcy reorganizations or other highly technical
transactions. In these cases, you should seek competent professional
advice.
Useful Items - You may want to see:
Publication
·
536
Net Operating Losses
·
538
Accounting Periods and Methods
·
544
Sales and Other Dispositions of Assets
·
551
Basis of Assets
Form (and Instructions)
·
SS—4
Application for Employer Identification Number
·
982
Reduction of Tax Attributes Due to Discharge of
Indebtedness (and Section 1082 Basis Adjustment)
·
1041
U.S.
Income Tax Return for Estates and Trusts
·
1041—ES
Estimated Income Tax for Fiduciaries
See How
To Get More Information, near the end of this publication
for information about getting these publications and forms.
Individuals in Chapter 12 or 13
A separate estate, for tax purposes, is not created for an individual
who files a petition under Chapter 12 or 13 of the Bankruptcy Code. You,
the individual, should continue to file the same federal income tax
return that was filed prior to the bankruptcy petition.
On your return, report all income received during the entire year and
deduct all allowable expenses. Do not include any debt canceled (because
of bankruptcy) in income on your return. However, you must reduce (to
the extent that you have) certain losses, credits or basis in property
by the amount of canceled debt. See Debt
Cancellation, later.
For information about determining the amount of tax due and paying
tax, see Tax Procedures,
later.
Note:
Interest on trust accounts In Chapter 13
proceedings. If you are an individual debtor
in a chapter 13 wage earner's plan, do not include as income on your
return interest earned on amounts held in trust accounts while awaiting
distribution to your creditors. This interest is not available either to
you or to your creditors. it is available only to the trustees, and is
taxable to the trustee as his or her individual income.
Individuals in Chapter 7 or 11
If you are an individual debtor who files for bankruptcy under chapter
7 or 11 of the Bankruptcy Code, a separate “estate”
is created consisting of property that belonged to you before the filing
date. This bankruptcy estate is a new taxable entity, completely
separate from you as an individual taxpayer.
If a husband and wife file a joint bankruptcy petition and their
estates are jointly administered, treat their estates as separate
entities for tax purposes. Two separate tax returns must
be filed (if they separately meet the filing requirements).
The estate, under a chapter 7 proceeding, is represented by a trustee.
The trustee is appointed by the bankruptcy court to administer the
estate and liquidate your nonexempt assets. In chapter 11, the debtor
remains in control of the assets as a “debtor-in-possession.”
However, sometimes the bankruptcy court will appoint a trustee in a
chapter 11 case. In this case, the debtor-in-possession must turn over
to the trustee control of the debtor's assets and operations.
The estate may produce its own income as well as incur its own
expenses. See The Bankruptcy Estate,
later. The creation of a separate bankruptcy estate also gives you a “fresh
start” —with certain exceptions, wages you earn and property
you acquire after the bankruptcy case has begun belong to you and do not
become a part of the bankruptcy estate.
If your bankruptcy case began but was later dismissed by the
bankruptcy court, the estate is not treated as a separate entity, and
you are treated as if the bankruptcy petition had never been filed in
the first place. File amended returns on Form 1040X to replace any
returns you previously filed. Include on any amended returns items of
income, deductions, or credits that were or would have been reported by
the bankruptcy estate on its returns and were not reported on returns
you previously filed. However, you may not be able to deduct
administrative expenses the former estate could have claimed. Also, the
bankruptcy exclusion cannot be used to exclude debt that was canceled
while you were under the bankruptcy court's protection. But the other
exclusions (such as insolvency) may apply.
Responsibilities of the Individual
Debtor
You, as the individual debtor, generally must file income tax returns
during the period of the bankruptcy proceedings. Do not include on your
return, the income, deductions, or credits belonging to the separate
bankruptcy estate. Also do not include as income on your return, the
debts canceled because of bankruptcy. However, the bankruptcy estate
must reduce certain losses, credits, and the basis in property (to the
extent of these items) by the amount of canceled debt. See Debt
Cancellation, later.
You have the option of ending your tax year on the day before you
filed your bankruptcy petition. This allows the tax due on that short
period return to be a claim against the bankruptcy estate. See Election
to End Tax Year, later.
See Tax Procedures,
later, for information about determining and paying the amount of tax
due.
Tax attributes.
Certain deduction and credit carryovers and decisions that
you made in earlier years are taken over by the bankruptcy estate when
you file for bankruptcy. These include carryovers of deductions, losses,
and credits, your method of accounting, and the basis and holding period
of assets. These are referred to as tax attributes.
When the estate is terminated, you
assume any remaining tax attributes that were taken over by the estate
and generally assume any attributes arising during the administration of
the estate. See Attribute carryovers,
later under The Bankruptcy Estate, for a list of attributes. Also, see Administrative
expenses under The Bankruptcy
Estate for a limitation.
Disclosure of return
information. The bankruptcy estate's income
tax returns are open, upon written request, to inspection by or
disclosure to you the individual debtor. The disclosure is necessary so
that you can properly figure the amount and nature of the tax
attributes, if any, that you must assume when the bankruptcy estate is
terminated.
In addition, your income tax
returns for the year the bankruptcy case begins and for earlier years
are open to inspection by or disclosure to the bankruptcy estate's
trustee. See Disclosure of return
information, later, under The
Bankruptcy Estate.
Transfer of assets to the
estate. Bankruptcy law determines which of your
assets become part of the bankruptcy estate. Generally, all of your
legal and equitable interests become property of the estate. However,
you may “exempt” certain property from
the estate.
A transfer (other than by sale or
exchange) of an asset from you to the bankruptcy estate is not treated
as a “disposition” for income tax
purposes. This means that the transfer does not result in gain or loss,
recapture of deductions or credits, or acceleration of income or
deductions. For example, the transfer of an installment obligation to
the estate would not accelerate gain under the rules for reporting
installment sales.
If you receive any assets from the
bankruptcy estate when it terminates, do not treat the transfer as a
taxable disposition. You treat these assets the same as the bankruptcy
estate would have treated them. This includes using the same basis,
holding period, and character of the assets as the bankruptcy estate did
before it was terminated.
Abandonments.
If you receive abandoned property from the estate, you
receive the same basis in the property that the estate had.
Carrybacks from your
activities. As the individual debtor, you
cannot carry back any net operating loss or credit carryback from a tax
year ending after the bankruptcy case has begun to any tax year ending
before the case began. The estate, however, can carry the loss back to
offset your pre-bankruptcy income.
Election to End Tax Year
If you are an individual debtor and have assets (other than those you
exempt from the bankruptcy estate), you may choose to end your tax year
on the day before the filing of your bankruptcy case. Then your tax year
is divided into 2 “short” tax years of
fewer than 12 months each. The first year ends on the day before the
filing date, and the second year begins with the filing date and ends on
the date your tax year normally ends. Once you make this choice, you may
not change it. Any income tax liability for the first short tax year
becomes an allowable claim (as a claim arising before bankruptcy)
against the bankruptcy estate. If this tax liability is not paid in the
bankruptcy proceeding, the liability is not canceled because of
bankruptcy and it can be collected from you as an individual.
If you do not choose to end the tax year, then no part of your tax
liability for the year in which bankruptcy proceedings begin can be
collected from the estate.
Making the election.
If you choose to end your tax year, you do so by filing a
return on Form 1040 for the first short tax year on or before the 15th
day of the fourth full month after the end of that first tax year.
Example.
John Doe files a bankruptcy petition on July 10. To have a timely
filed election, he must file Form 1040 (or an extension) for the period
January 1 through July 9 by November 15.
To avoid delays in processing the return, write “Section
1398 Election” at the top of the return. You may also make the
election by attaching a statement to an application for extension of
time to file a tax return (Form 4868 or other). The statement must say
that you choose under section 1398(d)(2) to close your tax year on the
day before the filing of the bankruptcy case. You must file the
application for extension by the due date of the return for the first
short tax year. If your spouse decides to also close his or her tax
year, see Election by debtor's
spouse, next.
Election by debtor's
spouse. If you are married, your spouse may
also join in the choice to end the tax year, but only if you and your
spouse file a joint return for the first short tax year. You must make
these choices by the due date for filing the return for the first short
tax year. Once you make the choice, it cannot be revoked for the first
year; however, the choice does not mean that you and your spouse must
file a joint return for the second short tax year.
Later
bankruptcy of spouse. If your spouse
files for bankruptcy later in the same year, he or she may also choose
to end his or her tax year, regardless of whether he or she joined in
the choice to end your tax year. Because each of you has a separate
bankruptcy, one or both of you may have 3 short tax years in the same
calendar year. If your spouse had joined in your choice, or if you had
not made the choice to end your tax year, you can join in your spouses
choice. But if you had made an election and your spouse did not join in
the election, you cannot join in your spouse's later election. This is
because you and your spouse, having different tax years, could not file
a joint return for a year ending on the day before your spouse's filing
of bankruptcy.
Example 1.
Paul and Mary Harris are calendar-year taxpayers. A voluntary chapter
7 bankruptcy case involving only Paul begins on March 4.
If Paul does not make an election, his tax year does not end on March
3. If he does make an election, Paul's first tax year is January
1—March 3, and his second short tax year begins on March 4. Mary could
join in Paul's election as long as they file a joint return for the tax
year January 1—March 3. They must make the election by July 15, the
due date for filing the joint return.
Example 2.
Fred and Ethel Barnes are calendar-year taxpayers. A voluntary chapter
7 bankruptcy case involving only Fred begins on May 6, and a bankruptcy
case involving only Ethel begins on November 1 of the same year.
Ethel could choose to end her tax year on October 31. If Fred had not
elected to end his tax year on May 5, or if he had elected to do so but
Ethel had not joined in his election, Ethel would have 2 tax years in
the same calendar year if she decided to close her tax year. Her first
tax year is January 1—October 31, and her second year is November
1—December 31.
If Fred had not decided to end his tax year as of May 5, he could join
in Ethel's choice to close her tax year on October 31, but only if they
file a joint return for the tax year January 1—October 31. If Fred had
elected to end his tax year on May 5, but Ethel had not joined in Fred's
choice, Fred could not join in Ethel's choice to end her tax year on
October 31, because they could not file a joint return for that short
year. They could not file a joint return because their tax years
preceding October 31 were not the same.
Example 3.
Jack and Karen Thomas are calendar-year taxpayers. A voluntary chapter
7 bankruptcy case involving only Karen begins on April 10, and a
voluntary chapter 7 bankruptcy case involving only Jack begins on
October 3 of the same year. Karen chooses to close her tax year on April
9 and Jack joins in Karen's choice.
Under these facts, Jack would have 3 tax years for the same calendar
year if he makes the election relating to his own bankruptcy case. The
first tax year would be January 1— April 9; the second April
10—October 2; and the third October 3—December 31.
Karen may (but does not have to) join in Jack's election if they file
a joint return for the second short tax year (April 1 0—October 2). If
Karen does join in, she would have the same 3 short tax years as Jack.
Also, if Karen joins in Jack's election, they may file a joint return
for the third tax year (October 3—December 31), but they are not
required to do so.
Annualizing taxable income. If you choose to close your tax year,
you must annualize your taxable income for each short tax year the same
way it is done for a change in an annual accounting period. See Short
Tax Year in Publication 538, Accounting
Periods and Methods, for information on how to annualize
your income and how to figure your tax for the short tax year.
Filing requirement.
If you elect to end your tax year on the day before filing
the bankruptcy case, you must file the return for the first short tax
year as explained earlier under Making
the election.
If you make this election, you
must also file a separate Form 1040 for the second short tax year by the
regular due date. You should note on the return that it is the “Second
Short Year Return After Section 1398 Election.”
If the bankruptcy case is later
dismissed, you (the debtor) must file an amended return to replace any
full or short year returns that you filed. Attach a statement to any
amended return you file explaining why you are filing an amended return.
In this situation, no bankruptcy estate is created for tax purposes.
Income that was or would be reported by the bankruptcy estate must be
reported on your return.
The Bankruptcy Estate
The filing of a bankruptcy petition for an individual debtor under
chapter 7 or chapter 11 of the bankruptcy code creates a separate
taxable bankruptcy estate. The trustee (for chapter 7 cases) or the
debtor-in-possession (for chapter 11 cases) is generally responsible for
preparing and filing the estate's tax returns and paying its taxes. The
debtor remains responsible for filing returns and paying taxes on any
income that does not belong to the estate.
If a bankruptcy case begins, but later is dismissed by the bankruptcy
court, the estate is not treated as a separate taxable entity. If tax
returns have been filed for the estate, amended returns must be filed to
move income and deductions from the estate's returns to the debtor's
returns. If no returns have been filed, report all income and deductions
on the debtor's returns.
The following discussions provide tax information for the bankruptcy
estate.
Treatment of income,
deductions, and credits. The gross income of
the bankruptcy estate includes any of the debtor's gross income to which
the estate is entitled under the bankruptcy law. The estate's gross
income also includes any income the estate is entitled to and receives
or accrues after the beginning of the bankruptcy case. Gross income of
the bankruptcy estate does not include amounts received or accrued by
the debtor before the bankruptcy petition date.
The bankruptcy estate may deduct
or take as a credit any expenses it pays or incurs, the same way that
the debtor would have deducted or credited them had he or she continued
in the same trade, business, or activity and actually paid or accrued
the expenses. Allowable expenses include administrative expenses, such
as attorney fees and court costs. These are discussed later under Administrative
expenses.
The bankruptcy estate figures its
taxable income the same way as an individual figures his or her taxable
income. The estate can take one personal exemption and either individual
(itemized) deductions or the basic standard deduction for a married
individual filing a separate return. The estate cannot take the higher
standard deduction allowed for married persons filing separately who are
65 or older or blind. The estate uses the rates for a married individual
filing separately to figure the tax on its taxable income.
Transfer of assets between
debtor and estate. Bankruptcy law
determines which of the debtor's assets become part of the bankruptcy
estate. These assets are treated the same in the estate's hands as they
were in the debtor's hands.
A transfer (other than by sale or
exchange) of an asset from the debtor to the bankruptcy estate is not
treated as a “disposition” for income tax
purposes. This means that the transfer does not result in gain or loss,
recapture of deductions or credits, or acceleration of income or
deductions. For example, the transfer of an installment obligation to
the estate would not accelerate gain under the rules for reporting
installment sales. The estate is treated the same way the debtor would
be regarding the transferred asset.
When the bankruptcy estate is
terminated, that is, dissolved, any resulting transfer (other than by
sale or exchange) of the estate's assets back to the debtor is not
treated as a disposition. This 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.
Attribute carryovers.
The bankruptcy estate must treat its tax attributes the same
way that the debtor would have treated them. These items must be
determined as of the first day of the debtor's tax year in which the
bankruptcy case begins. The bankruptcy estate gets the following tax
attributes from the debtor:
1.
Net
operating loss carryovers,
2.
Carryovers
of excess charitable contributions,
3.
Recovery
of tax benefit items,
4.
Credit
carryovers,
5.
Capital
loss carryovers,
6.
Basis,
holding period, and character of assets,
7.
Method
of accounting,
8.
Passive
activity loss and credit carryovers,
9.
Unused
at-risk deductions, and
10.
Other
tax attributes as provided in regulations.
Certain tax attributes of the
estate must be reduced by any excluded income from cancellation of debt
occurring in a bankruptcy proceeding. See Debt Cancellation, later.
Termination
of the estate. If the bankruptcy
estate has any tax attributes at the time it is terminated, they are
assumed by the debtor.
Passive
and at-risk activities. For bankruptcy
cases beginning on or after November 9,1992, treat passive activity
carryover losses and credits and unused at-risk deductions as tax
attributes that the debtor passes to the bankruptcy estate and the
estate passes back to the debtor when the estate terminates.
Additionally, transfers to the debtor (other than by sale or exchange)
of interests in passive or at-risk activities are treated as exchanges
that are not taxable. These transfers include the return of exempt
property to the debtor and the abandonment of estate property to the
debtor.
Cases
beginning before
November 9, 1992
.
If a bankruptcy case begins before November 9,1992, and ends
on or after that date, the debtor and the trustee for an individual
chapter 7 case (the debtor-in-possession for an individual chapter 11
case) can elect to have these provisions apply. In a chapter 7 case, the
election is made jointly by the debtor and the trustee of the bankruptcy
estate. In a chapter 11 case, the election is incorporated in the
bankruptcy plan. See
IRS
regulations 1.1398—1 and 1.1398—2 for more information on how to
make this election.
Administrative expenses.
The bankruptcy estate is allowed a deduction for
administrative expenses and any fees or charges assessed it. These
expenses are generally deductible as itemized deductions subject to the
2% floor on miscellaneous itemized deductions. However, administrative
expenses attributable to the conduct of a trade or business by the
bankruptcy estate or the production of the estate's rents or royalties
are deductible in arriving at adjusted gross income.
The expenses are subject to
disallowance under other provisions of the lnternal Revenue Code, such
as disallowing certain capital expenditures, taxes, or expenses relating
to tax exempt interest. These expenses can only be deducted by the
estate, and never by the debtor.
If the administrative expenses of
the bankruptcy estate are more than its gross income for the tax year,
the excess amount may be carried back 3 years and forward 7 years. The
amounts can only be carried back or forward to a tax year of the estate
and never to the debtor's tax year. The excess amount to be carried back
or forward is treated like a net operating loss and must first be
carried back to the earliest year possible. For a discussion of the net
operating loss, see Publication 536, Net
Operating Losses.
Change of accounting
period. The bankruptcy estate may change its
accounting period (tax year) once without getting approval from the
internal Revenue Service. This rule allows the trustee of the estate to
close the estate's tax year early, before the expected termination of
the estate. The trustee can then file a return for the first short tax
year to get a quick determination of the estate's tax liability.
Carrybacks from the estate. If the bankruptcy estate itself has a
net operating loss, separate from any losses passing to the estate from
the debtor under the attribute carryover rules, the bankruptcy estate
can carry the loss back not only to its own earlier tax years but also
to the debtor's tax years before the year the bankruptcy case began. The
estate may also carry back excess credits, such as the general business
credit, to the pro-bankruptcy years.
Return Requirements and Payment of
Tax
The trustee (or debtor-in-possession) must file an income tax return
on Form 1041, U.S. Income Tax Return
for Estates and Trusts if the estate has gross income that
meets or exceeds the amount required for filing. This amount is the
total of the personal exemption amount and the basic standard deduction
for a married individual filing separately. See the Form 1041
instructions for the current year's amount.
If a return is required, the trustee (or debtor-in-possession)
completes the identification area at the top of the Form 1041 and lines
23—29 and signs and dates it. Form 1041 is a transmittal for Form
1040, U.S. individual Income Tax
Return. Complete Form 1040 and figure the tax using the tax
rate schedule for a married person filing separately. In the top margin
of Form 1040, write “Attachment to Form 1041. DO
NOT DETACH.” Attach Form 1040 to the Form 1041.
Note:
The filing of a tax return for the bankruptcy estate does not relieve
the individual debtor of his or her tax filing requirement.
Estimated tax.
The trustee or debtor-in-possession must pay estimated tax
(if any is due) for the bankruptcy estate. See the Instructions to Form
1041—ES, Estimated income Tax for
Fiduciaries, for information regarding the dollar limits and
exceptions to filing Form 1041— ES and paying estimated tax.
Employer identification
number. The trustee (or debtor-in-possession)
must obtain an employer identification number (EIN) for a bankruptcy
estate if the estate must file any form, statement, or document with the
IRS
. The trustee uses this EIN on any tax return filed for the bankruptcy
estate including estimated tax returns. The trustee can obtain an EIN
for a bankruptcy estate by filing Form SS— 4, Application
for Employer Identification Number. Form SS—4 is available
at
IRS
or Social Security Offices. Trustees representing ten or more bankruptcy
estates (other than estates that will be filing employment or excise tax
returns) may file a consolidated application to obtain blocks often or
more EINs by following the procedures set out in Revenue
Procedure89—37, 1989—1 C.B. 919.
Note:
The social security number of the individual debtor cannot
be used as the EIN for the bankruptcy estate.
Employment taxes.
The trustee (or debtor in-possession) must withhold income
and social security taxes and tile employment tax returns for any wages
paid by the trustee (or debtor), including wage claims paid as
administrative expenses. Until these employment taxes are deposited as
required by the Internal Revenue Code, they should be set apart in a
separate bank account to ensure that funds are available to satisfy the
liability. If the employment taxes are not paid as required, the trustee
may be held personally liable for payment of the taxes. See Publication
15, Circular E, Employer's Tax Guide,
for details on employer tax responsibilities.
The trustee has the duty to
prepare and file Forms W—2, Wage and Tax Statement, in connection with
wage claims paid by the trustee, regardless of whether the claims
accrued before or during bankruptcy. If the debtor fails to prepare and
file Forms W—2 for wages paid before bankruptcy, the trustee should
instruct the employees to file an
IRS
Form 4852, SUBSTITUTE FOR
FORM
W-2, WAGE
AND
TAX STATEMENT OR
FORM
1099R, DISTRIBUTIONS FROM PENSIONS, ANNUITIES, RETIREMENT OR
PROFIT-SHARING PLANS, IRA'S, INSURANCE CONTRACTS,
ETC
., with their individual income tax returns.
Disclosure of return
Information. The debtor's income tax returns
for the year the bankruptcy case begins and for earlier years are, upon
written request, open to inspection by or disclosure to the trustee. If
the bankruptcy case was not voluntary, disclosure cannot be made before
the bankruptcy court has entered an order for relief, unless the court
rules that the disclosure is needed for determining whether relief
should be ordered.
For information concerning the
disclosure of the bankruptcy estate's tax return see Disclosure
of return in formation, earlier, under Responsibilities
of the Individual Debtor.
Example.
Cautlon.
This publication is not revised annually. Future changes to
the forms and their instructions may not be reflected in this example.
On
December 15, 1994
, Thomas Smith filed a bankruptcy petition under chapter 7. Joan Black
was appointed trustee to administer the estate and to distribute the
assets.
The estate received the following
assets from Mr. Smith:
1.
A
$100,000 certificate of deposit,
2.
Commercial
rental real estate with a fair market value of $280,000, and
3.
His
personal residence with a fair market value of $200,000.
Also, the estate received a
$251,500 capital loss carryover.
Mr. Smith's bankruptcy case was
closed on
December 31, 1995
. During 1995, Mr. Smith was relieved of $70,000 of debt by the court.
The estate chose a calendar year as its tax year. Joan, the trustee,
reviews the estate's transactions and reports the taxable events on the
estate's final return.
Schedule B (Form 1040).
The certificate of deposit earned $5,500 of interest during
1995. Joan reports this interest on Schedule B. She completes this
schedule and enters the result on Form 1040.
Form 4562.
Joan enters the depreciation allowed on Form 4562. She
completes the form and enters the result on Schedule E.
Schedule E (Form 1040).
The commercial real estate was rented through the date of
sale. Joan reports the income and expenses on Schedule E. She enters the
net income on Form 1040.
Form 4797.
The commercial real estate was sold on
July 1, 1995
, for $280,000. The property was purchased in 1983 at a cost of
$250,000. It was depreciated using straight line depreciation and the
total depreciation allowed or allowable as of the date of sale was
$120,000. Additionally, $25,000 of selling expenses were incurred. She
reports the gain or loss from the sale on Form 4797. She completes the
form and enters the gain on Schedule D (Form 1040).
Form 2119. Mr.
Smith's former residence was sold on
September 30, 1995
. The sale price was $200,000, the selling expenses were $20,000 and his
adjusted basis was $130,000. Joan enters this information on Form 2119.
Joan completes Form 2119 and enters the gain on Schedule D (Form 1040).
Schedule D (Form 1040).
Joan completes Schedule D, taking into account the $250,000
capital loss carryover from 1994 ($251,500 transferred to the estate
minus $1,500 used on the estate's 1994 return). She enters the results
on Form 1040.
Form 1040, page 1.
Joan completes page 1 of the 1040 and enters the adjusted
gross income on the first line of Form 1040, page 2.
Schedule A (Form 1040).
During 1995, the estate paid mortgage interest and real
property tax on Mr. Smith's former residence. It also paid income tax to
the state. Joan enters the mortgage interest, real estate tax and income
tax on Schedule A. Also, she reports the estate's administrative
expenses as a miscellaneous deduction subject to the 2% floor. She
completes the Schedule A and enters the result on page 2 of Form 1040.
Form 1040, page 2.
Joan determines the estate's taxable income and figures its
tax using the tax rate schedule for married filing separately. She then
enters the estate's estimated tax payments and figures the amount the
estate still owes.
Form 982.
Joan completes the Schedule D worksheet for capital loss
carryover. Because $70,000 of debt was canceled, Joan must reduce the
tax attributes of the estate by the amount of the canceled debt. See Debt
Cancellation, later. In 1996, Thomas Smith (the individual)
will assume the estate's tax attributes. Mr. Smith will assume a capital
loss carryover of $3,500 ($73,500 carryover minus the $70,000 attribute
reduction).
Form 1041.
Joan enters the total tax, estimated tax payments, and tax
due from Form 1040 on Form 1041. She completes the identification area
at the top of Form 1041, then signs and dates the return.
Sample Form 1040 - page 1
Sample Form 1040 - page 2
Sample Schedule A
Sample Schedule B
Sample Schedule D
Sample Schedule E
Sample Form 2119
Sample Form 4797 - page 1
Sample Form 4797 - page 2
Sample Form 4562
Sample Form 982 - page 1
Sample Capital Loss Carryover Worksheet
Sample Form 1041
Sample Form 982 - page 2
Partnerships and Corporations
A separate taxable estate is not created when a partnership or
corporation files a bankruptcy petition. The court appointed trustee is,
however, responsible for filing the regular income tax returns on Form
1065 or Form 1120.
Partnerships
The filing requirements for a partnership in bankruptcy proceedings do
not change. However, the filing of required returns becomes the
responsibility of an appointed trustee, receiver, or a
debtor-in-possession rather than a general partner.
A partnership's debt that is canceled because of bankruptcy is not
included in the partnership's income. It may or may not be included in
the individual partners' income. See Partnerships, later under Debt
Cancellation.
Corporations
The following discussion covers only the highlights of the bankruptcy
tax rules applying to corporations. Because the details of corporate
bankruptcy reorganizations are beyond the scope of this publication, you
may want to seek the help of a professional tax advisor.
See Corporations under Debt
Cancellation, for information about a corporation's debt
canceled because of bankruptcy.
Tax-Free Reorganizations
The tax-free reorganization provisions of the Internal Revenue Code
apply to a transfer by a corporation of all or part of its assets to
another corporation in a title 11 or similar case, but only if, under
the reorganization plan, stock or securities of the corporation to which
the assets are transferred are distributed in a transaction qualifying
under IRC section 354, 355, or 356.
A “title 11 or similar case,” for this
purpose, is a bankruptcy case under title 11 of the United States Code,
or a receivership, foreclosure, or similar proceeding in a federal or
state court, but only if the corporation is under the jurisdiction of
the court in the case and the transfer of assets is under a plan of
reorganization approved by the court. In a receivership, foreclosure, or
similar proceeding before a federal or state agency involving certain
financial institutions, the agency is treated as a court.
Generally, section 354 provides that no gain or loss is recognized if
a corporation's stock is exchanged solely for stock or securities in the
same or another corporation under a qualifying reorganization plan. In
this case, shareholders in the bankrupt corporation would recognize no
gain or loss if they exchange their stock solely for stock or securities
of the corporation acquiring the bankrupt's assets.
Section 355 generally provides that no gain or loss is recognized by a
shareholder if a corporation distributes solely stock or securities of
another corporation that the distributing corporation controls
immediately before the distribution. Section 356 provides that in an
exchange that would qualify under section 354 or 355 except that other
property or money besides the permitted stock or securities is received
by the shareholder, gain is recognized by the shareholder only to the
extent of the money and the fair market value of the other property
received. No loss is recognized in this situation.
Filing Requirements
The filing requirements of a corporation involved in bankruptcy
proceedings do not change. However, the filing of required returns
becomes the responsibility of an appointed trustee, receiver, or a
debtor-in-possession, rather than a corporate officer.
Exemption from tax return
filing. If you are a trustee, receiver, or an
assignee of a corporation that is in bankruptcy, receivership,
dissolution, or in the hands of an assignee by court order, you may
apply to your
IRS
District Director for relief from filing federal income tax returns for
the corporation. To qualify, the corporation must have ceased business
operations and must have neither assets nor income.
Your request to the District
Director must include the name, address, and employer identification
number of the corporation and a statement of the facts (with any
supporting documents) showing why you need relief from the filing
requirements. You must also include a statement that you are making the
request and furnishing the information under penalties of perjury. The
District Director will act on your request within 90 days.
Personal Holding Company Tax
A corporation that is subject to the jurisdiction of the cout in a
title 11 or similar case is exempt from the personal holding company
tax, unless the main reason for beginning or continuing this case is to
avoid paying this tax. A“ title 11 or similar case”
is defined earlier under Tax-Free
Reorganizations.
Tax Procedures
The following section discusses the procedures for determining the
amount of tax due from the debtor or the bankruptcy estate, paying the
tax claim, and obtaining a discharge of the tax liability.
Determination of Tax
The first step in the determination of the tax due is filing a return.
As an individual bankrupt debtor, you file a Form 1040 for the tax year
involved, and the trustee of your bankruptcy estate files a Form 1041,
as explained earlier under Individuals
in Chapter 7 or 11. A bankrupt corporation, or a receiver,
bankruptcy trustee, or assignee having possession of, or holding title
to, substantially all the property or business of the corporation, files
a Form 1120 for the tax year.
After the return is filed, the Internal Revenue Service may
redetermine the tax liability shown on the return. When the
administrative remedies within the Service have been exhausted, the tax
issue may be litigated either in the bankruptcy court or in the U.S. Tax
Court, as explained in the following discussion.
Request for prompt
determination of tax liability by the trustee.
The trustee of the bankruptcy estate may request a
determination of any unpaid liability of the estate for tax incurred
during the administration of the case by the filing of a tax return and
a request for such a determination with the internal Revenue Service.
Unless the return is fraudulent or contains a material
misrepresentation, the trustee, the debtor, and any successor to the
debtor are discharged from liability for the tax upon payment of the
tax:
1.
As
determined by the Internal Revenue Service,
2.
As
determined by the bankruptcy court, after the completion of the
IRS
examination, or
3.
As
shown on the return, if the
IRS
does not:
a.
Notify
the trustee within 60 days after the request for the determination that
the return has been selected for examination, or
b.
Complete
the examination and notify the trustee of any tax due within 180 days
after the request (or any additional time permitted by the bankruptcy
court).
Making
the request for determination.
To request a prompt determination of any unpaid tax
liability of the estate, the trustee must file a written application for
the determination with the
IRS
District Director for the district in which the bankruptcy case is
pending. The application must be submitted in duplicate and executed
under the penalties of perjury. The trustee must submit with the
application an exact copy of the return (or returns) filed by the
trustee with the
IRS
for a completed tax period, and a statement of the name and location of
the office where the return was filed. On the envelope write “Personal
Attention of the Special Procedures Function.
DO NOT OPEN IN MAILROOM.”
The
IRS
examination function will notify the trustee within 60 days from receipt
of the application whether the return filed by the trustee has been
selected for examination or has been accepted as filed. If the return is
selected for examination, it will be examined as scon as possible. The
examination function will notify the trustee of any tax due within 180
days from receipt of the application or within any additional time
permitted by the bankruptcy court.
Bankruptcy court
jurisdiction. Generally, the bankruptcy court
has authority to determine the amount or legality of any tax imposed on
the debtor or the estate, including any fine, penalty, or addition to
tax, whether or not the tax was previously assessed or paid.
The
bankruptcy court does not have authority to determine the amount
or legality of a tax, fine, penalty, or addition to tax that was
contested before and finally decided by a court or administrative
tribunal of competent jurisdiction (that became res
Judicata) before the date of filing the bankruptcy petition.
Also, the bankruptcy court does
not have authority to decide the right of the bankruptcy estate to a tax
refund until the trustee of the estate properly requests the refund from
the Internal Revenue Service and either the Service determines the
refund or 120 days pass after the date of the request.
If you (the debtor) have already
claimed a refund or credit for an overpayment of tax on a properly filed
return or claim for refund, the trustee may rely on that claim.
Otherwise, if the credit or refund was not claimed by you, the trustee
may make the request by filing the appropriate original or amended
return or form with the District Director for the district in which the
bankruptcy case is pending. On the return or claim for refund write “Personal
Attention of the Special Procedures Function. DO
NOT OPEN IN MAILROOM.”
The appropriate form for the trustee to use in making the claim for
refund is as follows:
1.
For
income taxes for which an individual debtor had filed a Form 1040, Form
1040A, or Form 1 040 EZ, the trustee should use a Form 1 040X, Amended
U.S. Individual Income Tax Return.
2.
For
income taxes for which a corporate debtor had filed a Form 1120, the
trustee should use a Form 1120X, Amended
U.S. Corporation Income Tax Return.
3.
For
income taxes for which a debtor had filed a form other than Form 1040,
Form 1040A, Form 1O4OEZ, or Form 1120, the trustee should use the same
type of form that the debtor had originally filed, and write “Amended
Return” at the top of the form.
4.
For
taxes other than certain excise taxes or income taxes for which the
debtor had filed a return, the trustee should use a Form 843, Claim
for Refund and Request for Abatement, attaching an exact
copy of any return that is the subject of the claim along with a
statement of the name and location of the office where the return was
filed.
5.
For
excise taxes you reported on Forms 720,730, or 2290, the trustee should
use Form 8849, Claim for Refund of
Excise Taxes or Schedule C of Form 720, whichever is
appropriate.
6.
For
overpayment of taxes of the bankruptcy estate incurred during the
administration of the case, the trustee may choose to use a properly
executed tax return (for income taxes, a Form 1041) as a claim for
refund or credit.
The
IRS
examination function, if requested by the trustee or
debtor-in-possession as discussed later, will examine the appropriate
amended return, claim, or original return tiled by the trustee on an
expedite basis, and will complete the examination and notify the trustee
of its decision within 120 days from the date of filing of the claim.
Tax Court jurisdiction.
The filing of a bankruptcy petition automatically results in
a stay (suspension) of any U.S. Tax Court proceeding to determine your
tax liability as the debtor. This stay continues until one of the acts
removing it occurs. The stay may be lifted by the bankruptcy court upon
your request, the request of the
IRS
, or the request of any other party in interest. Because the bankruptcy
court has power to lift the stay and allow you to begin or continue a
Tax Court case involving your tax liability, the bankruptcy court has,
in effect, during the pendency of the stay, the sole authority to
determine whether the tax issue is decided in the bankruptcy court
itself or in the Tax Court.
Suspension
of time for filing. In any bankruptcy
case, the 90—day period for filing a Tax Court petition, after the
issuance of the statutory notice of deficiency, is suspended for the
time you are prevented from filing the petition because of the
bankruptcy case, and for 60 days thereafter. However, even if the
statutory notice was issued before the bankruptcy petition was filed,
the suspension exists if any part of the 90—day period remained at the
date the bankruptcy petition was filed.
Trustee
may intervene. The trustee of your
bankruptcy estate in any title 11 bankruptcy case may intervene, on
behalf of the estate, in any proceeding in the U.S. Tax Court to which
you are a party.
Tax assessment.
Generally, the automatic stay rules prevent a creditor from
taking actions to collect prepetition debts. However, the automatic stay
does not apply to:
1.
An
audit to determine tax liability,
2.
A
demand for tax returns,
3.
The
issuance of a notice of deficiency to the debtor, or
4.
The
making of an assessment for any tax and the sending of a notice and
demand for payment of the tax assessed (for bankruptcy cases filed after
October 22, 1994
).
Any tax lien that attaches to the
estate's property because of an assessment described above can only take
effect when the property (or its proceeds) are transferred back to the
debtor. Also, the tax must be the debtor's debt that will not be
discharged in the case.
Disclosure of return
information. In bankruptcy cases other than
those of individuals filing under chapter 7 or 11, and in receivership
proceedings where substantially all the debtor's property is in the
hands of the receiver, current and earlier returns of the debtor are,
upon written request, open to inspection by or disclosure to the trustee
or receiver, but only if the Internal Revenue Service finds that the
trustee or receiver has a material interest which will be affected by
information on the return.
Payment of Tax Claim
After the filing of a bankruptcy petition and during the period the
debtor's assets or those of the bankruptcy estate are under the
jurisdiction of the bankruptcy court, these assets are not subject to
levy. The Internal Revenue Service may file a proof of claim in the
bankruptcy court the same way as other creditors. This claim may be
presented to the bankruptcy court even though the taxes have not yet
been assessed or are subject to a Tax Court proceeding.
Eighth priority taxes.
In bankruptcy, the debtor's debts are assigned priorities
for payment. Most of the prepetition tax debts are classified as eighth
priority claims. Generally, prepetition taxes
are certain income and other taxes that the debtor is considered to owe
before he or she files a bankruptcy petition.
The following federal taxes, if
unsecured, are prepetition eighth priority taxes of the government:
1.
Income
taxes for tax years ending on or before the date of filing the
bankruptcy petition, for which a return is due (including extensions)
within 3 years of the tiling of the bankruptcy petition.
2.
Income
taxes assessed within 240 days before the date of filing the petition.
This 240-day period is increased by any time, plus 30 days, during which
an offer in compromise with respect to these taxes was pending, that was
made within 240 days after the assessment.
3.
Income
taxes that were not assessed before the petition date, but were
assessable as of the petition date, unless these taxes were still
assessable solely because no return, a late return (within 2 years of
the filing of the bankruptcy petition), or a fraudulent return was
filed.
4.
Withholding
taxes for which you are liable in any capacity.
5.
Employer's
share of employment taxes on wages, salaries, or commissions (including
vacation, severance, and sick leave pay) paid as priority claims under
11
USC
507(a)(3) or for which a return is due within 3 years of the filing of
the bankruptcy petition, including a return for which an extension of
the filing date was obtained.
6.
Excise
taxes on transactions occurring before the date of filing the bankruptcy
petition, for which a return, if required, is due (including extensions)
within 3 years of the filing of the bankruptcy petition. If a return is
not required, these excise taxes include only those on transactions
occurring during the 3 years immediately before the date of filing the
petition.
Priority of payment.
For a chapter 7 case, the preceding eighth priority
prepetition taxes may be paid out of the assets of the bankruptcy estate
to the extent there are assets remaining after paying the claims of
secured creditors and other creditors having higher priority claims.
Different rules apply to payment
of eighth priority prepetition taxes under chapters 11, 12, and 13:
1.
In
chapter 11, the debtor can pay these taxes over a period of 6 years from
the date of assessment, including interest,
2.
In
chapter 12, the debtor can pay such tax claims in deferred cash payments
over time, and
3.
In
chapter 13, the debtor can pay such taxes over 3 years (or over 5 years
with court approval).
Certain taxes are assigned a
higher priority for payment. Taxes incurred during administration by the
bankruptcy estate are paid first, as administrative expenses. Taxes
arising in the ordinary course of your business or financial affairs in
an involuntary bankruptcy case, after
the filing of the bankruptcy petition but before the earlier of the
appointment of a trustee or the order for relief are included in the
second priority of payment. The employee's portion of the employment
taxes on the first $4,000 (to be adjusted
4/1/98
) described in (5) above is included in the third priority.
Relief from penalties.
A penalty for failure to pay tax, including failure to pay
estimated tax, will not be imposed for any period during which a title
11 bankruptcy case is pending, under the following conditions. If the
tax was incurred by the bankruptcy estate, the penalty will not be
imposed if the failure to pay resulted from an order of the court
finding probable insufficiency of funds of the estate to pay
administrative expenses. If the tax was incurred by you as the debtor,
the penalty will not be imposed if:
1.
The
tax was incurred before the earlier of the order for relief or (in an
involuntary case) the appointment of a trustee, and
2.
The
bankruptcy petition was filed before the due date for the tax retum
(including extensions) or the date for imposing the penalty occurs on or
after the day the bankruptcy petition was filed.
This relief from the
failure-to-pay penalty does not apply to any penalty for failure to pay
or deposit tax withheld or collected from others and required to be paid
over to the U.S. government. Nor does it apply to any penalty for
failure to timely file a return.
FUTA credit.
An employer is generally allowed a credit against the
federal unemployment tax (FUTA) for contributions made to a state
unemployment fund, if the contributions are paid by the last day for
filing an unemployment tax return for the tax year. If the contributions
to the state fund are paid after that date, generally only 90% of the
otherwise allowable credit may be taken against the federal unemployment
tax.
However, for any unemployment tax
on wages paid by the trustee of a title 11 bankruptcy estate, if the
failure to pay the state unemployment contributions on time was without
fault by the trustee, the full amount of the credit is allowed.
Statute of limitations for
collection. In a title 11 bankruptcy case,
the period of limitations for collection of tax (generally, 10 years
after assessment) is suspended for the period during which the Internal
Revenue Service is prohibited from collecting, plus 6 months thereafter.
Discharge of Unpaid Tax
Debts are divided into two categories; dischargeable and
nondischargeable. Dischargeable debts are those that the debtor is no
longer personally liable to pay after the bankruptcy proceedings are
concluded. Nondischargeable debts are those that are not canceled
because of the bankruptcy proceedings. The debtor remains personally
liable for their payment.
As a general rule, there is no discharge
for you as an individual debtor at the termination of a bankruptcy case
for the second and eighth priority taxes described earlier, or for taxes
for which no return, a late return (filed within 2 years of the filing
of the bankruptcy petition), or a fraudulent return was filed. However,
claims against you for other taxes predating the bankruptcy petition by
more than 3 years may be discharged. However, if the
IRS
has a lien on the debtor's property, this property may be seized to
collect discharged tax debts.
Exception for Individuals
with regular Income. If you complete all
payments under a chapter 13 debt adjustment plan for an individual with
regular income, the court may grant you a discharge of debts, including
a discharge of the second and eighth priority prepetition taxes
described earlier. However, if you fail to complete all payments under
the plan, these taxes are not discharged although the court may grant a
discharge of other debts in limited circumstances.
Debt Cancellation
If a debt is canceled or forgiven, other than as a gift or bequest,
the debtor generally must include the canceled amount in gross income
for tax purposes. A debt includes any indebtedness for which the debtor
is liable or which attaches to property the debtor holds.
Exceptions and Exclusions
There are several exceptions and exclusions from the inclusion of
canceled debt in income. The exceptions include:
1.
The
cancellation of a student loan for a student required to work for
certain employers. See Cancellation
of student loan in Publication 525, Taxable and Nontaxable Income.
2.
The
cancellation of debt that would have been deductible if paid.
3.
The
reduction of a debt by the seller of property if the debt arose from the
purchase of the property.
The exclusions are discussed next.
Exclusions
Do not include a canceled debt in
gross income if any of the following situations apply:
·
The
cancellation takes place in a bankruptcy case under the U.S. Bankruptcy
Code. See Bankruptcy case exclusion,
later.
·
The
cancellation takes place when you are insolvent (see
Insolvency exclusion, later), and the amount excluded is not
more than the amount by which you are insolvent.
·
The
canceled debt is qualified farm debt (debt incurred in operating a
farm). See chapter 4 of Publication 225, Farmer's
Tax Guide.
·
The
canceled debt is qualified real property business indebtedness (certain
debt connected with business real property). See Publication 525, Taxable
and Nontaxable Income.
Order of exclusions.
If the cancellation of debt occurs in a title 11 bankruptcy
case, the bankruptcy exclusion takes precedence over the insolvency,
qualified farm debt, or qualified real property business indebtedness
exclusions.
To the extent that the taxpayer is
insolvent, the insolvency exclusion takes precedence over qualified farm
debt or qualified real property business indebtedness exclusions.
Bankruptcy case exclusion.
A bankruptcy case is a case under title 11 of the United
States Code, but only if the debtor is under the jurisdiction of the
court and the cancellation of the debt is granted by the court or occurs
as a result of a plan approved by the court.
None of the debt canceled in a
bankruptcy case is included in your gross income in the year canceled.
Instead, certain losses, credits, and basis of property must be reduced
by the amount of excluded income (but not below zero). These losses,
credits, and basis in property are called tax attributes and are
discussed under Reduction of Tax
Attributes, later.
Insolvency exclusion.
You are insolvent when, and to the extent, your liabilities
exceed the fair market value of your assets. Determine your liabilities
and the fair market value of your assets immediately before the
cancellation of your debt to determine whether or not you are insolvent
and the amount by which you are insolvent.
Exclude from your gross income
debt canceled when you are insolvent, but only up to the amount by which
you are insolvent. However, you must
use the amount excluded to reduce certain tax attributes, as explained
later under Reduction of Tax
Attributes.
Example.
$4000 of the Simpson Corporation's liabilities are cancelled outside
bankruptcy. Immediately before the cancellation, the Simpson
Corporation's liabilities totaled $21,000 and the fair market value of
its assets was $17,500. Because its liabilities were more than its
assets, it was insolvent. The amount of the insolvency was $3,500
($21,000 — $17,500).
The corporation may exclude only $3,500 of the $4,000 debt
cancellation from income because that is the amount by which it was
insolvent. It must also reduce certain tax attributes by the $3,500 of
excluded income. The remaining $500 of canceled debt must be included in
income.
Reduction of Tax Attributes
If a debtor excludes canceled debt from income because it is canceled
in a bankruptcy case or during insolvency, he or she must
use the excluded amount to reduce certain “tax
attributes.” Tax attributes include the basis of certain assets
and the losses and credits listed next. By reducing these tax
attributes, tax on the canceled debt is in part postponed instead of
being entirely forgiven. This prevents an excessive tax benefit from the
debt cancellation.
If a separate bankruptcy estate was created, the trustee or
debtor-in-possession must reduce the estate's attributes (but not below
zero) by the canceled debt. See
individuals under chapter 7 or chapter 11, later.
Order of reduction.
Generally, use the amount of canceled debt to reduce the tax
attributes in the order listed below. However, you may choose to use all
or a part of the amount of canceled debt to first reduce the basis of
depreciable property before reducing the other tax attributes. This
choice is discussed later.
Net
operating loss. First, reduce any net
operating loss for the tax year in which the debt cancellation takes
place, and any net operating loss carryover to that tax year.
General
business credit carryovers.
Second, reduce any carryovers, to or from the tax year of
the debt cancellation, of amounts used to determine the general business
credit.
Minimum
tax credit. Third, reduce any
minimum tax credit that is available as of the beginning of the tax year
following the tax year of the debt cancellation.
Capital
losses. Fourth, reduce any net capital
loss for the tax year of the debt cancellation, and any capital loss
carryover to that year.
Basis.
Fifth, reduce the basis of your property as described under Basis
Reduction, later. This reduction applies to the basis of
both depreciable and nondepreciable property.
Passive
activity loss and credit carryovers.
Sixth, reduce any passive activity loss or credit carryover
from the tax year of the debt cancellaton.
Foreign
tax credit. Last, reduce any
carryover, to or from the tax year of the debt cancellation, of an
amount used to determine the foreign tax credit or the Puerto Rico and
possession tax credit.
Amount of reduction.
Except for the credit carryovers, reduce the tax attributes
listed earlier one dollar for each dollar of canceled debt that is
excluded from income. Reduce the credit carryovers by 33⅓ cents
for each dollar of canceled debt that is excluded from income.
Making the reduction.
Make the required reductions in tax attributes after
figuring the tax for the tax year of the debt cancellation, in reducing
net operating losses and capital losses, first reduce the loss for the
tax year of the debt cancellation, and then any loss carryovers to that
year in the order of the tax years from which the carryovers arose,
starting with the earliest year. Make the reductions of credit
carryovers in the order in which the carryovers are taken into account
for the tax year of the debt cancellation.
Individuals under chapter 7
or chapter 11. In an individual
bankruptcy under chapter 7 (liquidation) or chapter 11 (reorganization)
of title 11, the required reduction of tax attributes must be made to
the attributes of the bankruptcy estate, a separate taxable entity
resulting from the filing of the case. Also, the trustee
of the bankruptcy estate must make the choice of whether to
reduce the basis of depreciable property first before reducing other tax
attributes. See the discussion of The
Bankruptcy Estate, earlier.
Basis Reduction
If any amount of the debt cancellation is used to reduce the basis of
assets as discussed under Reduction
of Tax Attributes, the following rules apply to the extent
indicated.
When to make the basis
reduction. Make the reduction in basis at
the beginning of the tax year following the tax year of the debt
cancellation. The reduction applies to property held at that time. See
section 1.1017—1 of the Income Tax Regulations for more information.
Bankruptcy and insolvency
reduction limit. The reduction in
basis because of canceled debt in bankruptcy or in insolvency cannot be
more than the total basis of property held immediately after the debt
cancellation, minus the total liabilities immediately after the
cancellation. This limit does not apply if an election is made to reduce
basis before reducing other attributes. This election is discussed
later.
Exempt property under title
11. If debt is canceled in a
bankruptcy case under title 11 of the United States Code, make no
reduction in basis for property that the debtor treats as exempt
property under section 522 of title 11.
Election to reduce basis
first. You (the estate in the case of an
individual bankruptcy under chapter 7 or 11) may choose to reduce the
basis of depreciable property before reducing any other tax attributes.
However, this reduction of the basis of depreciable property cannot be
more than the total basis of depreciable property held at the beginning
of the tax year following the tax year of the debt cancellation.
Depreciable property means any
property subject to depreciation, but only if a reduction of basis will
reduce the amount of depreciation or amortization otherwise allowable
for the period immediately following the basis reduction. You may choose
to treat as depreciable property any real property that is stock in
trade or is held primarily for sale to customers in the ordinary course
of trade or business. You must generally make this choice on the tax
return for the tax year of the debt cancellation, and, once made, you
can only revoke it with
IRS
approval. However, if you establish reasonable cause, you may make the
choice with an amended return or claim for refund or credit.
Making
elections. Make the election to
reduce the basis of depreciable property before reducing other tax
attributes as well as the election to treat real property inventory as
depreciable property, on Form 982, Reduction
of Tax Attributes Due to Discharge of Indebtedness (and Section 1082
Basis Adjustment).
Recapture of basis
reductions. If any basis in property is
reduced under these provisions and is later sold or otherwise disposed
of at a gain, the part of the gain that is from this basis reduction is
taxable as ordinary income. Figure the ordinary income part by treating
the amount of this basis reduction as a depreciation deduction and by
treating any such basis reduced property that is not already either
section 1245 or section 1250 property as section 1245 property. In the
case of section 1250 property, make the determination of what would have
been straight line depreciation as though there had been no basis
reduction for debt cancellation. Sections 1245 and 1250 and the
recapture of gain as ordinary income are explained in chapter 4, Dispositions
of Depreciable Property, in Publication 544, Sales
and Other Dispositions of Assets.
Partnerships
If a partnership's debt is canceled because of bankruptcy or
insolvency, the rules for the exclusion of the canceled amount from
gross income and for tax attribute reduction are applied at the
individual partner level. Thus, each partner's share of debt
cancellation income must be reported on the partner's return unless the
partner meets the bankruptcy or insolvency exclusions explained earlier.
Then all choices, such as the choices to reduce the basis of depreciable
property before reducing other tax attributes, to treat real property
inventory as depreciable property, and to end the tax year on the day
before filing the bankruptcy case, must be made by the individual
partners, not the partnership.
Depreciable property.
For purposes of reducing the basis of depreciable property
in attribute reduction, a partner treats his or her partnership interest
as depreciable property to the extent of the partner's proportionate
interest in the partnership's depreciable property. This applies only if
the partnership makes a corresponding reduction in the partnership's
basis in its depreciable property with respect to the partner.
Partner's basis In
partnership. The allocation of an amount of
debt cancellation income to a partner results in that partner's basis in
the partnership being increased by that amount. At the same time, the
reduction in the partner's share of partnership liabilities caused by
the debt cancellation results in a deemed distribution, in turn
resulting in a reduction of the partner's basis in the partnership.
These basis adjustments are separate from any basis reduction under the
attribute-reduction rules described earlier.
Corporations
Corporations in a bankruptcy proceeding or insolvency generally follow
the same rules for debt cancellation and reduction of tax attributes as
an individual or individual bankruptcy estate would follow.
Stock for Debt Exchange
If a corporation transfers its stock in satisfaction of indebtedness
and the fair market value of its stock is less than the indebtedness it
owes, the corporation has income (to the extent of the difference) from
the cancellation of indebtedness. After 1994, a corporation can exclude
all or a portion of the income created by the stock for debt transfer if
it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding,
it can exclude the income to the extent it is insolvent. However, the
corporation must reduce its tax attributes (to the extent it has any) by
the amount of excluded income.
Stock for debt exception.
The stock for debt exception was repealed for transfers made
after 1994 unless the corporation filed for bankruptcy (or similar court
proceeding) before 1994. Generally, before 1995, a corporation did not
realize income because of such stock for debt exchanges if it was in
bankruptcy or to the extent it was insolvent. Consequently, there was no
gross income to exclude and no reduction of its tax attributes was
necessary. The principal difference between the stock for debt exception
and the stock for debt exchange is that the corporation does not reduce
its tax attributes under the stock for debt exception.
Earnings and profits
The earnings and profits of a corporation do not include income from
the discharge of indebtedness to the extent of the amount applied to
reduce the basis of the corporation's property as explained earlier.
Otherwise, discharge of indebtedness income, including amounts excluded
from gross income, increases the earnings and profits of the corporation
(or reduces a deficit in earnings and profits).
If there is a deficit in the corporation's earnings and profits and
the interest of any shareholder of the corporation is terminated or
extinguished in a title 11 or similar case (defined earlier), the
deficit must be reduced by an amount equal to the paid-in capital
allocable to the shareholder's terminated or extinguished interest.
S Corporations
For S corporations, the rules for excluding income from debt
cancellation because of bankruptcy or insolvency apply at the corporate
level.
Net operating losses.
A loss or deduction that is disallowed for the tax year of
the debt cancellation because it exceeds the shareholders' basis in the
corporation's stock and debt is treated as a net operating loss for that
tax year in making the required reduction of tax attributes for the
amount of the canceled debt.
Tax Attribute Reduction Example
The sample tilled-in Form 982, Reduction
of Tax Attributes Due to Discharge of Indebtedness (and Section 1082
Basis Adjustment), shown in this publication is based on the
following situation.
Tom Smith is in financial difficulty, but he has been able to avoid
declaring bankruptcy. In 1995, he reached an agreement with his
creditors, whereby they agreed to forgive $10,000 of the total that he
owed them, in return for his setting up a schedule for repayment of the
rest of his debts.
Immediately before the debt cancellation, Tom's liabilities totaled
$120,000 and the fair market value of his assets was $100,000 (his total
basis in all these assets was $90,000). At the time of the debt
cancellation, he was considered insolvent by $20,000. He can exclude
from income the entire $10,000 debt cancellation because it was not more
than the amount by which he was insolvent.
Among Tom's assets, the only depreciable asset is a rental condominium
with an adjusted basis of $50,000. Of this, $10,000 is allocable to the
land, leaving a depreciable basis of $40,000. He has a long-term capital
loss carryover to 1996 of $5,000. He also has a net operating loss of
$2,000 and a $3,000 net operating loss carryover from 1994. He has no
other tax attributes arising from the current tax year or carried to
this year.
Ordinarily, in applying the $10,000 debt cancellation amount to reduce
tax attributes, Tom would first reduce his $2,000 net operating loss,
next his $3,000 net operating loss carryover from 1994, and then his
$5,000 net capital loss carryover. However, he figures that it is better
for him to preserve his loss carryovers for the next tax year.
Tom elects to reduce basis first. He can reduce the depreciable basis
of his rental condominium (his only depreciable asset) by $10,000. The
tax effect of doing this will be to reduce his depreciation deductions
for years following the year of the debt cancellation. However, if he
later sells the condominium at a gain, the part of the gain from the
basis reduction will be taxable as ordinary income.
Tom must file Form 982, as shown here, with his individual return
(Form 1040) for the tax year of the debt discharge. In addition, he must
attach a statement describing the debt cancellation transaction and
identifying the property to which the basis reduction applies. This
statement is not illustrated.
How to Get More Information
You can get help from the
IRS
in several ways.
Free publications and
forms. To order free publications and forms,
call 1—800—TAX—
FORM
(1—800—829—3676). You can also write to the
IRS
Forms Distribution Center nearest you. Check your income tax package for
the address. Your local library or post office also may have the items
you need.
For a list of free tax
publications, order Publication 910, Guide
to Free Tax services. It also contains an index of tax
topics and related publications and describes other free tax information
services available from
IRS
, including tax education and assistance programs.
If you have access to a personal
computer and modem, you also can get many forms and publications
electronically. See How To Get Forms
and Publications in your income tax package for details. If
space permitted, this information is at the end of this publication.
Tax questions.
You can call the
IRS
with your tax questions. Check your income tax package or telephone book
for the local number, or you can call 1—800—829—1040.
Telephone help for
hearing-impaired persons. If you have
access to TDD equipment, you can call 1—800—829—4059 to ask tax
questions or to order forms and publications. See your income tax
package for the hours of operation.
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