Bankruptcy

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IRS Tax Liens - continued 2
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Overview
Bankruptcy Terms
Bankruptcy Legislation
Bankruptcy Section 6658
Bankruptcy Fraud
Statute of Limitations
Golden Parachute
Definition of "pending"
Chapter 9 Cases
Collection
Delinquent Accounts
Common Issues
IRS Case Processing
Proof of Claim
Chapter 7 Cases
Payments
Chapter 11
Chapter 12
Chapter 13
Closing

 

 

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

http://www.irs.gov/publications/p908/index.html

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 1

Sample Form 1040 - page 2

Sample Form 1040 - page 2

Sample Schedule A

Sample Schedule A

Sample Schedule B

Sample Schedule B

Sample Schedule D

Sample Schedule D

Sample Schedule E

Sample Schedule E

Sample Form 2119

Sample Form 2119

Sample Form 4797 - page 1

Sample Form 4797 - page 1

Sample Form 4797 - page 2

Sample Form 4797 - page 2

Sample Form 4562

Sample Form 4562

Sample Form 982 - page 1

Sample Form 982 - page 1

Sample Capital Loss Carryover Worksheet

Sample Capital Loss Carryover Worksheet

Sample Form 1041

Sample Form 1041

Sample Form 982 - page 2

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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