This section provides an introduction to bankruptcy and how the cases are handled.

Bankruptcy is a condition existing as the result of the actual filing of a petition under the Bankruptcy Code which provides procedures for individuals, partnerships, and corporations to satisfy their creditors when they are insolvent. It is a matter of federal statutory law found in Title 11 of U.S. Code, commonly known as the Bankruptcy Code (BC). Title 11 contains the substantive and procedural provisions for bankruptcy liquidation and reorganization cases filed after September 30, 1979. The law has three primary objectives:

Bankruptcy cases filed before October 1, 1979, are governed by the Bankruptcy Act. It will not be covered in this section because there are very few, if any, of those cases which are still active.

The Bankruptcy Code provides the law under which bankruptcy proceedings are commenced, administered, and closed. There are five types of bankruptcies which can be filed under various chapters of Bankruptcy Codes and are defined below. However, for purposes of determining federal tax liabilities, the important chapters are 7, 11, 12, and 13.

Examiners should immediately notify the Insolvency Support section upon learning that a taxpayer under examination is involved in a bankruptcy proceeding for which there is no bankruptcy freeze on the master file (transaction code 520, closing code 81, 83, or 84 through 89, freezing accounts from assessments, refunds, and offsets) and for which Examination has received no prior notification from Insolvency Support (or from Examination, PSP Support). Examiners should also immediately notify Insolvency Support of the amounts of any potential deficiencies, penalties, and interest, so that proofs of claim can be filed before the bar date. A proof of claim for an unassessed tax liability should be based upon as factual an estimate as possible. When the correct and complete amount due can be determined, the claim will be superseded by an amended claim. However, some bankruptcy courts will not permit claims to be amended to list larger liabilities after a bar date and/or confirmation has passed. See IRM 5.9.6.7 through 5.9.6.8.2.

Procedures outlined herein (IRM 4.27) apply to all bankruptcy cases commenced after September 30, 1979, the effective date of the Bankruptcy Reform Act of 1978 (P.L. 95–598). The impact of revisions to the Code made by the Bankruptcy Tax Act of 1980 (P.L. 96–589) and by the Bankruptcy Reform Act of 1994, commonly referred to as BRA ‘94 (P.L. 103–394), is also included.

In order to better comprehend bankruptcy law and effectively examine bankruptcy cases, familiarity with bankruptcy terminology is essential. See EXHIBIT 4.27.1–1 for common Bankruptcy Definitions and Concepts.

The Area Counsel of the Internal Revenue Service represents the interests of the Service’s compliance efforts (Collections and Examination) with the Department of Justice and also serves as Special Assistant to the US Attorney (SAUSA) in the Bankruptcy Court in many cities. Area Counsel works closely with and, when designated as SAUSA, may act as part of the Department of Justice. Area Counsel can best judge when Department of Justice should become involved in any bankruptcy proceeding. However, Insolvency Support now has the authority in routine cases to make certain types of direct referrals to the U.S. Attorney or Justice Department. See IRM 5.9.4.11.1.

In conjunction with Insolvency Support, Examination will promptly inform Area Counsel when:

It is the responsibility of Examination to promptly respond to all requests from both Area Counsel and Insolvency Support with any supporting data, documents, or other examination information from the administrative file. Examination should be aware of and comply with the deadlines and requirements imposed by the Bankruptcy Court that affect the examination process.

The filing of a bankruptcy petition under any chapter creates a bankruptcy estate. However, for purposes of federal tax liability, only an individual Chapter 7 or 11 bankruptcy estate creates a separate taxable entity. The trustee or debtor-in-possession (DIP) of an individual bankruptcy estate is required to file tax returns and to pay any tax which may be due if the estate has gross income that meets or exceeds the amount required for filing (IRC sec. 1398(c)). This amount is the total of the personal exemption amount and the basic standard deduction for a married individual filing separately. The trustee or DIP must obtain a taxpayer identification number for the estate. The filing of a tax return for the bankruptcy estate does not relieve the individual debtor of his or her tax filing requirement.

No separate taxable entity results from commencement of a bankruptcy case involving a partnership or corporation (IRC sec. 1399). However, the bankruptcy trustee of a partnership in bankruptcy is required under BC sec. 346(c)(2) to make and file tax returns of the partnership that the partnership would have been required to make and file under local or state law. The trustee should at the same time make and file all federal tax returns for the partnership. Also, the bankruptcy trustee of a corporation in bankruptcy is required to file annual income tax returns and pay any corporate taxes which are due for the corporation (IRC sec. 6012(b)(3)).

For purposes of IRC sec. 1398(a), a partnership shall not be treated as an individual, but the interest in a partnership of a debtor who is an individual shall be taken into account under IRC sec. 1398 in the same manner as any other interest of the debtor (IRC sec. 1398(b)(2)).

IRC sec. 1398(d) provides the individual debtor with an election to close the taxable year as of the day before the date on which the bankruptcy case commences (the petition filing date). The election may be made only on or before the due date for filing the return for the taxable year which ends on the day before the petition date and, once made, is irrevocable. If the election is made, the debtor’s taxable year, which otherwise would include the commencement date, is divided into two "short" taxable years of less than 12 months. The first such year ends on the day before the commencement date; the second such year begins on the commencement date (IRC sec. 1398(d)(2)(A)). If the election is not made, the commencement of the bankruptcy case does not affect the taxable year of an individual debtor (IRC sec. 1398(d)(1)). As a result of the debtor’s election, his/her income tax liability for the first short taxable year becomes (under the bankruptcy law) an allowable claim against the bankruptcy estate as a claim arising before bankruptcy. Accordingly, any tax liability for that year is collectible from the estate, depending on the availability of estate assets to pay debts of that priority. Inasmuch as any such tax liability for an electing debtor’s first short taxable year is not dischargeable, the individual debtor remains liable for any amount not collected from the bankruptcy estate (BC sec. 523(a)(1)). If the debtor does not make the election, no part of the debtor’s tax liability from the year in which the bankruptcy case commences is collectible from the estate, but is collectible directly from the individual debtor. If the election is made, the debtor is required to annualize his/her taxable income for each short taxable year in the same manner as if a change of annual accounting period had been made (IRC sec. 1398(d)(2)(f)).

If the debtor making the election was married on the date his/her bankruptcy case commenced, the debtor’s spouse can join in the election to close the taxable year only if the debtor and the spouse filed a joint return for the first short taxable year (IRC sec. 1398(d)(2)(B)). However, the filing of a joint return for the first short taxable year does not require the debtor and the spouse to file a joint return for the second short taxable year. If during the same year a bankruptcy case involving the debtor’s spouse is commenced, the spouse can elect to terminate his/her then taxable year as of the day before the commencement date, whether or not the spouse previously had joined in the debtor’s election. If the spouse previously had joined in the debtor’s election or if the debtor had not made an election, the debtor can join in the spouse’s election. But if the debtor had made an election and the spouse had not joined in the debtor’s election, the debtor cannot join in the spouse’s election inasmuch as the debtor and the spouse, having different taxable years, could not file a joint return for a year ending with the spouse’s commencement date (IRC sec. 6013).

The gross income of the bankruptcy estate includes any of the debtor’s gross income to which the estate is entitled under bankruptcy law. It includes any income the estate is entitled to and receives or accrues after the beginning of the bankruptcy case (IRC sec. 1398(e)(1)). Gross income of the bankruptcy estate does not include amounts received or accrued by the debtor before the bankruptcy petition date (IRC sec. 1398(e)(2)).

The determination whether the bankruptcy estate may deduct or take as a credit any amount it pays or incurs is made as if the amount was paid or incurred by the debtor in carrying on the same trade, business, or activity the debtor engaged in before the commencement date. IRC sec. 1398(e)(3).

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 incident to creation of bankruptcy estate from the debtor to the 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 (IRC sec. 1398(f)(1)).

When the bankruptcy estate is terminated, 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 taxable gain or loss, recapture of deductions or credits, or acceleration of income or deductions to the estate (IRC sec. 1398(f)(2)). Transfer back to the debtor by abandonment receives similar tax free treatment.

On the first day of the debtor’s taxable year in which the bankruptcy case is commenced, the bankruptcy estate succeeds to the tax attributes of the debtor that are included in IRC sec. 1398(g). The character of tax attributes in the estate’s hands is identical as they would have been in the debtor’s hands. These attributes include 1) net operating loss carryovers, 2) carryovers of excess charitable contributions, 3) recovery of tax benefit, 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. The amount of debt cancellation (debt discharged) and the amount to be offset against the estate’s tax attributes is shown by filing Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) in the year of discharge. This form should be attached to the tax return of the bankruptcy estate. Tax attributes remaining under IRC Section 1398(i) at the time the case is closed by the Bankruptcy Court revert to the debtor in that year. (It may be several years after the discharge date depending on the complexity of the case). The tax attributes are not available for the taxpayer’s use during this period prior to the close of the case. For additional information concerning passive activity losses, credits, and at risk amounts, see Reg. secs. 1.1398–1 and 1.1398–2.

The bankruptcy estate is allowed deductions for administrative, liquidation, and reorganization expenses which it incurs. Allowable administrative expenses, such as attorney fees and court costs, include any expenses allowed under BC sec. 503 and any fee or charge assessed against the estate under Chapter 123 of Title 28 of the U.S. Code, to the extent not disallowed under any other provision of Title 26 (IRC sec. 1398(h)(1)).

If the administrative expenses of the bankruptcy estate are more than its gross income for the taxable year, the excess amount may be carried back 3 years and forward 7 years. The excess amount can only be carried back or forward to a taxable year of the estate and never to the debtor’s taxable 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 (IRC sec. 1398(h)(2)(B)).

The amount of the administrative loss to be carried to each taxable year is determined under IRC sec. 172(b)(2), except that the amount of any regular (non-administrative expense) net operating loss is computed before the amount of the administrative expense net operating loss (IRC sec. 1398(h)(2)(C)).

The bankruptcy estate may change its accounting period (tax year) once without getting approval from the Service (IRC sec. 1398(j)(1)). This rule allows the trustee of the estate to close the estate’s tax year early, before the expected termination of the estate, so that the trustee can file a return for the first short taxable year created by the election to get a BC sec. 505(b) prompt determination of the estate’s tax liability. See IRM 4.27.5.

If the bankruptcy estate has a net operating loss, separate from any administrative expense net operating loss and from any losses passing to the estate from the debtor (under the attribute carryover rules), it can carry the loss back not only to its own earlier tax years but also to the debtor’s tax years before the bankruptcy case began (IRC sec. 1398(j)(2)(A)). The estate may also carry back excess credits, such as the general business credit, to the debtor’s pre-petition taxable years.

An individual debtor may not carry back tax attributes arising in post-petition taxable years to pre-petition taxable years. (IRC sec. 1398(j)(2)(B)).