Tax & Business Insights

Some Tax Consequences of Bankruptcy Chapter 7 - Part I

Volume 22 Issue 5 --  September/October 2010

Spurred in part by the declines in real estate markets over the past few years, the number of individuals filing Chapter 7 Bankruptcy petitions have nearly doubled. Many tax practitioners, facing clients who have been through Chapter 7 proceedings, must determine the tax consequences of their clients’ Bankruptcies.

Although individuals can file Bankruptcy petitions under Chapter 7, Chapter 11, or Chapter 13, this newsletter will focus on Chapter 7. Other types of bankruptcies have different tax issues.

In today’s climate, Chapter 7 proceedings are often completed in as little as 3 months. In such cases, what are the tax consequences?

To understand the tax consequences, it is necessary to know a little about the Chapter 7 process. Chapter 7 is sometimes referred to as a “liquidation.” It does not involve any attempt to reorganize or adjust debts so that they can be repaid in the future. Instead, Chapter 7 involves a transfer of all of the debtors assets and liabilities (as of the date the Chapter 7 petition is filed) to a Bankruptcy Estate (“the Estate”).

The Estate is a separate taxpaying entity. On the date of the petition, it succeeds to the debtor’s tax attributes. So long as the Estate is in effect, only the Estate, not the debtor, can use the debtor’s tax attributes, like loss carryovers. When the Chapter 7 is over, the Estate terminates and all of the remaining tax attributes are transferred back to the debtor. While there are a number of tax planning options prior to filing a Chapter 7 petition, in many cases tax practitioners first learn of a client’s Chapter 7 only after it has occurred!

Any consideration of Chapter 7 must take into account § 108 of the Tax Code, which governs the recognition of income from the cancellation (or discharge) of debt (“CODI”). While a person receiving CODI during  Chapter 7 need not recognize taxable income from the CODI, § 108 requires that certain tax attributes be reduced by the amount of the CODI excluded from income.

For example, suppose Amy filed a Chapter 7 and obtained a discharge. At the time she filed the petition, she had a net operating loss (NOL) of $500,000. As a result of the Chapter 7 discharge, she had CODI of $300,000. After the conclusion of the Chapter 7, Amy’s NOL is $200,000. A number of tax attributes, in addition to NOLs, can be affected by a Chapter 7.

Because of the required tax attribute reduction, it is impossible to prepare a tax return for either the year of the Chapter 7 or any subsequent year without knowing the tax consequences of the Chapter 7.

As indicated above, while the Chapter 7 is ongoing, the Estate is a separate taxpayer and if its income exceeds certain levels, the Estate must file its own tax return (on Form 1041). This leads to a number of complications.

It is possible for a Chapter 7 debtor to elect to close his or her tax year as of the date of the Chapter 7 petition filing. If that election is made, the debtor will have two separate, short tax years. The election can have not only tax consequences but also substantive effects in the Chapter 7 itself. For present purposes, let’s see how this might work.

Suppose Bob files a Chapter 7 petition on May 1 and elects to terminate his tax year. Also assume that Bob obtains his discharge on October 31 of that year. That means the Estate is in effect from May 1 through October 31.

In this situation, Bob has two separate tax years, the first from January 1 though April 30, and the second from May 1 though December 31. Meanwhile, the Estate has a tax “year” from May 1 though October 31.

In many Chapter 7s, this election is not made, and the debtor has only one tax year for the year in which the Chapter 7 was filed. Obviously, in order to prepare a debtor’s tax return for the year of the Chapter 7 filing, it is essential to know whether this election was made or not.

Regardless of whether the election was made, while the Chapter 7 is pending, there are two taxpayers — the debtor and the Estate. The debtor reports all of his or her income earned after the date of the petition, while the Estate must report all income and expenses relating to the assets received at the time of the petition. For example, if a debtor owned rental property on the date of the petition, the associated rental income and expenses would be reported by the Estate while the property remains in the Estate’s hands. Conversely, any wages earned by the debtor after the date of the petition are reported on the debtor’s tax return.

In the next issue, we will look at a number of other tax aspects of Chapter 7 proceedings.

If you have questions about the tax consequences of underwater mortgages, please contact the Tax & Business Professionals.

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