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
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
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
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
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
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
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.
you have questions about the tax consequences of underwater mortgages, please
contact the Tax & Business Professionals.
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.