Volume 22 Issue 6 -- November/December 2010
In the last issue, we looked at some of the basic tax consequences of Chapter 7 Bankruptcy proceedings. In this issue, we will conclude this exploration.
Whenever a Bankruptcy Estate has more than a minimum amount of gross income ($9,350 in 2009), the Estate must file a return. The return is filed by the Bankruptcy Trustee, not the debtor, and there are special filing rules. Generally, the Estate’s return, in addition to reporting the Estate’s income and tax, is used as a transmittal for the debtor’s individual tax return (Form 1040). The Estate’s return will also usually report the result of any tax attribute reductions as a result of cancellation of debt income (CODI).
If the Estate has less than the requisite amount of income, the Estate need not file a return. In that case, the debtor will need to file his or her own return and, apparently, report the results of any tax attribute reductions, although there is little explicit guidance covering such situations.
In many smaller Chapter 7s, the Estate may not file a tax return. As a result, it is common for tax practitioners to face the situation of the client asking for a return for the year of the Chapter 7 (or the following year) and having little more information than the client saying the he or she filed a bankruptcy petition. What is the tax practitioner to do?
Gathering the critical information is the first task. Typically, the client will have little to offer, other than, perhaps, a large stack of papers resulting from the Chapter 7 itself and a number of Form 1099s.
The first thing to determine is whether the client elected to terminate the tax year on the filing of the Chapter 7 petition. If so, two returns will be needed for that year. If not, as is probably more common, only one return will be required.
Assuming that no election was made and that the Estate did not file a tax return, the next task is to determine how much CODI there was. This is critical to determining the amount and status of the client’s tax attributes post-Chapter 7. This requires determining what debts were discharged in the Chapter 7. Unfortunately, there is usually no simple way to determine this.
On filing the petition, the debtor must list on various schedules all of his or her liabilities. On discharge, the Court Order usually says nothing more than that the debtor is granted a discharge. Typically, unless the scheduled or listed liability is exempted from discharge or paid in the Chapter 7, it will be discharged.
As a practical matter, it will usually be necessary to review the detailed schedules attached to the original Chapter 7 petition in order to produce a list of the debts that may have been discharged. Next, it is necessary to find out whether any of those debts were either paid or excluded from the discharge.
Unless they were paid or exempted, the debts listed in the Chapter 7 schedules would form the starting point for computing the amount of CODI and thus the amount of any tax attribute reduction.
As noted in the previous issue, a person in Chapter 7 need not recognize income from the discharge of debt, but instead various tax attributes, such as loss and credit carryovers and the basis of assets, must be reduced. This is computed and reported on Form 982.
In determining the amount of CODI and thus the amount of the attribute reduction, it is important to remember the tax treatment of abandonments and repossessions. When property subject to a debt is abandoned or foreclosed, there are two separate tax consequences. The foreclosure or abandonment is treated as a disposition for which gain or loss must be computed. Any gain from a disposition of property is not CODI and is not excluded from income by § 108. Depending upon whether the property was abandoned or foreclosed, the gain or loss computation will be different.
The amount of the tax attribute reduction is the based on the amount of CODI excluded from income by § 108 and does not include any gain from the disposition of property. Tax attributes subject to reduction, in the following order, are:
- Net Operating Loss Carryovers
- General Business Credit Carryovers
- Minimum Tax Credit Carryovers
- Capital Loss Carryovers
- Basis of Property
- Passive Activity Loss and Credit Carryovers
- Foreign Tax Credit Carryovers.
It is possible to elect to reduce the basis of depreciable property first.
If you need assistance in determining the tax
consequences of a Chapter 7 or in tax planning for a client contemplating a
Chapter 7, please give us a call..
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
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