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Bankruptcy - An Accountants Viewpoint

© by Greta P. Hicks, CPA

As an accountant who works with persons and businesses who owe the IRS money, I think of bankruptcy as a last resort solution to an IRS debt. Bankruptcy as a solution is and should be considered along with the IRS offer-in-compromise program or an installment payment plan.

My reasons for recommending bankruptcy to clients is that under a Chapter 7 or Chapter 11, it is possible to receive a discharge of non-priority IRS debts. Also, at times it is difficult to arrange a reasonable installment payment plan with the Internal Revenue Officer and the debtor may receive a more favorable payment plan through filing of a Chapter 13 bankruptcy. See EXHIBIT A for more information of types of bankruptcies.

Other reasons for declaring bankruptcy may include threats of seizure of assets by IRS or threats of involuntary bankruptcy by other creditors or the discharge of debts of other creditors. Before bankruptcy, discuss thoroughly all options with your tax advisor, Certified Public Account, enrolled agent,. tax attorney and a bankruptcy attorney who is familiar with discharged of IRS debts.

Chapter 11 bankruptcy is by far the most complex type of bankruptcy. A bankruptcy estate is created and assets and liabilities are transferred to the estate which is a separate taxable entity separate and a part from the bankrupt individual. The income from the transferred assets become a part of the estate and an income tax return is required to be filed. The expenses associated with the assets and liabilities are also a part of the estate and it’s tax return. A trustee is appointed and monthly operating reports are required. In short, the estate is under the operation of court appointed bankruptcy trustee. (See EXHIBIT A )

The debtor is still required to file their or its own income tax return containing that income earned separate and apart from the bankruptcy estate. The debtor will retain assets which are defined under state and federal law as exempt, and will have income, expenses, and deductions which are not a part of the bankruptcy proceedings. Filing of bankruptcy is not reasonable cause of non-filing income and payroll tax returns.

In all bankruptcies, there is a income tax effect on the debtor whether an individual, corporation, or partnership. Under Internal Revenue Code general rules, when a debt is discharged, the entity has taxable income equal to the amount of debt forgiven. Unless... the entity was bankrupt at the time of the discharge. But... there is a trade off. When bankrupt, the amount of debt forgiven reduces certain tax attributes (See EXHIBIT B). In essence, the tax on the debt forgiveness is not forgiven but deferred to a later date. For example, assume the taxpayer has a rent house, the debt forgiven would reduce the basis (cost) of the rent house so that when the house was sold any gain recognized would be taxable to the extent of the debt earlier forgiven.

The income tax filings are further complicated by the fact that the reduction of the tax attribute(s) may have happened in a bankruptcy estate and was passed down or back to the debtor at the conclusion of the bankruptcy. The bankruptcy estate most likely had a separate tax professional from the debtor’s regular income tax preparer. This type of situation requires the debtor, trustee, debtor’s accountant, and trustee’s accountant to maintain and exchange records to allow the tax preparer to adequately to trace the amount of debt forgiven and those tax attributes reduced, if any.

When you, as a business person, debtor, seek the services of a tax professional, enter into the engagement knowing that you will need to provide the Certified Public Accountant, enrolled agent, or tax attorney with sufficient records to properly advise you on the appropriate income tax treatment before, during and after bankruptcy.


EXHIBIT A
TYPES OF BANKRUPTCY


Chapter 7

  • Chapter 7 is often called a straight, complete, or total bankruptcy. If a business, the business ceases to exist after a Chapter 7 bankruptcy. ( Exhibit C & D )
  • Individuals and most entities can quality for a Chapter 7 bankruptcy.
  • A bankruptcy trustee is appointed by the court to administer the assets acquired by the bankruptcy estate from the debtor.
  • There are assets which are exempt from being a part of the bankruptcy. Exempt assets are defined by state and federal law and your bankruptcy attorney which advise you in using these exemptions to your best advantage.
  • At the conclusion of a Chapter 7 bankruptcy, debts are discharged including selected IRS debts.


Chapter 11

  • Chapter 7 bankruptcy can best be described as a reorganization. The debtors assets are transferred to the bankruptcy estate. The estate is managed by a trustee and at the conclusion the remaining assets are then transferred back to the debtor
  • Individuals and most entities qualify for a Chapter 11 bankruptcy.
  • Chapter 7 is by far the most complex of the types of bankruptcy.
  • A trustee is appointed by the Court.
  • The reorganization plan is approved by the Bankruptcy Court and the trustee is required to submit monthly reports to the court.
  • Any professional (accountant, attorney, etc) wanting to perform services to the bankrupt estate must be approved by the court.


Chapter 13

  • Chapter 13 is often called a working man’s bankruptcy and is limited to individuals. (Exhibit E)
  • The amount o unsecured debts and secured debt is also limited.
  • A trustee is appointed.
  • The debtor makes payments to the Court based upon a budget and the trustee in turn pays creditors.
  • The budget or plan is designed to pay in full all claims within 5 years.
  • A debtor who files under Chapter 13 can later be converted to a Chapter 7.


EXHIBIT B
REDUCTION OF TAX ATTRIBUTES

When a debt is forgiven, the amount of debt forgiveness reduces certain tax attributes. In other words, the debtor gives up deductions, credits, or basis. The debtor is not taxed on the debt forgiveness in the year of the forgiveness but the tax effect is deferred to a later tax year. The Internal Revenue Code specifies which attributes must be reduced and the order to reduction. The amount of the debt forgiveness and the attributes available for reduction will determine the date the taxation of the debt forgiveness is triggered.

The order of reduction of tax attributes is:

  • Net operating loss carryovers
  • General business credit carryovers
  • Minimum tax credit carryovers
  • Capital loss carryovers
  • Basis in assets
  • Passive activity loss and credit carryovers
  • Foreign tax credit carryovers

An election to first reduce basis in assets can be made by filing a Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

For example: If basis in assets is reduced any gain triggered by the debt forgiveness reduction would be deferred until the asset was sold. Without an election to reduce basis, the net operating loss reduction would result in the triggering of a taxable event in the current year. Maximizing the benefit of this election needs to be discussed with a professional tax person such as a Certified Public Accountant, enrolled agent, or tax attorney.


EXHIBIT C
DISCHARGEABLE TAXES

To quality for being dischargeable, taxes must meet all three rules.

  • Income taxes, employer’s and excise taxes for tax years ending on or before the date of filing the bankruptcy petition, for which a return was due prior to 3 years of the filing of the bankruptcy petition.
  • Income taxes were the return was filed after the filing date but filed prior to 2 years of the filing of the bankruptcy petition.
  • Income taxes, such as an income tax audit, that were assess more than 240 days before the date of filing the petition.


"3 yr, 2 yr And 240 Day Rule"

3 year 2 year 240 day
Examples:
Current year tax return Delinquent returns IRS audits
Tax year on tax return
is over 3 years old.
The delinquent return
has been filed more
than 2 years ago.
The increase in tax
due was assessed
more than 240 days
ago.


EXHIBIT D
TAXES WHICH ARE NOT DISCHARGED

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 filing of the bankruptcy petition.

  • 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.
  • Income taxes assess within 240 days before the date of filing the petition. This 240 days 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.
  • Trust Fund Taxes, Social Security, Medicare, and income tax withheld from employee’s paychecks for which you are liability in any capacity are never dischargeable at the corporate, partnership, partner, or individual level.
  • Employer’s share of employment taxes on wages, salaries, or commissions (including vacation, severance, and sick leave pay) paid as a priority claim or for which a return is due within 3 years of the filing of bankruptcy petition, including a return for which an extension of filing date was obtained.
  • Excise taxes on transactions occurring before the date of filing the bankruptcy petition, for which a return, if required, is due (including extension) 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.


EXHIBIT E
PRIORITY PAYMENT OF TAXES

Tax are paid in the priority as defined in the Bankruptcy Code. If funds are available the taxes are paid in this order.

  • Taxes incurred during the administration of the bankruptcy estate.
  • Taxes incurred after the bankruptcy petition was filed but before a trustee was appointed.
  • Withholding taxes such as the employee’s share of income tax, social security, and Medicare taxes withheld during the last 3 years.
  • Taxes which do not meet the 3 year, 2 year, and 240 day rule are paid based upon the type of bankruptcy.
    • Chapter 7 - after other creditors
    • Chapter 11 within 6 years
    • Chapter 13 within 3 to 5 years.

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GRETA P. HICKS, CPA and former IRS manager, concentrates in solutions to IRS problems and advises business and tax professional on IRS policies and procedures. Ms Hicks is owner of TAX SOLUTIONS, Inc., a company providing educational materials and programs on solutions to IRS problems and is a nationally known speaker and writer on solutions to IRS problems. To arrange for consultation contact: Greta's web site: http://www.gretahicks.com

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