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
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.
TYPES OF BANKRUPTCY
- 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 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 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.
- 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
- A debtor who files under Chapter 13 can later be converted to a
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
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"
|Current year tax return
|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
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
- 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
- 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
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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List of Articles by Greta P. Hicks, CPA
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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