Bankruptcy Corporations and Partnerships
Partnerships and Corporations
A separate taxable estate is not created when a partnership or corporation
files a bankruptcy petition. The court appointed trustee is, however,
responsible for filing the regular income tax returns on Form 1065 or
Form 1120.
Partnerships
The filing requirements for a partnership in bankruptcy proceedings
do not change. However, the filing of required returns becomes the responsibility
of an appointed trustee, a receiver, or a debtor-in-possession rather
than a general partner.
A partnership's debt that is canceled because of bankruptcy is not included
in the partnership's income. It may or may not be included in the individual
partners' income. See Partnerships, later under Debt Cancellation.
Corporations
The following discussion covers only the highlights of the bankruptcy
tax rules applying to corporations. Because the details of corporate
bankruptcy reorganizations are beyond the scope of this publication,
you may want to seek the help of a professional tax advisor.
See Corporations under Debt Cancellation for information about a corporation's
debt canceled because of bankruptcy.
Tax-Free Reorganizations
The tax-free reorganization provisions of the Internal Revenue Code
apply to a transfer by a corporation of all or part of its assets to
another corporation in a title 11 or similar case, but only if, under
the reorganization plan, stock or securities of the corporation to which
the assets are transferred are distributed in a transaction qualifying
under IRC section 354, 355, or 356.
A "title 11 or similar case," for this purpose, is a bankruptcy
case under title 11 of the United States Code, or a receivership, foreclosure,
or similar proceeding in a federal or state court, but only if the corporation
is under the jurisdiction of the court in the case and the transfer
of assets is under a plan of reorganization approved by the court. In
a receivership, foreclosure, or similar proceeding before a federal
or state agency involving certain financial institutions, the agency
is treated as a court.
Generally, IRC section 354 provides that no gain or loss is recognized
if a corporation's stock is exchanged solely for stock or securities
in the same or another corporation under a qualifying reorganization
plan. In this case, shareholders in the bankrupt corporation would recognize
no gain or loss if they exchange their stock solely for stock or securities
of the corporation acquiring the bankrupt corporation's assets.
IRC section 355 generally provides that no gain or loss is recognized
by a shareholder if a corporation distributes solely stock or securities
of another corporation that the distributing corporation controls immediately
before the distribution. IRC section 356 provides that in an exchange
that would qualify under IRC section 354 or 355 except that other property
or money besides the permitted stock or securities is received by the
shareholder, gain is recognized by the shareholder only to the extent
of the money and the FMV of the other property received. No loss is
recognized in this situation.
Filing Requirements
The filing requirements of a corporation involved in bankruptcy proceedings
do not change. However, the filing of required returns becomes the responsibility
of an appointed trustee, a receiver, or a debtor-in-possession, rather
than a corporate officer. A bankruptcy trustee, receiver, or debtor-in-possession,
having possession of or holding title to substantially all of the property
or business of the debtor corporation, must file the debtor's corporate
income tax return for the tax year.
Exemption from tax return filing. If you are a trustee, a receiver,
or an assignee of a corporation that is in bankruptcy, receivership,
or dissolution, or in the hands of an assignee by court order, you may
apply to the IRS for relief from filing federal income tax returns for
the corporation. To qualify, the corporation must have ceased business
operations and must have neither assets nor income for the tax year.
The exemption request must be submitted to the local IRS Insolvency
office handling the case.
Your request to the IRS must include the name, address, and EIN of the corporation and a statement of the facts (with any supporting documents) showing why you need relief from the filing requirements. You must also include the following statement: "I hereby request relief from filing federal income tax returns for tax years ending _____ for the above-named corporation and declare under penalties of perjury that to the best of my knowledge and belief the information contained herein is correct." The statement must be signed by you, and you must include your notice of appointment to act on behalf of the corporation (unless you are a bankruptcy trustee or debtor-in-possession). The IRS will act on your request within 90 days.
Tax Determination and Payment
Prompt Determination Requests
By following Rev. Proc. 2006-24, 2006-22 I.R.B. 943, http://www.irs.gov/irb/2006-22_IRB/ar12.html,
the bankruptcy trustee may request a determination of any unpaid tax
liability incurred by the bankruptcy estate during the administration
of the case by filing a tax return and a request for such a determination
with the IRS. For cases filed after October 16, 2005, unless the return
is fraudulent or contains a material misrepresentation, the estate,
trustee, debtor, and any successor to the debtor are discharged from
liability for the tax upon payment of the tax:
1. As determined by the IRS,
2. As determined by the bankruptcy court, after the completion of the
IRS examination, or
3. As shown on the return, if the IRS does not:
a. Notify the trustee within 60 days after the request for the determination
that the return has been selected for examination, or
b. Complete the examination and notify the trustee of any tax due within
180 days after the request (or any additional time permitted by the
bankruptcy court).
For cases filed before October 17, 2005, the same rules apply, except
that the bankruptcy estate is not discharged from the liability.
Making the request for determination. As detailed in Rev. Proc.
2006-24, to request a prompt determination of any unpaid tax liability
of the estate, the trustee must file a signed written request, in duplicate,
with the Centralized Insolvency Operation, P.O. Box 21126, Philadelphia,
PA 19114 (marked "Request for Prompt Determination"). The
request must be submitted in duplicate and must be executed under penalties
of perjury. In addition, the trustee must submit with the request an
exact copy of the return(s) filed by the trustee with the IRS for a
completed tax period and must contain the following information:
" A statement indicating that it is a request for prompt determination
of tax liability and specifying the type of return and tax period for
each return being filed.
" The name and location of the office where the return was filed.
" The name of the debtor.
" Debtor's social security number, TIN, or EIN.
" Type of bankruptcy estate.
" Bankruptcy case number.
" Court where the bankruptcy is pending.
The copy of the return(s) submitted with the request must be an exact
copy of a valid return. A request for prompt determination will be considered
incomplete and returned to the trustee if it is filed with a copy of
a document that does not qualify as a valid return. A document that
does not qualify as a valid return includes a return form filed by the
trustee with the jurat stricken, deleted, or modified. A return must
be signed under penalties of perjury to qualify as a return.
The IRS examination function will notify the trustee within 60 days from receipt of the request whether the return filed by the trustee has been selected for examination or has been accepted as filed. If the return is selected for examination, it will be examined as soon as possible. The examination function will notify the trustee of any tax due within 180 days from receipt of the application or within any additional time permitted by the bankruptcy court.
If a prompt determination request is incomplete, all the documents received will be returned to the trustee by the Field Insolvency office assigned the request with an explanation identifying the missing item(s) and asking that the request be refiled once corrected. An incomplete request includes one submitted with a copy of a return form, the original of which does not qualify as a valid return. Once corrected, the request must be filed with the IRS at the Field Insolvency address specified in the correspondence accompanying the incomplete request being returned. In the case of an incomplete request submitted with a copy of an invalid return document, the trustee must file a valid original return with the appropriate IRS office and submit a copy of that return with the corrected request when the request is refiled.
The 60-day period for notifying the trustee whether the return filed by the trustee is being selected for examination or is being accepted as filed does not begin to run until a complete request package is received by the IRS. If the IRS receives an incomplete request, the 60-day period for notifying the trustee whether the return filed by the trustee is being selected for examination or is being accepted as filed does not begin to run until a complete request is received by the Field Insolvency office specified by the IRS in its correspondence returning the incomplete request.
If the IRS does select the estate's return for examination, properly informs the trustee as explained above, and redetermines the tax shown on the return, the trustee may contest the IRS's determination in bankruptcy court. See Bankruptcy court jurisdiction, next.
Bankruptcy court jurisdiction. Generally, the bankruptcy court has authority to determine the amount or legality of any tax imposed on the debtor or the estate, including any fine, penalty, or addition to tax, whether or not the tax was previously assessed or paid.
The bankruptcy court does not have authority:
1. to determine the amount or legality of a tax, fine, penalty, or addition
to tax that was contested before and adjudicated by a court or administrative
tribunal of competent jurisdiction before the date of filing the bankruptcy
petition, or
2. to decide the right of the bankruptcy estate to a tax refund until
the trustee properly requests the refund from the IRS and either:
" The IRS makes a determination about the refund,
" 120 days have passed since the date of the trustee's request,
or
" A determination has been made by a governmental unit of such
requests.
Requests for refund or credit. If the debtor has already claimed a refund
or credit for an overpayment of tax on a properly filed return or claim
for refund, the trustee may rely on that claim. Otherwise, if the credit
or refund was not claimed by the debtor, the trustee may make the request,
on behalf of the bankruptcy estate, by filing the appropriate original
or amended return or form with the Advisory Group Manager within the
Advisory, Insolvency, and Quality (AIQ) Office of the IRS area office
having jurisdiction over the person for whom the trustee is acting.
The appropriate form for the trustee to use in making the claim for
refund is as follows:
1. For income taxes for which an individual debtor had filed a Form
1040, Form 1040A, or Form 1040EZ, the trustee should use a Form 1040X.
2. For income taxes for which a corporate debtor had filed a Form 1120,
the trustee should use a Form 1120X, Amended U.S. Corporation Income
Tax Return.
3. For income taxes for which a debtor had filed a form other than Form
1040, Form 1040A, Form 1040EZ, or Form 1120, the trustee should use
the same type of form that the debtor had originally filed, and write
"Amended Return" at the top of the form.
4. For taxes other than certain excise taxes or income taxes for which
the debtor had filed a return, the trustee should use a Form 843, Claim
for Refund and Request for Abatement, attaching an exact copy of any
return that is the subject of the claim along with a statement of the
name and location of the office where the return was filed.
5. For excise taxes you reported on Forms 720, 730, or 2290, the trustee
should use Form 8849, Claim for Refund of Excise Taxes, or Form 720X,
Amended Quarterly Federal Excise Tax Return, whichever is appropriate.
6. For overpayment of taxes of the bankruptcy estate incurred during
the administration of the case, the trustee may use a properly executed
tax return (for income taxes, a Form 1041) as a claim for refund or
credit.
Once the IRS examination function receives the trustee's claim for refund,
it will examine the refund claim on an expedited basis and notify the
trustee of its decision within 120 days from the date of the filing
of the claim. If the trustee disagrees with the IRS's decision or does
not receive a decision from the IRS within 120 days of filing the claim,
the trustee may ask the bankruptcy court to determine the estate's right
to the refund.
Tax Court jurisdiction. The filing of a bankruptcy petition automatically
results in a stay against the commencement or continuation of certain
Tax Court proceedings concerning the debtor. For bankruptcy cases begun
before October 17, 2005, the scope of the stay varies depending on whether
the debtor is an individual or a corporation. If the debtor is an individual
and the bankruptcy case was filed after October 16, 2005, the scope
of the stay varies depending on whether the debtor is an individual
or a corporation. If the debtor is an individual and the bankruptcy
case was filed after October 16, 2005, the stay prohibits the commencement
of a Tax Court case concerning liabilities of the debtor for tax periods
that ended before the bankruptcy order for relief (the date of the filing
of the bankruptcy petition in voluntary cases). If the debtor is a corporation
in a case filed after October 16, 2005, the stay prohibits the commencement
or continuation of a Tax Court proceeding concerning any liabilities
for tax periods of the debtor that may be determined by the bankruptcy
court; in chapter 11 cases of corporations, therefore, the bankruptcy
court may generally determine the debtor corporation's tax liabilities
for tax periods ending before the date a plan of reorganization is confirmed.
Because the bankruptcy court has the power to lift the stay and allow the debtor to begin or continue a Tax Court case, the bankruptcy court has, in effect, during the pendency of the stay, the sole authority to determine whether the tax issue is decided in bankruptcy court or in Tax Court.
Suspension of time for filing. In any bankruptcy case, the 90-day period for filing a Tax Court petition, after the issuance of the statutory notice of deficiency, is suspended for the time the debtor is prevented from filing the petition because of the bankruptcy case, and for an additional 60 days thereafter. This means that if the statutory notice was issued before the bankruptcy petition was filed, and the 90-day period had not expired, the running of the 90-day period will be suspended while the stay prevents the commencement of the Tax Court case. The 90-day period will begin to run again 60 days after the stay against filing the petition ends. The suspension exists if any part of the 90-day period remained at the date the bankruptcy petition was filed. The 90-day period for filing a Tax Court petition after issuance of a Notice of Determination in an innocent spouse case, however, is not suspended by the filing of a bankruptcy petition. Thus, if the IRS issues a final notice of determination denying the debtor's request for innocent spouse relief during the bankruptcy case, the debtor is prohibited from petitioning the Tax Court while the automatic stay is in effect. However, the 90-day period for petitioning the Tax Court is not suspended. The debtor must ask the bankruptcy court to lift the automatic stay before petitioning the Tax Court.
Trustee may intervene. The trustee of a bankruptcy estate in any title 11 bankruptcy case may intervene, on behalf of the estate, in any proceeding in the Tax Court to which the debtor is a party.
Tax assessment. Generally, the automatic stay rules prevent
a creditor from taking actions to collect prepetition debts. However,
the automatic stay does not apply to:
1. An audit to determine tax liability,
2. A demand for tax returns,
3. The issuance of a notice of deficiency to the debtor, or
4. The making of an assessment for any tax and the sending of a notice
and demand for payment of the tax assessed (for bankruptcy cases filed
after August 17, 2005).
Any tax lien that attaches to the estate's property because of an assessment
described above can only take effect when the property (or its proceeds)
is transferred back to the debtor. Also, the tax must be the debtor's
debt that will not be discharged in the case.
Disclosure of return information. In bankruptcy cases other than those of individuals filing under chapter 7 or 11, current and earlier returns of the debtor are, upon written request, open to inspection by or disclosure to the trustee or receiver, but only if the IRS finds that the trustee has a material interest that will be affected by information on the return. Material interest is generally defined as a financial or monetary interest. Material interest is not limited to the trustee's responsibility to file a return on behalf of the bankruptcy estate.
Payment of Tax Claim
After the filing of a bankruptcy petition and during the period the
debtor's assets or those of the bankruptcy estate are under the jurisdiction
of the bankruptcy court, assets in the bankruptcy estate are not subject
to levy. The IRS may file a proof of claim in the bankruptcy court the
same way as other creditors. This claim may be filed in the bankruptcy
court even though the taxes have not yet been assessed or are subject
to a Tax Court proceeding.
Secured tax claims. If the IRS filed a notice of federal tax lien before
the bankruptcy petition was filed, the IRS will have a secured claim
to the extent the lien attached to equity in the debtor's assets and
will be treated as such in the bankruptcy case. In chapter 7 cases,
the trustee may be able to subordinate the tax lien to some extent to
pay certain non-tax priority claims. For chapter 11 cases filed after
October 16, 2005, if the secured claim would otherwise have been entitled
to treatment as a priority claim, the chapter 11 plan must provide for
the secured tax claim in the same manner and over the same period as
an unsecured eighth priority tax claim.
Eighth priority taxes. In bankruptcy, the debtor's debts are assigned priorities for payment. Certain tax debts that arose before the bankruptcy case was filed are classified as eighth priority claims.
The following federal taxes, if unsecured, are eighth priority taxes
of the government:
1. Income taxes on or measured by income or gross receipts for a tax
year ending on or before the date of the filing of the petition for
which a return, if required, is last due, including extensions, after
3 years before the date of the filing of the bankruptcy petition.
2. Income taxes on or measured by income or gross receipts assessed
within 240 days before the date of the filing of the petition. The 240-day
period is exclusive of any time during which an offer in compromise
for that tax was pending or in effect during that 240-day period plus
30 days, and exclusive of any time during which a stay of proceedings
against collections was in effect in a prior case during the 240-day
period plus 90 days.
3. Income taxes that were not assessed before the bankruptcy petition
date, but were assessable as of the petition date, unless these taxes
were still assessable solely because no return was filed, a late return
was filed within 2 years of the filing of the bankruptcy petition, a
fraudulent return was filed, or because the debtor willfully attempted
to evade or defeat the tax.
4. Withholding taxes that were incurred in any capacity.
5. Employer's share of employment taxes on wages, salaries, or commissions
(including vacation, severance, and sick leave pay) paid as priority
claims under 11 U.S.C. 507(a)(4), or for which a return was last due
within 3 years of the filing of the bankruptcy petition, including a
return for which an extension of the filing date was obtained.
6. Excise taxes on transactions occurring before the date of filing
the bankruptcy petition, for which a return, if required, is last due
(including extensions) 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.
Priority of payment. For a chapter 7 case, the preceding eighth
priority taxes may be paid out of the assets of the bankruptcy estate
to the extent there are assets remaining after paying the claims of
secured creditors and other creditors having higher priority claims.
Different rules apply to payment of eighth priority prepetition taxes
under chapters 11, 12, and 13:
1. For chapter 11 cases filed before October 17, 2005, a chapter 11
plan can provide for payment of these taxes, with post-confirmation
interest, over a period of 6 years from the date the taxes were assessed.
For chapter 11 cases filed after October 16, 2005, a chapter 11 plan
can provide for payment of these taxes, with post-confirmation interest,
over a period of 5 years from the date of the bankruptcy order for relief
(the bankruptcy petition date in voluntary cases), in a manner not less
favorable than the most favored non-priority claims (except for convenience
claims under section 1122(b) of the Bankruptcy Code).
2. In chapter 12, the debtor can pay such tax claims in deferred cash
payments over time, except that for cases filed on or after April 20,
2005, certain priority taxes may be paid as general unsecured claims
if they result from the disposition of a farm asset if the debtor receives
discharge, and
3. In chapter 13, the debtor can pay such taxes over 3 years (or over
5 years with court approval).
Certain taxes are assigned a higher priority for payment. Taxes incurred
during administration by the bankruptcy estate are given second priority
treatment, as administrative expenses. Taxes arising in the ordinary
course of your business or financial affairs in an involuntary bankruptcy
case, after the filing of the bankruptcy petition but before the earlier
of the appointment of a trustee or the order for relief, are included
in the third priority payment category. If you have employees, your
employees' portion of employment taxes on the first $10,950 (this amount
adjusted every 3 years) of wages that they earned during the 180-day
period before the date of your bankruptcy filing or the cessation of
your business (whichever occurs first) is given fourth priority treatment.
Your portion of the employment taxes on these wages, as the employer,
is given eighth priority treatment.
Relief from certain penalties. A penalty for failure to pay tax,
including failure to pay estimated tax, will not be imposed for any
period during which a bankruptcy case is pending, under the following
conditions. If the tax was incurred by the bankruptcy estate, the penalty
will not be imposed if the failure to pay resulted from an order of
the court finding probable insufficiency of funds of the estate to pay
administrative expenses. If the tax was incurred by you as the debtor,
the penalty will not be imposed if:
1. The tax was incurred before the earlier of the order for relief or
(in an involuntary case) the appointment of a trustee, and
2. The bankruptcy petition was filed before the due date for the tax
return (including extensions) or the date for imposing the penalty occurs
on or after the day the bankruptcy petition was filed.
This relief from the failure-to-pay penalty does not apply to any penalty
for failure to pay or deposit tax withheld or collected from others
and required to be paid over to the U.S. government. Nor does it apply
to any penalty for failure to timely file a return.
FUTA credit. An employer is generally allowed a credit against FUTA for contributions made to a state unemployment fund, if the contributions are paid by the last day for filing an unemployment tax return for the tax year. If the contributions to the state fund are paid after that date, the credit shall not exceed 90% of the otherwise allowable credit that may be taken against FUTA.
However, for any unemployment tax on wages paid by the trustee of a title 11 bankruptcy estate, if the failure to pay the state unemployment contributions on time was without fault by the trustee, 100% of the credit is allowed.
Statute of limitations for collection. In a bankruptcy case, the period of limitations for collection of tax (generally, 10 years from the date of assessment) is suspended for the period during which the IRS is prohibited from collecting, plus 6 months thereafter.
Discharge of Unpaid Tax
If you are a debtor in a bankruptcy case, the bankruptcy court may enter
an order providing you with a discharge of debts. However, not all of
your debts may be discharged. The scope of the bankruptcy discharge
depends on the chapter you are in and the nature of the debt. Many tax
debts are excepted from the bankruptcy discharge.
If you are an individual under chapter 7, the following tax debts, including
interest, are not subject to discharge: taxes entitled to eighth priority,
taxes for which no return was filed, taxes for which a return was filed
late after 2 years before the bankruptcy petition was filed, taxes for
which a fraudulent return was filed, and taxes that you willfully attempted
to evade or defeat. Penalties in a chapter 7 case are dischargeable
unless the event that gave rise to the penalty occurred within 3 years
of the bankruptcy and the penalty relates to a tax that is not discharged.
Corporations and other entities that are not individuals do not receive
a discharge in chapter 7 cases.
The same exceptions to discharge that apply to individuals in chapter
7 cases apply to individuals in chapter 11 cases. Different rules apply
for corporations. A corporation in chapter 11 may receive a broad discharge
when the plan is confirmed, but secured and priority claims must be
satisfied under the plan and there is an exception to discharge for
taxes for which the debtor filed a fraudulent return or willfully attempted
to evade or defeat, for bankruptcy cases filed after October 16, 2005.
There are two types of discharge for individuals in chapter 13. A debtor
who completes payments under the chapter 13 plan may receive a broad
chapter 13 discharge of the debts provided for in the plan. However,
priority tax claims must be paid in full under the chapter 13 plan,
and for chapter 13 cases filed after October 16, 2005, the following
taxes are excepted from the broad chapter 13 discharge: withholding
taxes for which you are liable in any capacity, taxes for which no return
was filed, taxes for which a return was filed late after 2 years before
the bankruptcy petition was filed, taxes for which a fraudulent return
was filed, and taxes that the debtor willfully attempted to evade or
defeat. Further, for cases filed after October 16, 2005, there is an
exception from discharge for debts where the creditor, including the
IRS, did not receive notice of the chapter 13 case in time to file a
claim.
A debtor that does not complete payment under a chapter 13 plan may,
in some cases, be entitled to a discharge, but all the exceptions to
discharge for individuals in chapter 7 cases would apply. The chapter
7 discharge exceptions also apply to individuals in chapter 12. The
discharge for non-individuals in chapter 12 is similar to the pre-October
17, 2005, broad discharge an individual receives in chapter 13.
If a tax is discharged, the discharged tax may still be collectable
from the debtor's pre-bankruptcy property if the IRS filed a Notice
of Federal Tax Lien before the bankruptcy petition was filed. This is
because perfected liens generally pass through bankruptcy unaffected,
even if the debtor's personal liability for the debt is discharged.
If the IRS did not file a Notice of Federal Tax Lien before the bankruptcy
petition was filed, the tax lien will generally be removed from the
debtor's pre-bankruptcy property as a result of the bankruptcy, even
if the debtor exempted the property out of the bankruptcy estate. However,
the tax lien that arises when a tax is assessed may not be removed if
the property was excluded from the bankruptcy estate, even if a Notice
of Federal Tax Lien was not filed, and never became estate property.
Debt Cancellation
If a debt is canceled or forgiven, other than as a gift or bequest,
the debtor generally must include the canceled amount in gross income
for tax purposes. A debt includes any indebtedness for which the debtor
is liable or that attaches to property the debtor holds. In the event
that the amount forgiven is $600 or more, the debtor should receive
a Form 1099-C, Cancellation of Debt, from the lender. See Form 1099-C
and the separate instructions. The debtor may not have to report the
entire amount of canceled debt as income, as a variety of exceptions
may apply. See Exceptions and Exclusions, next.
Exceptions
The exceptions include:
1. The cancellation of a student loan for a student required to work
for certain employers. See Canceled Debts in Publication 525.
2. The cancellation of debt that would have been deductible if paid.
See Deductible Debt under Canceled Debts in chapter 5 of Publication
334.
3. The reduction of a debt by the seller of property if the debt arose
from the purchase of the property.
Exclusions
Do not include a canceled debt in gross income if any of the following
situations apply:
" The cancellation takes place in a bankruptcy case under the U.S.
Bankruptcy Code. See Bankruptcy case exclusion, later.
" The cancellation takes place when the debtor is insolvent (see
Insolvency exclusion, later), and the amount excluded is not more than
the amount by which the debtor is insolvent.
" The canceled debt is qualified farm debt (debt incurred in operating
a farm). See Cancellation of Debt in chapter 3 of Publication 225.
" The canceled debt is qualified real property business indebtedness
(certain debt connected with business real property). See Publication
525.
" The canceled debt is qualified principal residence indebtedness
(applies to debt canceled between January 1, 2007, and December 31,
2009). See IRC section 108(a)(1)(E).
Order of exclusions. If the cancellation of debt occurs in a
title 11 bankruptcy case, the bankruptcy exclusion takes precedence
over the insolvency, qualified farm debt, qualified real property business
indebtedness, or qualified principal residence indebtedness exclusions.
To the extent that the taxpayer is insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions. The principal residence exclusion takes precedence over the insolvency exclusion, unless otherwise elected. See IRC section 108(a)(2)(C).
Bankruptcy case exclusion. A bankruptcy case is a case under title 11 of the United States Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
None of the debt canceled in a bankruptcy case is included in the debtor's gross income in the year it was canceled. Instead, certain losses, credits, and basis of property must be reduced by the amount of excluded income (but not below zero). These losses, credits, and basis in property are called tax attributes and are discussed under Reduction of Tax Attributes, later.
Insolvency exclusion. A debtor is insolvent when, and to the extent, the debtor's liabilities exceed the FMV of the assets. Determine the debtor's liabilities and the FMV of the assets immediately before the cancellation of the debtor's debt to determine whether or not the debtor is insolvent and the amount by which the debtor is insolvent.
Exclude from the debtor's gross income debt canceled when the debtor
is insolvent, but only up to the amount by which the debtor is insolvent.
However, you must use the amount excluded to reduce certain tax attributes,
as explained later under Reduction of Tax Attributes.
Example.
$4,000 of the Simpson Corporation's liabilities are canceled outside
bankruptcy. Immediately before the cancellation, the Simpson Corporation's
liabilities totaled $21,000 and the FMV of its assets was $17,500. Because
its liabilities were more than its assets, it was insolvent. The amount
of the insolvency was $3,500 ($21,000 ? $17,500). The corporation may
exclude only $3,500 of the $4,000 debt cancellation from income because
that is the amount by which it was insolvent. It must also reduce certain
tax attributes by the $3,500 of excluded income. The remaining $500
of canceled debt must be included in income.
Reduction of Tax Attributes
If a debtor excludes canceled debt from income because it is canceled
in a bankruptcy case or during insolvency, he or she must use the excluded
amount to reduce certain "tax attributes." Tax attributes
include the basis of certain assets and the losses and credits listed
later. By reducing the tax attributes, the tax on the canceled debt
is partially postponed instead of being entirely forgiven. This prevents
an excessive tax benefit from the debt cancellation.
If a separate bankruptcy estate was created, the trustee or debtor-in-possession
must reduce the estate's attributes (but not below zero) by the canceled
debt. See Individuals under chapter 7 or chapter 11, earlier.
Order of reduction. Generally, use the amount of canceled debt
to reduce the tax attributes in the order listed below. However, the
debtor may choose to use all or a part of the amount of canceled debt
to first reduce the basis of depreciable property before reducing the
other tax attributes. This choice is discussed later.
Net operating loss. Reduce any NOL for the tax year in which the debt cancellation takes place, and any NOL carryover to that tax year.
General business credit carryovers. Reduce any carryovers, to or from the tax year of the debt cancellation, of amounts used to determine the general business credit.
Minimum tax credit. Reduce any minimum tax credit that is available as of the beginning of the tax year following the tax year of the debt cancellation.
Capital losses. Reduce any net capital loss for the tax year of the debt cancellation, and any capital loss carryover to that year.
Basis. Reduce the basis of the debtor's property as described under Basis Reduction, later. This reduction applies to the basis of both depreciable and nondepreciable property.
Passive activity loss and credit carryovers. Reduce any passive activity loss or credit carryover from the tax year of the debt cancellation.
Foreign tax credit. Last, reduce any carryover, to or from the tax year of the debt cancellation, of an amount used to determine the foreign tax credit or the Puerto Rico and possession tax credit.
Amount of reduction. Except for the credit carryovers, reduce the tax attributes listed earlier 1 dollar for each dollar of canceled debt that is excluded from income. Reduce the credit carryovers by 33 cents for each dollar of canceled debt that is excluded from income.
Making the reduction. Make the required reductions in tax attributes after figuring the tax for the tax year of the debt cancellation. In reducing NOLs and capital losses, first reduce the loss for the tax year of the debt cancellation, and then any loss carryovers to that year in the order of the tax years from which the carryovers arose, starting with the earliest year. Make the reductions of credit carryovers in the order in which the carryovers are taken into account for the tax year of the debt cancellation.
Individuals under chapter 7 or 11. In an individual bankruptcy under chapter 7 or 11 of title 11, the required reduction of tax attributes must be made to the attributes of the bankruptcy estate, a separate taxable entity resulting from the filing of the case. Also, the trustee of the bankruptcy estate must make the choice of whether to reduce the basis of depreciable property first before reducing other tax attributes. See the discussion of Taxes and the Bankruptcy Estate, earlier.
Basis Reduction
If any amount of the debt cancellation is used to reduce the basis of
assets as discussed under Reduction of Tax Attributes, the following
rules apply to the extent indicated.
When to make the basis reduction. Reductions in basis due to debt cancellation
are made at the beginning of the tax year following the cancellation.
The reduction applies to property held at that time. See Regulations
section 1.1017-1 for more information.
Bankruptcy and insolvency reduction limit. The reduction in basis for canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later.
Exempt property under title 11. If debt is canceled in a bankruptcy case under title 11 of the United States Code, do not reduce the basis in property that the debtor treats as exempt property under section 522 of title 11.
Election to reduce basis in depreciable property first. The estate, in the case of an individual bankruptcy under chapter 7 or 11, may choose to reduce the basis of depreciable property before reducing any other tax attributes. However, this reduction of the basis of depreciable property cannot be more than the total basis of depreciable property held at the beginning of the tax year following the tax year of the debt cancellation.
Depreciable property means any property subject to depreciation, but only if a reduction of basis will reduce the amount of depreciation or amortization otherwise allowable for the period immediately following the basis reduction. The debtor may choose to treat as depreciable property any real property that is stock in trade or is held primarily for sale to customers in the ordinary course of trade or business. The debtor must generally make this choice on the tax return for the tax year of the debt cancellation, and, once made, the debtor can only revoke it with IRS approval. However, if the debtor establishes reasonable cause, the debtor may make the choice with an amended return or claim for refund or credit.
Making elections. Make the election to reduce the basis of depreciable property before reducing other tax attributes, as well as the election to treat real property inventory as depreciable property, on Form 982.
Recapture of basis reductions. If any basis in property is reduced under these provisions and is later sold or otherwise disposed of at a gain, the part of the gain corresponding to the basis reduction is taxable as ordinary income. Figure the ordinary income part by treating the amount of the basis reduction as a depreciation deduction and by treating any such basis-reduced property that is not already either IRC section 1245 or IRC section 1250 property as IRC section 1245 property. In the case of IRC section 1250 property, make the determination of what would have been straight line depreciation as though there had been no basis reduction for debt cancellation. IRC sections 1245 and 1250 and the recapture of gain as ordinary income are explained in Publication 544.
Partnerships
If a partnership's debt is canceled because of bankruptcy or insolvency,
the rules for the exclusion of the canceled amount from gross income
and for tax attribute reduction are applied at the individual partner
level. Thus, each partner's share of debt cancellation income must be
reported on the partner's return unless the partner meets the bankruptcy
or insolvency exclusions explained earlier. Then all choices, such as
the choices to reduce the basis of depreciable property before reducing
other tax attributes, to treat real property inventory as depreciable
property, and to end the tax year on the day before filing the bankruptcy
case, must be made by the individual partners, not the partnership.
Depreciable property. For purposes of reducing the basis of depreciable
property in attribute reduction, a partner treats his or her partnership
interest as depreciable property to the extent of the partner's proportionate
interest in the partnership's depreciable property. This applies only
if the partnership makes a corresponding reduction in the partnership's
basis in its depreciable property with respect to the partner.
Partner's basis in partnership. The allocation of an amount of debt
cancellation income to a partner results in that partner's basis in
the partnership being increased by that amount. At the same time, the
reduction in the partner's share of partnership liabilities caused by
the debt cancellation results in a deemed distribution, in turn resulting
in a reduction of the partner's basis in the partnership. These basis
adjustments are separate from any basis reduction under the attribute-reduction
rules described earlier.
Corporations
Corporations in a bankruptcy proceeding or insolvency generally follow
the same rules for debt cancellation and reduction of tax attributes
as an individual or individual bankruptcy estate would follow.
Stock for Debt Exchange
If a corporation transfers its stock (or if a partnership transfers
an interest in the partnership) in satisfaction of indebtedness and
the FMV of the stock or interest is less than the indebtedness owed,
the corporation or partnership has income to the extent of the difference
from the cancellation of indebtedness. The corporation or partnership
can exclude all or a portion of the income created by the stock or interest
debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy
proceeding, it can exclude the income to the extent it is insolvent.
However, the corporation or partnership must reduce its tax attributes
to the extent it has any by the amount of the excluded income.
Stock for debt exception. The stock for debt exception was repealed
for transfers made after 1994 unless the corporation filed for bankruptcy
(or similar court proceeding) before 1994. Generally, before 1995, a
corporation did not realize income because of such stock for debt exchanges
if it was in bankruptcy or to the extent it was insolvent. Consequently,
there was no gross income to exclude and no reduction of its tax attributes
was necessary. The principal difference between the stock for debt exception
and the stock for debt exchange is that the corporation does not reduce
its tax attributes under the stock for debt exception.
Earnings and profits
The earnings and profits of a corporation do not include income from
the discharge of indebtedness to the extent of the amount applied to
reduce the basis of the corporation's property as explained earlier.
Otherwise, discharge of indebtedness income, including amounts excluded
from gross income, increases the earnings and profits of the corporation
(or reduces a deficit in earnings and profits).
If there is a deficit in the corporation's earnings and profits and
the interest of any shareholder of the corporation is terminated or
extinguished in a title 11 or similar case (defined earlier), the deficit
must be reduced by an amount equal to the paid-in capital allocable
to the shareholder's terminated or extinguished interest.
S Corporations
For S corporations, the rules for excluding income from debt cancellation
because of bankruptcy or insolvency apply at the corporate level.
Net operating losses. A loss or deduction that is disallowed for the
tax year of the debt cancellation because it exceeds the shareholders'
basis in the corporation's stock and debt is treated as an NOL for that
tax year in making the required reduction of tax attributes for the
amount of the canceled debt.
Tax Attribute Reduction Example
The sample filled-in Form 982 shown on the next page is based on the
following situation.
Tom Smith is in financial difficulty, but he has been able to avoid
declaring bankruptcy. In 2007, he reached an agreement with his creditors
whereby they agreed to forgive $10,000 of the total that he owed them
in return for his setting up a schedule for repayment of the rest of
his debts.
Immediately before the debt cancellation, Tom's liabilities totaled
$120,000 and the FMV of his assets was $100,000 (his total basis in
all these assets was $90,000). At the time of the debt cancellation,
he was considered insolvent by $20,000. He can exclude from income the
entire $10,000 debt cancellation because it was not more than the amount
by which he was insolvent.
Among Tom's assets, the only depreciable asset is a rental condominium
with an adjusted basis of $50,000. Of this, $10,000 is allocable to
the land, leaving a depreciable basis of $40,000. He has a long-term
capital loss carryover to 2008 of $5,000. He also has an NOL of $2,000
and a $3,000 NOL carryover from 2005. He has no other tax attributes
arising from the current tax year or carried to this year.
Ordinarily, in applying the $10,000 debt cancellation amount to reduce
tax attributes, Tom would first reduce his $2,000 NOL, next, his $3,000
NOL carryover from 2005, and then his $5,000 net capital loss carryover.
However, he figures that it is better for him to preserve his loss carryovers
for the next tax year.
Tom elects to reduce basis first. He can reduce the depreciable basis
of his rental condominium (his only depreciable asset) by $10,000. The
tax effect of doing this will be to reduce his depreciation deductions
for years following the year of the debt cancellation. However, if he
later sells the condominium at a gain, the part of the gain from the
basis reduction will be taxable as ordinary income.
Tom must file Form 982, as shown here, with his individual return (Form
1040) for the tax year of the debt discharge. In addition, he must attach
a statement describing the debt cancellation transaction and identifying
the property to which the basis reduction applies. This statement is
not illustrated.
Courtesy of IRS Publication 908 (March 2008)