Thursday, January 23, 2014
Federal Taxation of Individual in Chapter 11
The Internal Revenue Service Publication 908 reviews various aspects of the federal taxation of the individual in chapter 11 bankruptcy.
Bankruptcy Estate as Separate Taxable Entity - The bankruptcy estate of an individual in chapter 11 is a separate taxable entity. The debtor’s pre-petition income is included on his personal income tax return. The bankruptcy estate includes in its gross income all of the debtor’s income, including wages and income from the estate’s property, to which the estate is entitled. Any amounts not included in the bankruptcy estate's income are included in the individual's personal income. The debtor is to allocate his wages between the debtor and the bankruptcy estate. A simple percentage method may be used. Income from exempt and abandoned property, although initially part of the estate, are subsequently excluded from the estate. An individual (as debtor-in-possession) may be compensated by the bankruptcy estate for managing its business. Such payments are to be reported by the debtor on his individual returns as miscelleaneous income.
Tax Returns - The individual files a Form 1040 and the bankruptcy estate files a Form 1041 for the involved tax year. Form 1040 is to be attached to the Form 1041. In the case of a joint bankruptcy filing of a husband and wife, the bankruptcy estate is treated as two separate taxable entities and that two separate tax returns are filed for the bankruptcy estate. The bankruptcy estate must file the Form 1041 if its gross income exceeds the amount required for filing based on a statues of a married individual filing separately.
A “Notice 2006-83 Statement” is required to be attached to the individual and bankruptcy estate’s tax returns regarding the chapter 11 case. The statement should list the date of filing of the bankruptcy case, the case number, the location of the Bankruptcy Court, and the bankruptcy estate’s employment identification number. EIN. This statement is to reflect the allocations of income and withheld income taxes and describe the method used for such allocations. A model statement is included in Publication 908.
Election to End Tax Year - An individual may elect to close his tax year as of the day before the date the bankruptcy case is file. In such case, the tax year is divided into two short tax years (adding up to 12 months). Any tax liability for the first short year becomes an allowable claim against the bankruptcy estate. If such election is not made, the commencement of the bankruptcy estate does not affect the individual’s tax year and no part of the debtor’s income tax liability for such year can be collected from the bankruptcy estate.
Computation of Tax, Tax Attributes - The bankruptcy estate figures its taxable income and takes deductions and credits in the same manner that the debtor would have on his individual tax return. The bankruptcy estate uses the rates for a married individual filing separately and can take one personal exemption and either itemize deductions or take the standard deduction for a married individual filing a separate tax return.
The bankruptcy estate figures its tax attributes the same way the debtor would have. These amounts are figured on the date the bankruptcy is filed. The tax attributes the bankruptcy estate takes from the debtor include the following: NOL carryovers, basis, holding period, and character of assets, method of accounting, etc. Certain tax attributes of the estate must be reduced by an excluded income from cancellation of debt occurring during the bankruptcy case.
Debt Cancellation – Cancelled or forgiven debt is generally income for tax purposes, with certain exceptions such as if the debt is cancelled during a bankruptcy case or while the debtor is insolvent. Certain tax attributes (such as certain losses, credits, and basis of property) though may be reduced by the amount of the excluded income. Cancellation during bankruptcy takes precedence over the insolvency exclusion. Bankruptcy cancellation would be as a result of a plan confirmed by the Bankruptcy Court. A person is generally insolvent when and to the extent liabilities exceed the fair market value of the assets just before the cancellation of the debt.
Administrative Expenses – the bankruptcy estate is allowed a deduction for administrative expenses and fees or charges assessed. These are generally deductible as itemized deductions. Administrative expenses attributable to the conduct of a trade or business by the bankruptcy estate are deducted at arriving as adjusted gross income.
Employer identification Number (“EIN”) – a chapter 11 individual debtor needs to obtain an employer identification number for the estate to use on any tax returns filed for the estate. Such number should be provided as soon as reasonably possible to those persons that are required to file information returns for the bankruptcy estate’s gross income, gross proceeds, or other types of reportable payments. The payors should report such amounts using the bankruptcy estate’s name and EIN. One may obtain an EIN at www.irs.gov/businesses/small, by calling (800) 829-4933, or by mailing a Form SS-4.
Form W-2 – An individual chapter 11 debtor does not need to provide his EIN to his employer for use with on his W-2. The employer should continue to report all wage income and tax withholdings, whether pre-or post-petition, on the Form W-2 issued under the debtor’s individual social security number. Determination of income tax withholding, FICA, FUTA are not changed.
Closing of Bankruptcy Estate – the bankruptcy estate ends as a taxable entity when the chapter 11 case is closed, dismissed, or converted to chapter 13. If the case is converted to chapter 7, the bankruptcy estate will continue to exist as a separate taxable entity. Generally, once the bankruptcy estate is ended, gross income realized thereafter is reported to the debtor not the estate. The debtor should send notice of such closing to all persons previously notified of the bankruptcy case to ensure that items are reported to the debtor social security number or EIN instead of to the bankruptcy estate.
Dismissal of Bankruptcy Case – the Bankruptcy Code provides that the taxing authority may request a dismissal of your case if you fail to file the required tax return or pay taxes owed after the bankruptcy case is filed. If the chapter 11 case is dismissed, the debtor is treated as is the bankruptcy petition was never filed. Amended returns on Form 1040X are to be filed to replace the returns filed by the bankruptcy estate. The amended returns are to include the items of income, deductions, and creditor that were included on the bankruptcy estate’s tax return that were not reported on the individual’s tax return.