CHAPTER FOUR

Taxation of Bankruptcy Estates and Debtors

§ 4.1 Introduction

§ 4.2 Responsibility for Filing Income Tax Returns

(a) Responsibility of Trustee

§ 4.3 Accounting for the Bankruptcy Estate

(a) Separate Entity

(b) Returns to Be Filed

(c) Attribute Carryover to Estate

(i) Passive Activity Losses

(ii) Gain on Sale of Residence

(iii) Unlisted Attributes

(iv) Accounting Period

(v) Net Operating Loss

(d) Estate’s Income

(i) Partnerships and S Corporations

(e) Estate’s Deductions, Credits, and Employment Taxes

(i) Accrued Expenses

(ii) Administrative Expenses

(f) Net Operating Loss Carryback

(g) Change in Accounting Period

(h) Tax Liability of the Estate

(i) Distributions from the Estate

(j) Abandonment of Property

(i) Argument for Taxable Event

(A) Avoidance of Liability

(B) Denial of Fresh Start

(C) Transfer as a Taxable Event

(D) Substance over Form

(E) Section 1398 (f)(2)

(ii) Internal Revenue Service’s Position

(iii) Court Rulings

(iv) Abandonment to Debtor or Creditor

(k) Abandonment of Proceeds

§ 4.4 Accounting for the Debtor (Individual)

(a) Individual Debtor’s Taxable Year

(i) Procedures for Election

(ii) Electing “Short” Tax Year

(b) Tax Refunds and Estimated Tax Payments

(c) Income and Deductions

(d) Attribute Carryover to Debtor

(i) Method of Accounting

(e) Loss Carryback

(f) Automatic Stay

§ 4.5 Summary

§ 4.1 INTRODUCTION

The procedure for filing tax returns for corporations is well established; however, much controversy existed in the past over the types of returns to file for individuals and partnerships. To eliminate some of the uncertainty as to whether a separate entity was created, the Bankruptcy Tax Act added sections 1398 and 1399 to the Internal Revenue Code (I.R.C.).

The objective of this chapter is to discuss the provisions of I.R.C. section 1398 that impact both the bankruptcy estate and the debtor. The state and local tax provisions contained in the Bankruptcy Code that impact the bankruptcy estate and the debtor are described in Chapter 8.

§ 4.2 RESPONSIBILITY FOR FILING INCOME TAX RETURNS

A trustee that fails to file a return and pay the taxes may be held liable for such taxes. I.R.C. section 6012(b)(4) was amended by the Bankruptcy Tax Act of 1980 to provide that “[returns] of an estate, a trust, or an estate of an individual under chapter 7 or 11 of title 11 of the United States Code shall be made by the fiduciary thereof.” In In re Joplin, Jr.,1 the Tenth Circuit held that the trustee had the responsibility to file a tax return even though the Internal Revenue Code provided (under I.R.C. section 6012 as existed prior to the 1980 amendments) that the trustee for a corporation in bankruptcy had a duty to file the returns but was silent with regard to the responsibility of a trustee for an individual. In Joplin, the IRS instituted an adversary proceeding in the bankruptcy court against State Farm, the trustee’s surety, seeking recovery of the unpaid tax. Both the bankruptcy court and the district court ruled against the IRS. The Tenth Circuit reversed the decision of the district court, vacated the dismissal of the claim against State Farm, and remanded the matter to the district court for further proceedings.

Relating to chapter 7, section 704 of the Bankruptcy Code requires the trustee, if authorized to operate the business, to file with the governmental unit charged with responsibility for collecting or determining any tax arising out of such operation. In In re Harry Fondiller,2 the bankruptcy court noted that, in a chapter 7 case, the trustee is charged with the responsibility of preparing and submitting to the IRS tax returns based on (former) section 728(b) of the Bankruptcy Code. The court also noted that I.R.C. section 1398(c) requires that the trustee pay the tax incurred by the estate. The court went on to note that, if the tax is not paid on or before the due date, I.R.C. section 6601(a) indicates that interest shall be paid from the due date until the date the tax is actually paid.3

Section 1106 of the Bankruptcy Code indicates that the trustee is responsible for filing a tax return for any year in which the debtor has not filed a tax return that is required by law. This return is to be furnished without personal liability and must include the information that is required by the governmental unit with which the return is to be filed and that is available in light of the condition of the debtor’s books and records. In In re Hudson Oil Co.,4 the bankruptcy court held that, although the trustee’s liability is limited under section 1106(a)(6) of the Bankruptcy Code, the trustee is not excused from filing the corporate return for a year that ended just prior to the filing of the petition. The court also held that the IRS is not precluded from imposing late filing penalties and negligence penalties against the corporation if the trustee files the return late or inaccurately. The return filed in this case was a corporate return, but the same responsibility should be expected of the trustee if the debtor is an individual.

I.R.C. section 1398 provides that a separate estate is created in a chapter 7 or chapter 11 filing. The bankruptcy court held that in a chapter 13 case, a separate estate is not created and the debtor is responsible for filing federal income tax returns.5

The IRS has taken the position in a number of cases that no separate tax entity is created in chapter 12 cases, and the taxes incurred on the sale of farm assets after commencement of a case or after confirmation of a chapter 12 plan are not dischargeable.6

Whenever a separate taxable estate or entity is created in a bankruptcy case concerning a debtor under the Internal Revenue Code of 1986, a separate taxable estate is also created under section 346 for state and local tax purposes. The trustee shall make tax returns of income required under any such state or local law.7 When no separate estate is created, such as with a corporation or partnership, the trustee shall make such tax returns of corporations and of partnerships as are required under any state or local law. The estate shall be liable for any tax imposed on such corporation or partnership, but not for any tax imposed on partners or members.8

In In re Shank,9 the bankruptcy court examined the question as to whether the creditors’ representative or the debtors are responsible for filing federal income tax returns and paying the taxes incurred in connection with the liquidation of assets sold as part of the debtors’ confirmed plan of reorganization. The debtors’ plan called for the disposition of estate property by two methods. The first method was for the estate to transfer property collateral to secured claim holders in full satisfaction of each recipient’s allowed secured claim. The second method called for the sale of various assets, the proceeds of which would be distributed first to secured claim holders in satisfaction of their allowed secured claims, second to priority claimants, and the remainder to unsecured claim holders. The debtors used an undefined term, “asset pool,” to describe the group of assets that were to be sold for the benefit of secured claim holders, priority claim holders, and unsecured claim holders. The debtors’ plan also appointed a creditors’ representative “to administer and liquidate the asset pool for the benefit of the debtors’ creditors as provided for in the plan.” The creditors’ representative’s specific duties included managing the assets in the asset pool, including, without limitation, collecting all rents, profits, and earnings arising from the same and paying all mortgages, taxes, and other expenses due and owing with respect to such assets from the rents, profits, and earnings of the asset pool; determining the listing price of the real property and negotiating the sale of the real properties and other interests in the asset pool; maintaining cash records; and making distributions to creditors provided for in the plan. The debtors were responsible for conveying the property to the parties provided for in the plan, including the creditors’ representative, and assisting in the marketing and sale of the properties.

The bankruptcy court noted: “It is clear that upon confirmation of a plan of reorganization, property of the bankruptcy estate vests in the reorganized debtor, a new entity, and administration of the estate ceases.”10 Additionally, the court noted that the duty to pay federal income taxes is tied to the duty to make an income tax return. The Supreme Court noted in Holywell11 by citing I.R.C. section 6151 that “[w]hen a return of tax is required . . . the person required to make such return shall . . . pay such tax.” Thus, the returns of an estate, trust, or an estate of an individual under chapter 7 or 11 of title 11 of the United States Code shall be made by the fiduciary thereof.

The bankruptcy court noted that in determining who is required to file tax returns and remit payment for taxes associated with the postconfirmation sale of the asset pool assets, the court’s task is to determine the nature of the ownership of the assets in the asset pool. Thus, a determination that the assets are owned by the debtors would place the tax liability burden on the Shanks. However, the court noted that a determination that acknowledged ownership of the assets by a trust would shift the onus of filing returns and paying taxes to the creditors’ representative as a trustee pursuant to I.R.C. section 6012(b)(4). By reference to the plan and the law of trusts, the court concluded that the assets in the asset pool vested in the debtors upon confirmation of their plan and that no trust was created upon such confirmation. Consequently, the bankruptcy court concluded that the creditors’ representative “is neither obligated to file tax returns in connection with the liquidation of the Asset Pool assets, nor is he obligated to pay taxes arising therefrom.”12

(a) Responsibility of Trustee

The trustee may be liable for a disbursement of funds that ignored a notice of levy.13 The bankruptcy trustee for Central Micrographic Corporation’s chapter 7 filing was approached by a real estate broker indicating that he had a prospective buyer of the debtor’s assets. Trustee filed an application with the bankruptcy court to employ a business broker for the bankruptcy estate. The bankruptcy court’s order provided that the broker would be paid a commission if his prospect was the successful buyer of the debtor’s business.

A buyer was found, and the bankruptcy court ordered the sale of the property, which took place in June 1989. The agreement provided that payment of brokerage commissions was conditioned on approval of the bankruptcy court. The broker filed an application for allowance of a broker’s fee as broker for the trustee, seeking a commission of $20,000. In July of that year, the bankruptcy court set a hearing date of August 3 on the broker’s fee application, which the trustee received notice of before July 27. On July 27, the IRS served the trustee with a notice of levy for the broker’s outstanding federal tax liabilities that exceeded the $20,000 fee. On August 10, 1989, the bankruptcy court approved the fee application, and on the next day the trustee wrote the broker a check for $20,000. The government sued the trustee for failing to honor the levy. The trustee argued that the broker had no right to a broker’s commission until the bankruptcy court entered its order approving his application. The government contended that the broker had a property right in his commission at the time the notice of levy was served, even though he did not then have a present right to payment.

The district court held that the trustee is liable for failing to honor the levy against the broker’s property. The court agreed with the government claim that at the time the notice of levy was served on the trustee, the broker had fully performed his brokerage services and the transaction had closed. The court ruled that under federal law, the broker’s earned but unpaid commission constituted property or rights to property subject to levy. The court cited United States v. Hubbell14 and Randall v. H. Nakashima & Co.15 in concluding that a right to proceeds of a contract is property. The district court thus held the trustee liable for the entire $20,000 under I.R.C. section 6332(d)(1).

The trustee is required to withhold from any payment of claims for wages, salaries, commissions, dividends, interest or other payments, or collect, any amount required to be withheld or collected under applicable state or local tax law, and shall pay such amounts to the governmental unit at the time and in the manner required by such tax law.16

§ 4.3 ACCOUNTING FOR THE BANKRUPTCY ESTATE

(a) Separate Entity

When bankruptcy proceedings intervene in the affairs of an individual, a separate taxable entity is created.17 The new entity is the estate consisting of the property belonging to the debtor before bankruptcy, except exempt property. The trustee or debtor in possession is responsible for filing Form SS-4 (Application for Employer Identification Number) to obtain an identification number to use in filing tax returns. Trustees can now obtain a federal identification number online for the estate by going to the IRS Web site at www.IRS.gov.

I.R.C. section 1398(f)(1) provides that the transfer (other than by sale or exchange) of property from the debtor to the estate is not a disposition for tax purposes and that the debtor will be treated as the estate would be treated with respect to such assets. The same treatment applies for state and local taxes.18

After the petition has been filed, the bankruptcy estate can earn income and incur expenses. These transactions are administered by a trustee in a chapter 7 case, or by a debtor in possession (or a trustee) in a chapter 11 case, for the benefit of the creditors. Concurrently, the individual debtor can also earn income, incur expenses, and acquire property. In a chapter 11 case, income becomes part of the bankruptcy estate. These separate taxable entities for federal income tax purposes occur in bankruptcy cases under chapters 7 and 11 of title 11 of the U.S. Code; no new taxable entity is created, however, under chapter 12 or 13 of the U.S. Code. When a bankruptcy case involving an individual is dismissed by the bankruptcy court, the estate is not deemed to have been a separate taxable entity. Because chapter 12 is patterned after chapter 13, no new entity is created; however, section 1231 of the Bankruptcy Code provides the same state and local tax provisions for chapter 12 that apply for chapter 11. The date of the order for relief marks the beginning of the tax period of the estate for state and local tax purposes—thus it appears that the drafters of chapter 12 were interested in having the tax provisions of chapter 12 follow chapter 11 and not chapter 13. Under this assumption, a new entity is created; however, the issue appears to have been resolved in the courts.19 The consistent position of the IRS is that a new estate is not created.

In a private letter ruling,20 the IRS stated that, in the case of a chapter 12 petition, a separate estate is not created. The failure of the IRS to allow the use of a separate estate for federal tax purposes for chapter 12 farmers (or the failure of Congress to pass a federal provision consistent with the state and local tax laws) has resulted in several farmers’ electing to file chapter 11 instead of chapter 12. For example, in a chapter 12 case, if the trustee sells part of a farm at a gain, the tax responsibility remains with the individual. If the trustee has a plan confirmed before the end of the year in which the transfer occurred, the tax liability may not be provided for in the plan. Unsecured creditors may, in fact, receive from the sale of part of the farm the proceeds that should have gone to the IRS. The individual is then left responsible for the tax.

Appeals courts in the Eighth, Ninth, and Tenth Circuits have decided cases dealing with the treatment of taxes incurred on the postpetition sale of farm assets. The Eighth and Tenth Circuits have ruled in favor of debtors with postpetition sales while the Ninth Circuit has ruled in favor of the IRS in a case involving a postpetition sale.21 The Supreme Court has agreed to review the decision of the Ninth Circuit which held that capital gain taxes on postpetition sale of farm assets was not dischargeable under chapter 12 of the Bankruptcy Code.22

(b) Returns to Be Filed

In cases where the individual and the bankruptcy estate are separate entities, they are required to file separate returns. The estate files Form 1041 for the period beginning with the filing of the petition or for any subsequent year if gross income is equal to or greater than the sum of the exemption amount plus the basic standard deduction. For 2010, the filing requirement is gross income of at least $9,350. A bankruptcy judge held in In re Jackie Ray Wills23 that the estate must file a return if the estate’s gross income exceeds the dollar filing requirement, even though there may not be any tax liability because of other tax attributes of the debtor under I.R.C. section 1398(g) or deduction allowed by I.R.C. section 1398(h). The judge also ruled that the tax liability determination was to be made under the “hurry up” provisions of section 505 of the Bankruptcy Code. The estate would not be eligible for income averaging. The individual files Form 1040, as usual, and reports all income earned during the year. This includes income earned before bankruptcy proceedings, but not any income earned by the estate. I.R.C. section 6012(b)(4) requires that the fiduciary of the estate file the return. This would be the trustee, if appointed; otherwise, the debtor in possession must file the estate’s return.

The IRS issued letters to chapters 7 and 11 debtors indicating that two Form 1041s and two Form 1040s should be filed. The taxpayer and spouse will each be required to file Form 1041 and attach a separate Form 1040 with the tax calculated based on the rates for a married person filing separate returns. The income needs to be divided between the husband and wife. In community property states, all income earned by both spouses should be divided into half. Fifty percent of the income should be placed on the husband’s Form 1040 that is attached to his 1041, and the other 50 percent should be placed on the wife’s Form 1040 that is attached to her 1041. At one time the IRS was in the process of preparing a new form to be used in bankruptcy cases by the estate; however, that project has never been completed by the IRS.

The position taken by the IRS in this letter is consistent with the decision in In re Knobel, 24 but which the IRS objected to in this case. The bankruptcy court held that in the case of a jointly filed chapter 7 bankruptcy petition “each estate in a jointly filed case, unless the court orders substantive consolidation, is entitled to a personal exemption and a standard deduction, as an individual deemed to be married filing separately, in calculating their respective taxable income.” The IRS argued that only one estate and one taxable entity is created upon the filing of a joint petition under section 302 of the Bankruptcy Code. The bankruptcy court rejected the IRS position, noting that even though only one case is filed, only one case number is assigned, only one employer identification number is assigned, and only one trustee is appointed, the filing of a joint petition is for administrative purposes and does not result in de facto substantive consolidation. Thus, by issuing this letter, the IRS is unofficially reversing its position and accepting the conclusion reached by the bankruptcy court in Knobel.

The court noted that in the case of community property, the fact that into each estate falls the debtor’s and his or her spouse’s interest in community property makes segregation of property less than practical, and which may in the average case warrant substantive consolidation. However, according to the bankruptcy court, substantive consolidation does not occur until the courts have issued such an order. In In re Ageton,25 the Bankruptcy Appeals Panel concluded that the statute means what it says and “until and unless consolidation is ordered, there remains two estates subject to administration in a joint case.” As a result of Ageton, the Chief Judge for the Central District of California issued General Order 97-04, which has been superseded by Local Bankruptcy Rule (LBR) 1015-1(a) (1/12/2009), indicating that all chapter 7 petitions of spouses filed under one case number are to be deemed substantively consolidated under section 302(b) of the Bankruptcy Code unless the court orders otherwise. Thus, in the central district of California, the debtor should file only one Form 1041 for both the husband and wife. The tax liability will be calculated on a single Form 1040 for each joint petition based on the tax rates for a married person filing separate returns. Form 1040 will be attached to Form 1041 as described in the text. Only one tax identification number will be needed for each joint petition. It appears that this order is effective for all petitions filed after August 4, 1997. (The debtor’s Social Security number should not be reported on the tax returns.)

On Form 1041, the trustee for the estate will check the appropriate bankruptcy box in the upper left-hand corner, then file Form 1040, U.S. Individual Income Tax Return, figuring the tax for the bankruptcy estate the same way as for a married person filing separately. The tax liability from Form 1040 should be transferred to Form 1041, and the debtor in possession or the trustee should sign Form 1041.26

The trustee or debtor in possession must withhold income and Social Security taxes and file the related employment tax returns for wages paid that are administrative expenses, priority claims, or unsecured claims. According to orders generally issued by the U.S. trustees, these withheld taxes in chapter 11 cases are to be segregated in a separate account until the federal deposits are made. In chapter 7 and chapter 11 cases where the U.S. trustee may not demand segregation, it is still advisable to place these withholdings in a separate account or make immediate deposits, to avoid any potential liability for these taxes under I.R.C. section 6672.

Social Security taxes are to be withheld at the current rate. Federal income taxes are to be based on the withholding tax tables published in IRS, Circular E, Employer’s Tax Guide. The trustee or debtor in possession may also use the alternative 20 percent rate method as provided in Treasury Regulations (Treas. Reg.) section 31-3402(b)-1. In determining the amount of Social Security taxes and the federal and state unemployment taxes to be withheld, it would appear that the wages paid by the individual debtor prior to the filing of the petition should be included in the base. On Form W-2, issued to employees at year-end, the trustee or debtor in possession would include wages paid prior to the filing of the petition with those paid after the petition is filed. Thus, the employee will receive only one Form W-2, and excess amounts of Social Security taxes will not have been withheld.

Csontos27 suggested that this is the policy to follow in chapter 7 cases. (He did not address the issue in chapter 11 cases.) However, it could be argued that, because the separate estate is created, there are two separate taxable entities. There would therefore be a final Form W-2 filed by the debtor, including the period prior to the filing of the bankruptcy petition, and another W-2 for the period subsequent to the filing of the petition. The problem with this argument is that I.R.C. section 1398 creates a separate estate only for federal income tax purposes and only for individuals in a chapter 7 or chapter 11 case; it does not address the issue of employment taxes. As a practical matter, in a chapter 7 case, information about prepetition wages is often incomplete or missing or overlooked by the trustee, thus making it impossible to issue a single W-2 for wages paid during the reporting year. In addition, in an individual business debtor case, the business debtor would have used a different federal ID number than the one assigned to the estate, and thus there would be two accounts with the IRS; consequently, the IRS would be looking for separate employment tax returns and Forms W-2.

In a sense, there is the creation of a new legal entity, which might suggest that two IRS Form W-2s need to be filed. However, this application would apply to corporations as well as to individuals. Filing of two Form W-2s has not been the general practice.

If an employee fails to receive an IRS Form W-2 for any wages paid by the debtor in possession or the trustee for the period prior to or the period following the filing of the petition, IRS Form 4852, indicating the estimated amount of taxes withheld, should be completed and attached to the individual’s tax return. Following these procedures will allow the employee to receive credit for taxes withheld even though the withholdings may not have been reported to the IRS.

A problem does arise as to how to handle the quarterly tax returns that should be filed by the employer (e.g., Form 941). As discussed in § 11.2(d), the employer’s taxes and withholdings on wages paid prior to the date the petition is filed are considered prepetition taxes. It may be advisable to file two quarterly returns—one for wages paid that were earned prior to the filing of the petition, and the other for wages earned after the petition is filed.

Even though a separate estate may be created when an individual becomes involved in bankruptcy proceedings, this will not cause a Subchapter S corporation in which the individual is a shareholder to lose its S status. The Tax Reform Act of 1986 added I.R.C. section 1361(c)(3), which specifically allows the estate of a bankrupt to continue on as an S corporation shareholder.

(c) Attribute Carryover to Estate

The estate succeeds to (inherits) and takes into account the following income tax attributes of the debtor in a chapter 7 or 11 case:28

For example, the Treasury Regulations could allow the estate the benefit of I.R.C. section 1341 if the estate repays income the debtor received under claim of right.29 However, until added by Treasury Regulations, income tax computational benefits under section 1341 are not tax attributes that are transferred to the bankruptcy estate.30

The attributes are determined as of the first day of the debtor’s taxable year in which the case commences. For example, if a bankruptcy petition is filed on May 5, 20X2, and the individual does not file a short tax return, the tax attributes are carried over as of January 1, 20X2 (calendar-year taxpayer). Also, it would appear that the estate would be able to claim depreciation expense for the period of January 1 to May 5 even though the estate’s taxable year does not begin until May 5. Absent a short-year election by the debtor, any income earned by the chapter 7 or 11 individual subsequent to the beginning of the tax year but prior to the filing of the petition could not be offset against an NOL carryover. An election (see §§ 4.4(a)(i) and (ii)), however, can be made by the individual to file a short tax return and have the estate pay any tax due. If the debtor made this election, the tax attributes would carry over as of the date the bankruptcy petition was filed. Because of the election to file a short tax return, the date the petition was filed becomes the first day of the debtor’s taxable year in which the case commences.

(i) Passive Activity Losses

Treas. Reg. sections 1.1398-1 and 2 provide that the bankruptcy estate succeeds to the unused passive activity losses and credits under I.R.C. section 469 and to the unused losses from at-risk activities under I.R.C. section 465 of an individual debtor in a case under chapter 7 or chapter 11.

Under I.R.C. section 469, which was added to the code by the Tax Reform Act of 1986, passive activity losses and credits are disallowed and treated as deductions or credits allocable to the same activity in the next taxable year. Passive activity losses and credits were not among the attributes enumerated in I.R.C. sections 1398(g) and (i).

I.R.C. section 465, added to the code by the Tax Reform Act of 1976, limits a taxpayer’s deductible loss from an activity to the taxpayer’s amount “at risk” (within the meaning of I.R.C. section 465(b)) in that activity. If a loss is not allowed under I.R.C. section 465, it is treated as a deduction allocable to the same activity in the next taxable year. Losses that are not allowed under I.R.C. section 465 are not among the attributes enumerated in I.R.C. sections 1398(g) and (i).

The IRS noted that the transfer of unused passive activity losses and credits from the debtor to the estate is consistent with one of the primary purposes of I.R.C. section 1398, that is, to treat the bankruptcy estate as the tax successor of the debtor. The unused passive activity losses and credits to which the estate succeeds are determined as of the first day of the debtor’s taxable year in which the bankruptcy case commences, in accordance with the current provision of I.R.C. section 1398(g): The estate succeeds to and takes into account the specified attributes determined as of the first day of the taxable year in which the bankruptcy case commences.

Treas. Reg. sections 1.1398-1 and 2 do not just provide for the carryover of the tax attribute of unused passive activity losses and credits and the unused losses from at-risk activities under I.R.C. section 465. They also provide that a transfer of an interest in a passive activity to the debtor as exempt under section 522 of the Bankruptcy Code or as abandoned to the debtor under section 554(a) of that title is a nontaxable transfer. The impact of this section is discussed in §§ 2.8(a) and (d).

The regulations provide that, in the case of a transfer from the estate to the debtor (other than by sale or exchange), such as a transfer due to abandonment of an interest in a passive activity or former passive activity before the termination of the estate, the debtor succeeds to and takes into account the estate’s unused passive activity loss and credit from the activity (determined as of the first day of the estate’s taxable year in which the transfer occurs). In the case of a transfer of assets, such as in an abandonment, that constitute part of an activity, the debtor succeeds to and takes into account the allocable portion of unused passive activity loss and credit as determined by the estate.

The regulations provide that, upon the termination of the estate, the debtor shall succeed to and take into account the estate’s unused passive activity loss and credit as provided for in I.R.C. section 1398(i).

Treas. Reg. section 1.1398-2 provides that the bankruptcy estate succeeds to any unused at-risk losses of an individual debtor that are not allowed under I.R.C. section 465 in a case under chapter 7 or chapter 11. The rules in the regulations for the transfer of unused losses from the debtor to the estate and from the estate to the debtor generally parallel the rules in the regulations for passive activity losses and credits under I.R.C. section 469, including the nontaxability of a transfer to the debtor of exempt property or the abandonment of the property to the debtor.

In Private Letter Ruling 9304008, the IRS ruled that the debtor succeeds to any passive activity losses of the estate that are allocable to an asset that is abandoned as of the first day of the bankruptcy estate’s taxable year in which the abandonment occurs.31 It is assumed that the passive activity losses referred to are those that were incurred after the property was transferred to the estate. However, the debtor would also succeed to passive activity losses that are carried over to the estate under the election provisions of Treas. Reg. section 1.1398-2.

Treas. Reg. section 1.1398-1 contains special rules for any year in which an amended return cannot be filed because it is for a closed year for passive activity losses and credits; Treas. Reg. section 1.1398-2 contains special rules for unused at-risk losses under I.R.C. section 465.

(ii) Gain on Sale of Residence

Treas. Reg. section 1.1398-3 allows an estate to succeed to the exclusion from income of a gain on the sale of a residence. The Taxpayer Relief Bill of 1997 substantially changed I.R.C. section 121 to provide for a $500,000 ($250,000 nonjoint return) exclusion of gain realized on the sale or exchange of a principal residence. On December 24, 2002, the IRS issued regulations that added the exclusion of the gain on the sale of residence to the list of tax attributes under I.R.C. section 1398 that an individual’s bankruptcy estate may succeed to and take into account when determining the estate’s taxable income in a chapter 7 or 11 bankruptcy case.32 Prior to the issuance of Treas. Reg. 1.1398-3, the IRS indicated that it will no longer challenge the use of this exclusion by the trustee. In a chief counsel notice, the IRS advised district counsel attorneys of a change in its litigating position and will no longer challenge the use of the section 121 exclusion on the gain from a sale of a personal residence by the estate.33

(iii) Unlisted Attributes

Generally, courts have held that the debtor’s estate could not succeed to passive activity losses of the debtor in chapter 11 because they are not specifically listed or included under Treasury Regulations.34 This decision preceded the decision by the Treasury to add these losses to the list of attribute carryovers. This ruling may be viewed as contrary to Traylor v. Commissioner, in which the Tax Court held that related-party debt rules could be applied despite the absence of specific inclusion under Treasury Regulations.35

Over a half dozen cases have held that a trustee can use modified section 121 to allow for the estate a $500,000 ($250,000 single taxpayer) exclusion from income of the gain on the sale of a principal residence.36 Seeing how the courts were ruling on the estate being able to assume this attribute, the IRS first indicated that it would no longer challenge the use of this exclusion by the trustee and then subsequently issued the regulation referred to earlier.37

Section 541 of the Bankruptcy Code provides that, on the commencement of a bankruptcy case, an estate is created that comprises essentially all of the property of the debtor. That property includes:

Property that is exempt under section 522 of the Bankruptcy Code is not part of the estate. However, until it is determined that the property is in fact exempt, it is considered property of the estate.

The taxpayer is not entitled to a claim for refund after a bankruptcy case is closed and the trustee did not file for the refund.39 Weiner filed for bankruptcy in October 1985 and did not include his claim for a tax refund for 1980 in his list of assets. He was adjudicated bankrupt in May 1986, and the case was closed on September 1, 1986.

In looking at the issue as to whether Weiner was entitled to a claim for refund, the court reasoned that Weiner’s failure to disclose the claim caused the bankruptcy trustee to be unaware of the asset. Thus, the claim was neither abandoned nor administered, and as a result it remained the property of the estate. The court found that the claim did not revert to Weiner, and he could not maintain a claim to the refund because the bankrupt estate was the real party in interest. See § 4.4(b).

(iv) Accounting Period

Because the estate adopts the debtor’s method of accounting, it might be assumed that the estate would adopt the debtor’s tax year and date. However, the Internal Revenue Code makes no provision for this. A separate entity has been created. Treas. Reg. section 1.441-1(b)(3) states:

A new taxpayer in his first return may adopt any taxable year which meets the requirements of I.R.C. section 441 and this section without obtaining prior approval. The first taxable year of a new taxpayer must be adopted on or before the time prescribed by law (not including extensions) for the filing of the return for such taxable year.

Because the bankruptcy estate is taxed as an individual, I.R.C. section 645, which requires trusts to use a calendar year, is not applicable to bankruptcy estates.

A fiscal year is established by filing a tax return within the 15th day of the fourth month following the end of the month that is selected as the end of the taxable year.40 If the trustee or debtor in possession fails to establish a fiscal year on a timely basis, the estate must file the return on a calendar-year basis. A fiscal year is established only by filing a tax return on a timely basis. Temporary Treas. Reg. section 1.441-1T(b)(2) indicates that the election of a fiscal year cannot be made by filing an application for extension of time to file the return. The trustee or debtor in possession should evaluate the extent to which the payment of taxes could be delayed or reduced by the selection of the fiscal year. For example, if property with a low value is transferred in settlement of debt and results in a taxable gain, the taxpayer may want to extend the end of the fiscal year to allow for the inclusion of losses on the sale of other property.

In a private letter ruling,41 the IRS has granted a firm an extension to file an application to change its accounting period. The firm explained that it did not know when the application was due and that the due date arrived at a busy time (when the firm was emerging from bankruptcy). The IRS granted the firm an extension because good cause had been shown.

If the year selected by the trustee or debtor in possession for the estate is less than 12 months, income for the short year does not have to be annualized, as provided for in I.R.C. section 443(a). The estate will also be able to deduct the full exemption and the standard deduction for a married person filing a separate return.

(v) Net Operating Loss

I.R.C. section 1398 provides that the estate succeeds to the tax attributes of the debtor in a chapter 7 or chapter 11 case. Since section 1398 provides that the estate succeeds to the tax attributes of the debtor, it might be concluded that the estate does not succeed to the NOL carryovers that are allocated to the nonbankrupt spouse that has filed separate returns or is legally separated or divorced from the debtor.

Treas. Reg. section 1.172-7(d) provides that a husband and wife who are filing separate returns for the current year, but who filed joint returns for any or all of the intervening years, must allocate their joint NOLs to each spouse if they claim an NOL deduction during the current year for which separate returns are filed. Treas. Reg. section 1.172-7(d)(2) indicates that the NOL of each spouse for the tax year for which a joint return was made is the portion of the joint NOL that is attributable to the gross income and deductions of the spouse, with gross income and deductions of that spouse taken into account to the same extent that they are taken into account in computing the joint NOL.

Example 1 of Treas. Reg. section 1.172-7(g) indicates that Harry and Wanda filed joint returns for 20X1 and 20X2 and had an NOL in 20X1 of $1,000 and an NOL of $2,000 in 20X2. If these losses are carried to a year in which Harry and Wanda file separate returns, or Harry and Wanda file separate returns in any intervening year, the losses must be allocated to each spouse. Example 1 provides that if in 20X1 Harry’s deductions exceeded his gross income by $700 and Wanda’s deductions exceeded her gross income by $300, Harry would be entitled to $700 of the NOL and Wanda would be entitled to $300 of the NOL. In 20X2, if Harry’s gross income exceeded his deductions by $1,500 and Wanda’s deductions exceeded her income by $3,500, all of the NOL of $2,000 would be allocated to Wanda.

The Ninth Circuit, affirming the appellate panel’s decision in In re Feiler, held that a couple’s prepetition election under I.R.C. section 172 to waive their NOL carrybacks was avoidable by the bankruptcy trustee as a fraudulent transfer under 11 U.S.C. section 548.42

The Ninth Circuit noted that there are four requirements for fraudulent transfer under section 548(a)(1)(B):

The Ninth Circuit explained that the only item in dispute was whether section 548 can ever be used to avoid an election under I.R.C. section 172(b)(3), and, if so, whether the election satisfies the fourth requirement of section 548. The Ninth Circuit concluded that a bankruptcy trustee’s avoidance powers under section 548 take precedence over the otherwise irrevocable nature of a taxpayer’s election under I.R.C. section 172 and that the Feilers’ election to waive the NOL carrybacks and thereby forgo the tax refunds constituted a “transfer” to the government of an “interest of the debtor in property” under 11 section 548 of the Bankruptcy Code.

In United States v. Kapila,43 the bankruptcy court’s decision finding that a trustee could avoid an NOL carryback waiver made under I.R.C. section 172 was affirmed because, pursuant to section 548 of the Bankruptcy Code, the carryback was a property right under section 541 of the Bankruptcy Code, and the election had been made at a time when debtor was insolvent.

The United States acknowledges that the only two federal appellate courts to have considered the same issue raised here have concluded that an NOL carryback waiver is an interest in property avoidable by a bankruptcy trustee.44 It contends, however, that these cases were wrongly decided for reasons it now explains on appeal.

In support of its position that NOL carryback waivers are not property under the Bankruptcy Code, the United States relies on the operative language of section 1398(g), which provides the bankruptcy estate succeeds to and takes into account certain items determined as of the first day of the debtor’s taxable year in which the case commences.

The district court noted that while the Feiler and Russell decisions were not binding, their reasoning was persuasive. The court rejected the arguments made by the IRS in noting, among other comments, that the recognition of an NOL carryback waiver as an interest in property that is avoidable by a bankruptcy trustee is consistent with Congress’s clear intent that “property” and “an interest in property” be broadly defined under the Bankruptcy Code. The District Court was not persuaded by the United States’ argument that section 1398(g) alters this analysis. The court also noted that “[e]ven if the Court were to accept the United States’ position that a bankruptcy trustee only succeeds to NOLs as they existed at the time of the bankruptcy petition, that would not resolve the question of whether Taylor’s NOL carryback waiver is avoidable by Kapila as recognized by Feiler.”

In states that are community property states, it would appear that all of the income and deductions from property acquired and income earned after marriage would be allocated 50 percent to the husband and 50 percent to the wife.

While the NOL of a spouse may not be transferred to the estate under the provisions of I.R.C. section 1398, it might be argued that the NOL carryforward is property, especially under community property states, of the estate and thus would be transferred to the estate. Section 541 provides that all community property of a debtor’s spouse will be included in the debtor’s estate. Thus, if the NOL carryforward is considered community property, it will be transferred to the estate.

Two factors must be considered in determining if the NOL carryforward is community property.

• Is the NOL carryforward property?
• If the NOL carryforward is considered property, is it community property?

The Supreme Court held in Segal v. Rochelle45 that an estate in bankruptcy is entitled to use the loss carrybacks of the debtor. Thus, the estate can apply current losses to prior profits and be entitled to the tax refund. However, in Segal, the court did not rule on the issue of whether prior losses can be applied to current profits. The court noted that “[w]ithout ruling in any way on a question not before us, it is enough to say that a carryover into postbankruptcy years can be distinguished conceptually as well as practically.” The court further stated: “The bankrupts in this case had both prior net income and a net loss when their petitions were filed and apparently would have deserved an immediate refund had their tax year terminated on that date; by contrast, the supposed loss-carryover would still need to be matched in some future year by earnings, earnings that might never eventuate at all.” In In re Luster,46 the Seventh Circuit held in a pre–Bankruptcy Code case that an NOL carryforward is not property. The court noted that Luster was unable to transfer his NOL to creditors and that his creditors could not use his loss carryforwards to satisfy a judgment lien.

The next question to be addressed is whether, even if the NOL carryforward is considered property, it is community property. When a separate return is filed, the NOL carryforwards are not community property but are an attribute that is available for exclusive use of the taxpayer to whom the losses are allocated. If all of the NOLs of one taxpayer are used by the filing of a separate return, that taxpayer is not entitled to the loss of the other taxpayer as long as separate returns are filed. In In re Luster,47 the Seventh Circuit held that federal rather than state law governs transferability of federal tax benefits. It would appear that under federal law, the NOL carryforward would not be community property and thus would not be transferred to the estate. Under I.R.C. section 1398, only the tax attributes of the debtor are transferred to the estate.

The Second Circuit held that an NOL carryforward attributable to a corporate debtor belongs to the debtor under section 541 of the Bankruptcy Code and does not, under the law of consolidated returns, belong to its parent company.48 Prudential Lines and other cases based on the Bankruptcy Code have held that the NOL carryforward is property.49 If this holding was applied to the individual, the NOL carryforward in community property states of the nonfiling spouse would belong to the estate.

The bankruptcy court held the IRS was precluded from challenging the debtor’s application of an NOL carryback, because the statute of limitations for assessment had run for the year in which the loss was reported.50 The taxpayer followed the incorrect order in carrying back an NOL. The taxpayer claimed losses on his 1984 to 1986 returns based on his ownership interest in a limited partnership that was subject to the Tax Equity and Fiscal Responsibility Act (TEFRA) rules. The IRS made adjustments to partnership items that were subject to the TEFRA rules for those three years, which were allowed by the Tax Court.

When the IRS adjusted the taxpayer’s taxable income for the years in question, it is also reapplied the loss carryback in the proper order, resulting in a tax liability plus interest for 1986. The tax claim was assessed in October 1994. The taxpayer filed a chapter 7 case in 1995 and argued that the statute of limitations barred the IRS from making any adjustment relating to the carryback of the NOL. The bankruptcy court held that the NOL carryback was not an affected item under I.R.C. section 6231(a)(5), because it was not affected by any partnership item.

The estate may carry back any loss or tax attribute to a taxable period of the debtor that ended before the date of the order for relief to the extent that applicable state or local tax law provides for a carryback in the case of the debtor; and the same or similar attribute may be carried back by the estate to such a taxable period of the debtor under the Internal Revenue Code of 1986.51

(d) Estate’s Income

Gross income of the estate includes all income received or accrued by the estate and the gross income of the debtor to which the estate is entitled under title 11.52 With the addition of section 1115 to the Bankruptcy Code, in a chapter 11 estate of an individual, gross income of the estate also includes “earnings from services performed by the debtor after commencement of the case but before the case is closed, dismissed or converted to a case under chapter 7, 12 or 13.”53 Excluded from the estate is any income received or accrued by the debtor before the commencement of the case. For example, salary that was earned by a cash-basis debtor prior to bankruptcy but not received until after the commencement of the case would be income of the estate, provided the receivable from back wages is considered property of the estate under the Bankruptcy Code.

In looking at the income of the estate, it is important to distinguish between the property of the estate and the gross income of the estate. Under the previous bankruptcy law, the definition of property was narrowly defined. For example, the Supreme Court decision of Lines v. Frederick54 excluded earned income from the property of the bankruptcy’s estate. The Bankruptcy Code has defined property in a much broader way. Section 541(a)(6) of the Bankruptcy Code defines “property” as: “Proceeds, product, offspring, rents, and profits of or from property of the estate, except such as are earnings from services performed by an individual debtor after the commencement of the case.”

In the case of an accrual-basis taxpayer, gross income, which is accrued before commencement of the proceedings and included in the income of the individual debtor, would become property of the estate as of the date the petition was filed, and, as such, the estate would be entitled to the proceeds from wages earned prior to the commencement of the case.

(i) Partnerships and S Corporations

When an individual files a bankruptcy petition, section 541 of the Bankruptcy Code provides that the property of the debtor (unless excluded as exempt property under section 522 of the Bankruptcy Code), including interest in a partnership or stock in an S corporation, is considered property of the estate. In the case of a partnership, any income or loss from the partnership is reported on the return for the estate for all tax years ending after the petition is filed. For example, if an individual who owns an interest in Partnership Y files a chapter 11 petition on December 15, 20X2, all of the income, gains, and losses reported on Form K-1 from Partnership Y for the entire year are reflected on the tax return filed by the estate. This is true even though most of the events creating the gains and losses for Partnership Y occurred prior to the filing of the petition. The Form K-1 should reflect the new identification number of the estate and not the Social Security number of the individual. The trustee or the debtor in possession should advise the partnership about the new identification number to use on the partnership return, Form K-1.

In a private letter ruling,55 the IRS held that all items of income, gain, loss, deduction, or credit of a partnership for the year in which the individual partner files a bankruptcy petition are allocable to the bankruptcy estate. The IRS noted that the transfer of the debtor’s interest in the partnership to the bankruptcy estate does not close the taxable year of the partnership with respect to the debtor under I.R.C. section 706(c)(2)(A)(i), and the transfer is not treated as a change in a partner’s interest in the partnership under I.R.C. section 706(d).

It has been argued that income or loss from a partnership must be reported by the debtor and the estate according to their varying interests during the taxable year. This allocation may be made based on the time periods when the partnership interest was held by the debtor and the estate, or, as some would suggest, the amount attributable to the debtor might be determined by closing the books the day before bankruptcy was filed. Advocates of the varying-interests approach argue that it does not necessarily conflict with I.R.C. section 1398(f)(1); even though the transfer is not characterized as a “disposition,” it does not automatically follow that the debtor and estate had no variation of interest. Although the nondisposition status would prevent the application of I.R.C. section 706(c)(2) to the transfer, it would not preclude the effect of I.R.C. section 706(d), which is activated by a mere “change” in partner interest. For example, in Guaranty Trust Co. of New York v. Commissioner,56 the Supreme Court held (prior to the Internal Revenue Code of 1954, when there was not a special rule for decedents) that the decedent’s final Form 1040 was required to include partnership income for the partnership’s full tax year ending within the decedent’s final year plus his pro rata share of partnership profits through the date of his death. I.R.C. section 706(c), Treas. Reg. section 1.706- 1(c)(3), and legislative history57 indicate the need for a statutory amendment specifically addressing decedents in order to avoid the bunching-of-income result under Guaranty Trust. See McKee, Nelson, and Whitmire58 for a discussion recommending restricted scope for I.R.C. section 706(d) but not opposing the interpretation that the section can be applied to the commencement year of a chapter 7 or chapter 11 bankruptcy case against a partner who is an individual.

In the case of an S corporation, the gains and losses are prorated. The trustee or debtor in possession should provide the corporation the identification number of the estate to use to report the prorated income applicable to the estate.

(e) Estate’s Deductions, Credits, and Employment Taxes

Prior to the Bankruptcy Tax Act of 1980, considerable confusion existed as to the type of deductions allowed by the bankrupt estate. I.R.C. section 1398(e)(3) was passed in an attempt to resolve these problems by providing that an amount would be allowed as a deduction or credit if the debtor had paid or incurred the amount in connection with the debtor’s trade or business conducted prior to commencement of the proceedings and if the debtor would have been entitled to these deductions or credits. Also included in the amount paid would be wages to allow for the deduction of employment taxes. Expenses not paid by the estate but paid by the individual, a debtor subsequent to the filing of the petition, would be allowed as a deduction of the individual. There is no provision for the apportionment of deductions and credits between the debtor and the estate as exists with respect to the taxability of the debtor’s income. Generally the estate can take all deductions available to the individual including the standard deduction for a single person. Section 541 of the Bankruptcy Code provides that all community property of a debtor’s spouse that is under the sole, equal, or joint management and control of the debtor will be included in the debtor’s estate. In Smith v. Commissioner,59 the Tax Court concluded that in a year in which the wife was not in bankruptcy, the wife was not entitled to one half of the deductions otherwise available to the husband’s bankruptcy estate due to the fact that the wife had a community property interest in the assets which gave rise to the deductions. Thus, it would appear that any income or expense that is attributable to the community property that is in the bankruptcy estate will be an income or expense item of the estate and not that of the nonbankrupt spouse. The practical problem with this treatment is that it could deprive the nonbankrupt spouse a deduction for payments he or she made from noncommunity assets that would otherwise be deductible to such spouse (i.e., interest or property taxes on a home that is community property).

How should the estate handle payments that are made by the estate to the individual? Based on the preceding discussion, it might be assumed that the payments would be either wages or consulting type of income. As the result of a private letter ruling,60 there is now considerable uncertainty as to how to report these payments. The actual wording of I.R.C. section 1398(e)(3)(B) is:

Rule for making determinations with respect to deductions, credits, and employment taxes. Except as otherwise provided in this section, the determination of whether or not any amount paid or incurred by the estate—

shall be made as if the amount were paid or incurred by the debtor and as if the debtor were still engaged in the trades and businesses, and in the activities, the debtor was engaged in before the commencement of the case.

In the private letter ruling, the IRS looked at the issue of whether withdrawals by a debtor in possession are wages. In this situation, a farmer and his wife filed a chapter 11 petition. The farmer had been engaged to manage the farm for the bankruptcy estate as a debtor in possession, as provided for in the Bankruptcy Code. The bankruptcy estate treated the farmer as an employee of the estate and characterized amounts withdrawn from the estate for personal expenses as the payment of manager’s salary. The farmer asked whether, for federal employment tax purposes, a debtor in possession should be treated as an employee of the bankruptcy estate.

The IRS concluded that “[a]ccordingly, for purposes of determining whether the amounts withdrawn by you constitute wages for federal employment tax purposes, section 1398(e)(3)(B) of the Code requires such amounts to be treated as though they had been paid by you and as though you were still engaged in the business of operating your farm. Thus, we conclude that these amounts are not considered as wages paid you as an employee of the bankruptcy estate.”

It might be assumed from this private letter ruling that the IRS is stating that the amounts paid are not wages but distributions that are taxable to the individual and deductible by the estate, requiring Form 1099 to be filed. A careful review of the text would, however, also suggest that, because the payments cannot be considered wages for employment tax purposes, they could not be considered a deduction because the same modification (“amount . . . paid . . . as if the debtor were still engaged in the trades and businesses,” I.R.C. section 1398(e)(3)(B)) that applies to the wages also applies to the deduction.

Legislative history suggests that the purpose of the modification was not to consider the issue of how wages paid to the owner are handled but to deal with the problem of how to deduct expenses and handle wages if the trustee does not operate the debtor’s trade or business. A Senate Report on the subject stated:

Under present law, it is not clear whether certain expenses or debts paid by the trustee are deductible if the trustee does not actually operate the debtor’s trade or business (and if such expenses are not incurred in a new trade or business of the estate). To alleviate this problem, the bill provides that an amount paid or incurred by the bankruptcy estate is deductible or creditable by the estate to the same extent as that item would be deductible or creditable by the debtor had the debtor remained in the same trades, businesses, or activities after the case commenced as before and had the debtor paid or incurred such amount. The same test is applied to determine whether amounts paid by the estate constitute wages for purposes of Federal employment taxes (I.R.C. section 1398(e)).

In many cases, it would be to the advantage of the debtor to claim that amounts paid are not income (wages or Form 1099 income items) but distributions of the assets of the estate. Often, the individual has no deductions because all of his or her property was transferred to the estate and the individual must pay taxes on the income received from the estate. At the same time, the estate has the net operating losses of the individual that were acquired when the petition was filed, and does not need the wage deduction. The Private Letter Ruling61 might indicate that the amounts paid to the individual by the estate are withdrawals or distributions and not income. However, it is suggested here that the IRS has misapplied I.R.C. section 1398(e)(3)(B) and that it will not be extended to apply to deductions as well. The general practice that is followed today is to treat the amount “paid” as a deduction by the estate and as non-wage income to the debtor. The practical problem that arises for the debtor is that the amount paid has no withholding attached so the debtor needs to make estimated tax payments throughout the year or be saddled with tax due when the personal return for the year is filed. This is something that is often overlooked by debtors and their tax advisors.

(i) Accrued Expenses

One problem arises in accounting for the expenses paid by the estate. For example, if an accrual-basis taxpayer incurs and deducts an expenditure prior to filing of the petition and subsequently the estate makes the necessary payment, it would appear that the estate would not be able to make the deduction, but the taxpayer would be entitled to the deduction because the amount should have been deducted on the accrual basis prior to the commencement of the proceedings. Thus, wages that have been accrued by a debtor and that were subsequently paid by a trustee in a chapter 7 or chapter 11 proceeding would not be deductible by the estate. These deductions are prepetition obligations, and they do not constitute administrative expense as defined under section 503 of the Bankruptcy Code. All administrative expenses are those that generally arise after the commencement of a case. However, suppose that the expenses that were deductible for accounting purposes but not for tax purposes were not liabilities according to the definition of a liability found in the Bankruptcy Code. Once an item becomes a liability, which, let us assume, is subsequent to the filing of the petition, then it would appear that the item would be considered an administrative expense and there is a possibility that it could be deducted by the estate at the time it is filed. Keep in mind, however, that there is some uncertainty about the prospect of being able to deduct this item twice.62 The reality in many cases is that the expense deduction taken by the debtor created or increased an operating loss that was either carried back by the debtor or passed to the estate.

The Senate Finance Committee Report indicated that the new Internal Revenue Code did not intend to allow an item to be deducted twice. For example, the Committee Report stated:

If any item of deduction or credit of the debtor is treated under new code section 1398(e)(3) as a deduction or credit of the bankruptcy estate, that item is not allowable to the debtor as a deduction or credit on his or her return or a joint return with the debtor’s spouse. (New code section 1398(e)(3).) This rule is intended to insure that no particular item of deduction or credit can be allowable to both the debtor and the estate.63

(ii) Administrative Expenses

Considerable conflict existed under prior law as to how to handle administrative expenses. The Bankruptcy Tax Act contains several provisions that clarified some aspects of how to account for administrative expenses and subsequent administrative rulings have resolved most of the unanswered questions.

I.R.C. section 1398(h)(1) now provides that any administrative expense allowed under section 503 of the Bankruptcy Code and any fees or charges assessed under chapter 123 of title 28 of the U.S. Code (court fee and costs) are deductible expenses of the estate. These expenses are allowed even though some of them may not be considered trade or business expenses. Administrative expenses are, however, subject to disallowance under other provisions of the I.R.C., such as section 263 (capital expenditures), 265 (expenses relating to tax-exempt interest), or 275 (certain taxes). It would appear that the administrative expenses would also be subject to the disallowance of personal interest expense under I.R.C. section 163.

The administrative expenses would include the actual, necessary costs of preserving the estate, including wages, salaries, and commissions for services rendered after the commencement of the case. Also, any tax, including fines or penalties, is allowed unless it is related to a tax granted preference under section 507(a)(7) of the Bankruptcy Code. Compensation awarded professional persons, including accountants and attorneys for postpetition services, is an administrative expense.64 The Tax Court concluded that legal expenses, including bankruptcy legal expenses, were deductible because the litigated claims related to the debts of a corporation for which the debtor was a shareholder and officer.65 The failure of the corporation forced the debtor to file a bankruptcy petition.

Administrative, liquidation, and reorganization expenses not used in the current year may be carried back three years and carried forward seven years. The amount that is carried to any other taxable year is stacked after the net operating losses for that particular year. The unused administrative expenses can only be carried back or carried over to the taxable years of the estate. I.R.C. section 1398(h)(2)(D) also provides that expenses that are deductible solely because of the provision of I.R.C. section 1398(h)(1) are allowable only to the estate. Thus, the administrative expenses cannot be carried forward to the debtor once the bankruptcy proceedings are concluded.

Note that the restriction on carryback or carryover of administrative expenses to the estate applies only to those deductions that are allowed solely by reason of I.R.C. section 1398(h)(1). Thus, it would appear that an expense (even though it is an administrative expense in a bankruptcy case) that would normally be classified as an operating cost could be carried forward to the debtor, once the estate is terminated, as an item in the NOL carryover. Included would be salary, wages, and other costs necessary to operate a business in a chapter 11 case. However, costs such as attorneys’ fees for a wage earner, court filing costs, and other types of administrative costs that are not normally deductible, except for the fact that they are administrative expenses, are allowed only by the estate and would be classified as administrative expenses. In W. Ainsworth v. Commissioner,66 the Tax Court refused to allow the individual to deduct legal fees the individual paid related to the taxpayer’s personal bankruptcy. The court noted that there was insufficient evidence of a proximate relationship between the taxpayer’s business activities and the personal bankruptcy.

The administrative expense carryforward is considered after the net operating loss. First, a separate NOL computation would be made under I.R.C. section 172(b)(2), and then the administrative expense deduction would be carried forward after the NOL has been used. The Finance Committee of the Senate observed: “These carryovers are ‘stacked’ after the net operating loss deduction (allowed by section 172 of the Code) for the particular year.”67

In an Administrative Ruling, IRS Legal Memorandum,68 the IRS has concluded that I.R.C. section 67(e) applies to an individual debtor’s estate in bankruptcy. Thus, deductions for expenses paid or incurred with the administration of an individual’s estate in bankruptcy, which would not have been incurred if the property were not held by the bankrupt estate, are treated as allowable in arriving at adjusted gross income. In making this ruling, the IRS agreed with the bankruptcy court’s conclusion in the 2000 decision in In re Miller69 that a bankruptcy estate is a “trust or estate” under 67(e) and that the exception in section 67(e) applies to subchapter V bankruptcy estates, as well as other estates governed by subchapter J.

As a result of the Administrative Ruling Revenue Service Publication 908, the Bankruptcy Tax Guide has been revised to reflect the conclusions of In re Miller, stating that deductions for expenses that would not have been incurred if the property were not held by the bankrupt estate are allowable in arriving at adjusted gross income. These expenses are generally deductible as itemized deductions and are not subject to the 2 percent floor on miscellaneous itemized deductions. However, administrative expenses attributable to the conduct of a trade or business by the bankruptcy estate or the production of the estate’s rents or royalties are deductible in arriving at adjusted gross income.

(f) Net Operating Loss Carryback

I.R.C. section 1398(j)(2)(A) provides that, if the estate incurs a net operating loss (apart from the loss passing to the estate from the debtor, described in 4.3(c)), the estate can carry back, subject to the provisions of section 172, its NOL to taxable years of the individual debtor prior to the year in which the bankruptcy proceeding commenced as well as to previous taxable years of the estate. The new law also allows the bankruptcy estate to carry back excess credits, such as an investment tax credit, to the years prior to the commencement of the case. The individual is prohibited from carrying back either the NOLs or other credits (see § 4.4(e)).

(g) Change in Accounting Period

I.R.C. section 1398(j)(1) allows an estate to change its accounting period (taxable year) once without obtaining approval of the IRS, as is normally required under I.R.C. section 442. This rule allows the trustee to effect an early closing of the estate’s taxable year prior to the expected termination of the estate and then to submit a return for a “short year” for an expedited determination of tax liability as permitted under section 505 of the Bankruptcy Code.70 Income from the short year due to the estate’s being terminated prior to year-end need not be annualized. Thus, the full personal exemption and standard deduction are allowed (I.R.C. section 443(a)(2) and (c)).

(h) Tax Liability of the Estate

Administrative expenses are paid out of the property of the estate. Section 522 of the Bankruptcy Code provides that administrative expenses are not to be paid out of exempt property. Thus, the debtor should not be personally liable for any tax that is classified as an administrative expense. (See § 11.2(b) for a discussion of the taxes that are considered administrative expenses.) Any tax liability that is created by the estate on the disposition of property or on the transfer of property in settlement of the debt is an administrative expense of the estate under Bankruptcy Code section 503(b)(1)(B)(i). The tax obligation is not a debt of the debtor but of the estate.

In In re Seslowsky,71 the bankruptcy court indicated that the trustee, by not abandoning and keeping the interest of the partnership in the estate, effectively prevented the United States from pursuing the debtors for the unpaid income tax liability generated by the sale of the partnership’s assets.

The estate has the responsibility for paying, after the petition is filed, any tax that becomes due that would be classified as an administrative expense. This tax liability is an obligation of the estate and not of the individual. For example, in In re Kochell,72 the Seventh Circuit held that when the debtor filed the petition the estate succeeded to the individual retirement account (IRA) benefits. Any penalty tax under I.R.C. section 408(f)(1) due to the early withdrawal of funds from the IRA by the trustee is a liability of the estate. The court further ruled that “Kochell personally was out of the picture.”

In Larontonda v. Commissioner,73 the Tax Court held that an involuntary withdrawal from a Keogh account to satisfy a federal tax lien was not subject to the I.R.C. section 72(m)(5) penalty for premature withdrawal. However, the Office of Chief Counsel has announced nonacquiescence to this decision with no appeal (AOD No. CC-1988-010). The IRS in taking this position cited In re Kochell.74 This case involved an individual retirement account (IRA) distribution in bankruptcy where the court held that the statute makes no exceptions from the penalty except in cases of disability. The IRS also stated that the individual “benefitted to the same extent as if he had withdrawn the money himself in order to pay off creditors.”

The tax liability is not a tax attribute that reverts to the debtor upon the termination of the estate. Although the debt is not technically discharged, it appears that it will not become a liability of the individual debtor. Thus, in cases where all of the debtor’s property is secured with a low basis, such as farm property, and the property is transferred in settlement of the debt, the individual debtor may avoid having to pay the tax on the transfer by filing a chapter 12 petition after the sale or a chapter 7 or 11 petition before the transfer takes place. The tax obligation is that of the chapter 7 or 11 estate, but the estate has no assets with which to pay the tax. If a bankruptcy petition is not filed or if the property is transferred prior to the filing of the petition, the tax liability is a priority debt of the individual that cannot be discharged. In a chapter 12 filed after a sale, if the priority tax debt is unsecured and not fully paid through the chapter 12 plan, the unpaid portion can be discharged.75

Often, in situations where it is desirable to transfer (shift) the tax liability to the estate, it is better to file a chapter 11 petition and adopt a chapter 11 plan of liquidation. After all assets are sold, if there are not enough assets to pay the income taxes, it may be advisable to convert the chapter 11 petition to a chapter 7. In chapter 11 cases, I.R.C. section 1129(a)(9) provides that in order for a plan to be confirmed, the plan must provide for the payment of all administrative expenses. Thus, it may be necessary for the debtor to convert the case to chapter 7 in order to avoid this problem. If the judge, as has happened in some chapter 7 cases, allows the trustee to abandon the undersecured property to the debtor, it appears the tax liability would be that of the individual and not the estate. Section 554 of the Bankruptcy Code gives the trustee the right after notice and a hearing to abandon any property of the estate that is burdensome or that is of inconsequential value and benefit to the estate. See § 4.3(j).

A question may arise as to the status of the administrative expenses that were paid before the property was transferred. In In re Isis Foods,76 the district court held that administrative expenses may be paid prior to the effective date of the plan. In this case, the trustee objected to the payment of postpetition obligations incurred by a debtor in possession that he replaced. In fact, the debt was paid out of funds from which a secured lender had been expressly granted a super lien.

In In re Seslowsky,77 the bankruptcy court would not allow the IRS claim, resulting from the sale of a partnership where the sale proceeds were less than the tax on the gain, to be subordinated to that of other administrative expenses. The court noted that if there was any questionable conduct, it was on the part of the trustee. The proper course of action by the trustee might have been to seek judicial approval for abandonment of the partnership interest, under section 554 of the Bankruptcy Code.78 See § 11.2(b).

(i) Distributions from the Estate

Section 1398(f)(2) provides that in the termination of the estate, a transfer (other than by sale or exchange) of an asset of the estate from the estate to the debtor is not treated as a disposition for tax purposes. Proceeds from the sale of a claim were not considered a distribution from the bankruptcy estate.79 The taxpayer’s receipt of $5.75 million for the sale of her claims against her former husband’s bankruptcy estate was not a distribution from the bankruptcy estate to fall within I.R.C. section 1398, a payment from her ex-husband to fall under I.R.C. section 1041, or the sale of an inchoate marital right under United States v. Davis.80 The district court noted that because the taxpayer sold her claims against the bankruptcy estate to Tenneco, she must recognize gain unless her basis in the claim was equal to or greater than the amount she received. However, because her claims against the bankruptcy estate had no basis, she must pay tax on the entire $5.75 million received. In affirming the decision of the district court, the Fifth Circuit noted that the taxpayer might have been entitled to treat such distribution as a nontaxable payment incident to divorce, pursuant to I.R.C. section 1041; however, the transaction between the taxpayer and Tenneco can be characterized “as nothing other than a garden variety sale on which [taxpayer] recognized substantial and immediate gain.”81

For purposes of state and local tax law, a transfer from the estate to the debtor shall not be treated as a disposition of the property except to the extent that such transfer is treated as a disposition under the Internal Revenue Code of 1986.82

(j) Abandonment of Property

As noted, section 554(a) of the Bankruptcy Code provides: “After notice and a hearing, the trustee may abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate.” In situations where the value of the property is less than the amount of the secured claim and where the basis in the property is less than the value, a sale of the property or the transfer of the property to the creditor may result in a significant tax burden to the estate. To avoid this problem, the trustee often abandons the property.

Property may also be abandoned where the value of the collateral is greater than the debt, if the tax on the difference between the book value and the market value would be greater than the equity in the property. For example, assume that property with a basis of $50 and a fair market value of $250 is sold to satisfy a debt of $200. The tax on the gain at a rate of 40 percent, $80 (($250 – $50) × .40), is greater than the equity in the property, $50.

The trustee’s desire to abandon the property is based on the assumption that as a result of the abandonment there would be no gain or loss. I.R.C. section 1398(f) provides that the transfer of an asset to the estate from the individual is not to be considered as a disposition, that the estate shall be treated as the debtor would be treated with respect to that asset, and that “[i]n the case of termination of the estate, a transfer (other than by sale or exchange) of an asset from the estate to the debtor shall not be treated as a disposition . . . and the debtor shall be treated as the estate would be treated with respect to such asset.” I.R.C. section 1398(f) does not deal with the tax consequence when the property is transferred at a time other than on termination of the estate.

(i) Argument for Taxable Event

Although it may appear that the trustee or even the debtor in possession might have a required obligation to abandon property that is either burdensome to the estate or of inconsequential value, case law and a careful reading of the statute may suggest that there are some limitations on this responsibility and that such an abandonment is a taxable event.

(A) Avoidance of Liability

In the case of Midlantic National Bank v. New Jersey Department of Environmental Protection,83 the Supreme Court ruled that a bankruptcy trustee was not allowed to abandon real property when the effect of the abandonment was to relieve the estate on an environmental liability. This situation is not far from the situation faced by a trustee that has several pieces of property, some of which have large equity balances after paying taxes on the sale, with others resulting in a net cash outflow after taxes. However, taken as a group, sufficient cash will be realized to cover all of the tax liability arising on the disposition of the properties. If the only properties abandoned are those resulting in a tax liability larger than the net cash realized on sale of the properties, the IRS will not be able to collect the tax. The liabilities could be several million dollars and the debtor may be earning less than $50,000 per year.

(B) Denial of Fresh Start

Another reason to suggest that an abandonment of the property to the debtor by the trustee is a taxable event is that it does not limit opportunity of the debtor for a fresh start. If the abandonment to the debtor is not a taxable event, the tax on the subsequent sale or foreclosure of the property will deny the debtor a fresh start. Madoff suggests that the concept of giving the debtor an opportunity for a fresh start has retained its importance after enactment of the Bankruptcy Code.84

In In re A. J. Lane & Co.,85 the bankruptcy court held that where there is no other overriding policy, the fresh start policy is controlling. The court relied on Local Loan Co. v. Hunt86 (fresh start policy supports an interpretation that invalidates debtor’s assignment of future wages as security for debts discharged in bankruptcy) and In re Lindberg87 (fresh start policy favors interpretation that permits debtors to claim new homestead exemption at time of conversion from chapter 13 to chapter 7). The court also noted that in Segal v. Rochelle,88 the right to tax a refund due to loss carryback resulting from losses incurred prior to bankruptcy was deemed rooted in the debtor’s past so that inclusion of the refund right in a bankruptcy estate is not violative of fresh start policy.

The court in Lane concluded:

[T]axing the Debtor on the foreclosure following this proposed abandonment creates a clear burden on the Debtor’s fresh start, and there is no countervailing policy which overrides this consideration. Enhancement of the distribution to creditors is of course also a basic policy of bankruptcy law. But here creditors are not significantly prejudiced if the gain is considered that of the estate. The estate can use the large net operating loss carryover which it inherited from the Debtor.

(C) Transfer as a Taxable Event

Courts have held for an extended time period that I.R.C. section 1001(a) provides, in a sale or exchange of property, including foreclosure, that the taxpayer is chargeable with income on the excess of the amount realized over the adjusted basis. The bankruptcy court in Lane reasoned that an abandonment is also a transfer, in the following passage:

Foreclosure of a mortgage with recourse . . . is treated as a sale by the property owner notwithstanding the involuntary nature of the transaction. Helvering v. Hammel, 311 U.S. 504, 510, 85 L. Ed. 303, 61 S. Ct. 368 (1941). The same is true with respect to foreclosure of a mortgage or other lien where the holder of the lien has no recourse against the owner for a deficiency. Helvering v. Nebraska Bridge Supply & Lumber Co., 312 U.S. 666, 85 L. Ed. 1111, 61 S. Ct. 827 (1941). The amount realized for income tax purposes in the sale of property subject to a nonrecourse mortgage equals the balance of the debt, whether the sales price is more or less than the debt or the property’s value, and whether it is a sale to a third party or a deed in lieu of foreclosure. Commissioner v. Tufts, 461 U.S. 300, 103 S. Ct. 1826, 75 L. Ed. 2d 863 (1983) (assumed nonrecourse mortgage exceeded value of property); Crane v. Commissioner, 331 U.S. 1, 67 S. Ct. 1047, 91 L. Ed. 1301 (1947) (property sold for more than nonrecourse debt); Laport v. C.I.R., 671 F.2d 1028 (7th Cir. 1982) (deed in lieu of foreclosure). If the mortgage is with recourse, and the transaction involves satisfaction of the entire debt, the amount realized is also the full amount of the debt. Chilingirian v. Commissioner, 918 F.2d 1251 (6th Cir. 1990).89

In Yarbro v. Commissioner,90 the Fifth Circuit held that an abandonment was equivalent to the sale of the property. The taxpayer had invested in raw land whose value subsequently declined below the amount due on a nonrecourse bank mortgage incurred at the time of purchase. In 1976, the taxpayer notified the bank that he was abandoning the property due to the increased carrying costs; on his 1976 tax return, he claimed an ordinary loss. The taxpayer declined the bank’s request for a deed in lieu of foreclosure because of a desire to have further involvement with the property. The bank foreclosed on the property the following year. The IRS objected to the ordinary loss deduction on the ground that the taxpayer had incurred a capital loss because the surrender itself was a sale.

The bankruptcy court in Lane, noting that it could “see no difference between the act of surrender before it and the deed in lieu of foreclosure involved in Laport,” reasoned that the court in Yarbro “analyzed the transaction as a transfer of property by the taxpayer and the receipt of a benefit by him in the form of satisfaction of that portion of the debt equal to the property’s value. It viewed that benefit as precisely the same as what was received by the taxpayer in Nebraska Bridge Supply through foreclosure of a nonrecourse tax lien. The court therefore held that the surrender constituted a sale or exchange.”91

The court in Yarbro, according to Lane, “reasoned that both transactions are the functional equivalents of a foreclosure sale taxable to the owner under Hammel and Nebraska Bridge Supply, and that the taxpayer should not be able to change the tax consequences when the substance remains the same. It regarded the foreclosure which followed abandonment as merely a mechanical process to clear title.”92

The bankruptcy court in Lane noted:

The reasoning in Yarbro is inescapable. In the abandonment of overly encumbered property, as in the granting of a deed in lieu of foreclosure, a benefit is received in the amount of the secured debt which is discharged, the very same benefit which flows from the foreclosure of a nonrecourse mortgage. Where, as here, the debt is of the recourse variety, it is of course possible for borrower and lender to agree upon the discharge of the entire obligation so that the borrower receives that additional benefit. But this only changes the amount of benefit; it does not prevent the abandonment from constituting a sale. In declining to treat abandonment as a transfer taxable to the bankruptcy estate, the McGowan and Olson decisions . . . failed to recognize that the estate received a benefit in the discharge of the secured portion of the debt. See Samore v. Olson (In re Olson), 100 Bankr. 458, 462-63 (Bankr. N.D. Iowa 1989), aff’d, 121 Bankr. 346, 348 (N.D. Iowa 1990), aff’d, 930 F.2d 6, 8 (8th Cir. 1991); In re McGowan, 95 Bankr. 104, 108 (Bankr. N.D. Iowa 1988).93

(D) Substance over Form

When abandonment occurs, the trustee is in many cases abandoning an asset to the debtor, which allows the creditor to foreclose on the property out of court rather than requiring the creditor to foreclose on the property in the bankruptcy court after requesting the court (1) to remove the stay and (2) to allow the foreclosure. The Supreme Court looked at the issue of substance over form on the transfer of property in Commissioner v. Court Holding Co.94 Court Holding had negotiated an oral agreement to sell an apartment building, which was the corporation’s sole asset, and had received a deposit from the purchaser. The corporation conveyed the building in a liquidating dividend to its two stockholders after being advised by counsel that a sale of the building by the corporation would create a large income tax liability. The stockholders then conveyed the building to the purchaser under the terms originally negotiated. The Supreme Court, holding that the transaction was taxable to the corporation, stated:

The incidence of taxation depends upon the substance of a transaction. The tax consequences which arise from gains from a sale of property are not finally to be determined solely by the means employed to transfer legal title. Rather, the transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant. A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title. To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.95

The Court Holding doctrine has been applied in many other situations, as noted in Lane.96 For example, in Palmer v. Commissioner,97 the taxpayer owned property that he mortgaged as security for debt of his wholly owned corporation. He negotiated a sale of the property to obtain funds to reduce the debt, but, before the sale, the property was deeded to the corporation. The corporation made the sale in order to be taxed in a lower tax bracket. Based on the ruling in Court Holding, the court taxed the stockholder. The same result was reached in Hallowell v. Commissioner,98 where the taxpayer transferred appreciated stock from his personal brokerage account to his 96-percent-owned corporation, which sold the stock and reported the gain at its lower tax rate.

A trustee, in abandoning assets, seeks to accomplish what was attempted in Court Holding—to transfer property already the subject of a foreclosure sale to another party (debtor) for the sole purpose of having the debtor taxed on the foreclosure.

(E) Section 1398(f)(2)

I.R.C. section 1398(f)(2) provides that “[i]n the case of a termination of the estate, a transfer (other than by sale or exchange) of an asset from the estate to the debtor shall not be treated as a disposition for purposes of any provision of this title assigning tax consequences to a disposition, and the debtor shall be treated as the estate would be treated with respect to such asset.”

The bankruptcy court in Lane noted that “the plain meaning of this provision is that it applies only to a transfer from the estate to the debtor at the termination of the estate.”99 Lane goes on to note that any possible doubt is resolved by comparing I.R.C. section 1398(i), which (except for substituting “an” for “the”) uses the same phrase—“in the case of a termination of the estate”—in permitting the debtor to succeed to the estate’s unused NOL carryovers and other tax attributes. It is clear that I.R.C. section 1398(i) applies to transfers at the end of the case—that is, on termination of the estate—and thus the same interpretation should be placed on I.R.C. section 1398(f) regarding the transfer of property.

The bankruptcy court concluded that the “design of the statute is clear. The party holding the property, whether the debtor or the estate, is also entitled to any available net operating loss carryover, so that if that party incurs a taxable gain in the disposition of the property he can use the net operating loss carryover to offset the gain.”100 As further noted by Lane, an abandonment of the property by the trustee would destroy this symmetry.

The court in Lane stated:

Unfortunately, the decisions to date have ignored the interplay of subsections (f)(2) and (i). In In re McGowan, 95 Bankr. 104 (Bankr. N.D. Iowa 1988), at the request of the secured party, a chapter 7 trustee abandoned farm machinery in which the debtor had no equity. The trustee obliged the debtor by treating the abandonment as taxable to the estate, but the taxing authorities thought otherwise. Despite the overriding presence of the secured party, the court treated the abandonment as a nontaxable transfer to the debtor under section 1398(f)(2). The court believed that the phrase “termination of the estate” could have any one of a number of meanings—completion of administration of the entire estate, termination of the estate’s interest in specific property through abandonment, or termination of the estate’s interest in particular property through foreclosure. The court interpreted the phrase to include abandonment, without even mentioning subsection (i), much less recognizing the symmetry between it and subsection (f)(2). Surprisingly, in the interpretation of this tax statute the court was influenced by the broad definition of “transfer” contained in section 101(50) of the Bankruptcy Code. The court expressed concern that treating abandonment as taxable to the estate would reduce the dividend to unsecured creditors. It expressed no similar concern for the effect that the debtor’s tax liability from an ensuring foreclosure would have upon his fresh start.101

(ii) Internal Revenue Service’s Position

It has been the position of the IRS that, under the Bankruptcy Code, the transfer of the debtor’s assets to the trustee or debtor in possession in bankruptcy is not a taxable event and that the estate succeeds to the debtor’s basis, holding period, and character of assets. Also, it is the position of the IRS that the subsequent transfer of any surplus of a solvent estate to the individual is not a taxable event.102

As noted, Treas. Reg. sections 1.1398-1 and 2 provide (1) for the estate in a chapter 7 or chapter 11 case to succeed to the tax attribute of unused passive activity losses and credits and of unused losses under the at-risk rules of I.R.C. section 465, and (2) that a transfer of an interest in a passive activity or an at-risk activity under I.R.C. section 465 to the debtor as exempt under section 522 of the Bankruptcy Code or as abandoned to the debtor under section 554(a) of the Bankruptcy Code is a nontaxable transfer.

The IRS noted:

[T]he proposed regulations provide such a transfer of an interest in a passive activity as defined in section 469(c) shall not be treated as a taxable disposition. This rule is consistent with the case law, which holds that the transfer (other than by sale or exchange) of an asset from the estate to the debtor before the termination of the estate is a nontaxable disposition. See, e.g., In re Olson, 100 B.R. 458 (Bankr. N.D. Ia. 1989), aff’d, 121 B.R. 346 (N.D. Ia. 1990), aff’d, 930 F.2d 6 (8th Cir. 1991).103

A similar statement is made in reference to the transfer of at-risk property under I.R.C. section 465.

This ruling is inconsistent with the bankruptcy court’s decision in Lane,104 where the bankruptcy court held that the abandonment was a taxable event. The IRS did not mention this case or In re Larry F. and Mary A. Laymon,105 where the district court would not allow the debtor to abandon the property because of the potential adverse tax impact. These two regulations are viewed by some as being specific only to properties with passive activity losses and at-risk losses and not necessarily applicable to other properties, such as a personal residence. The issue of abandonment remains unresolved, particularly in a chapter 7 case. In a chapter 11 case, the addition of section 1115 now requires the debtor to include earnings from services as property of the estate after commencement of the case, but before the case is closed, dismissed, or converted. Abandonment is still an issue if requested by a creditor in connection with a stay relief motion as the debtor will need to factor the tax cost in the chapter 11 plan to either the individual or the estate.

Treas. Reg. section 1.1398 makes it critical that the individual creditor owning several properties carefully examine the tax consequences of each before deciding to file a petition. In general, it is best for the debtor to transfer property that will result in a tax (i.e., to sell the asset or transfer it to the creditor in full or partial settlement of the debt). The tax liability will then transfer to the estate if a short tax year petition is elected by the individual or if the taxable year ends before the petition is filed. Under these conditions, the tax liability is a liability of the estate; it will be an eighth priority and will be satisfied before any unsecured creditors will be paid. If there is an NOL, part or all of the tax liability may be absorbed by the NOL.

The other alternative is to file a chapter 11 petition and dispose of the properties that will result in a tax liability while the debtor is in control. For example, if the case is converted to chapter 7 or a trustee is appointed in chapter 11, the property may be abandoned in order to maximize the fees that a trustee can earn by administering the estate.

Consider the next example of three properties (in thousands):

The individual has a negative cash flow from the three properties and, as a result, is unable to make the required debt payments. The creditor of property I begins foreclosure action against the debtor. As a result, the debtor files a chapter 7 petition. The debtor has $5 million in NOLs. A trustee is appointed in the chapter 7 case and abandons property I and property II back to the debtor. The debtor allows the creditor to foreclose on property I or voluntarily transfers the properties to the creditor. As a result of the transfer, the taxpayer will have a gain (most likely capital, less any amount for recapture as ordinary income) of the difference between the amount of the debt and the basis of the property. Because the debtor is no longer personally liable for any deficiency, all of the gain will be gain on transfer and none of it will be income from debt discharge. Property II is sold for $11 million. The gains are (in thousands):

The gain will be reduced by the passive loss of $0.6 million. Assuming a 40 percent tax rate for both federal and state taxes, the debtor will have a tax obligation of $5.76 million. The individual has assets and will pay only a fraction of the $5.76 million tax debt over the next 10 years. If part of the gain is ordinary income due to recapture provisions, the taxpayer will not be able to offset this gain against the NOL because the NOL is one of the attributes that goes over to the estate as of the first day of the taxable year in which the bankruptcy petition is filed.

The estate will not have any tax liability. The cash realized from the sale of property III ($3 million) will be used to pay the trustee’s fees and the professional fees of the attorney and accountant; the balance will go to unsecured creditors. The individual with no assets has a tax claim of $5.76 million.

If the properties are sold, whether before or after the petition is filed, the gain on the transfer will be less because the income from debt discharge will be reported on the transfer of property I. The gains from the voluntary transfer of property I to the creditor for full settlement of the claim, and from the sale of both property II and property III for their market values, will be (in thousands):

If the debtor transfers property I to the bank and sells property II before the petition is filed, the tax claim will be much less because $6 million of the gain will be considered income from the discharge of debt. The total tax will be $3.6 million ($9 million × the 40 percent tax rate) before any benefit from the net operating loss carryover, if any, and the benefit of the passive loss carryover. This $3.6 million tax claim will go to the estate, provided the debtor elects to file a short tax year return or the bankruptcy petition is filed after the end of the tax year in which the transfer occurs. During the case, interest and penalties will not accrue on the tax. However, if the tax claim is not paid by the estate, it will not be discharged.

However, if the debtor files a chapter 11 plan and then transfers the property as described, the tax liability before any benefit from NOL and the unused passive activity losses will be only $2.8 million ($7 million × the 40 percent tax rate). This is a tax obligation of the estate, and, if the claim is not paid by the estate due to a lack of assets, the liability will not transfer back to the debtor. However, in this example, the estate has cash in the amount of $4 million from the sale of the properties and will be able to pay the tax liability.

The debtor might also want to consider the option of keeping property III and developing a plan that calls for the payment of tax over five years for the filing date where the payments are not necessarily the same each year.

In a private letter ruling,106 the IRS has ruled that the abandonment of an asset from the bankruptcy estate to the debtor was not a sale or other disposition.

In another private letter ruling,107 the IRS adopted the basic conclusions in In re David Roger McGowan.108 However, it held that the recourse debt became nonrecourse as a result of the discharge in bankruptcy. In this ruling, the debtor received a discharge shortly after the abandonment of a farm property. The debtor continued to farm the property for three years before the foreclosure occurred. As a result of the conversion of the debt from recourse to nonrecourse, all of the gain—difference between the basis in the property and amount of the debt discharged—was considered gain on exchange and none of the gain would be considered income from debt discharge.

(iii) Court Rulings

The courts are split on the issue of how abandonments should be handled. In McGowan,109 the bankruptcy court held that the abandonment of the property by the trustee was not a sale or exchange and that termination of the estate could in fact cover abandonments.

The trustee abandoned property subject to an undersecured debt where the market value of the property was greater than the basis. The trustee filed a tax return on the assumption that the abandonment was taxable to the estate and requested a determination of the tax. The bankruptcy court expressed concern that the trustee, by taking the position that the event was taxable, was not acting in the best interest of the estate and appeared to be more concerned with protecting the debtor. The court failed to acknowledge that the trustee was following the provisions of I.R.C. section 1398(f)(2), which provides that the transfer is not taxable upon termination of the estate.

The bankruptcy court noted in McGowan that I.R.C. section 1398(f)(2) does not define the term “termination of the estate” and that the term is open to several interpretations:110

This term could mean the closing of a case after full administration of the estate; a termination of the estate’s interest in property by virtue of abandonment or exemption; the termination of the estate’s interest in property as a result of completed state or federal court proceedings following modification or termination of the automatic stay if such proceedings terminate the estate’s interests under state law. It could have other meanings.

In In re Olson,111 the bankruptcy court (same judge) relied on McGowan, but acknowledged that McGowan might have been overly broad by including abandonment as involving termination of the estate. In Olson, the court stated that “[t]he definition of ‘transfer’ within the Bankruptcy Code is broad enough to encompass abandonments, and section 1398(f)(2) . . . enables the court to determine the liability issue. The court concludes from the foregoing that the abandonment by the trustee was a transfer other than by sale or exchange which is excepted from tax consequences under . . . section 1398(f)(2).”

The court then concluded without analysis that the meaning of “termination of the estate” includes the termination of the estate’s interest in property pursuant to section 554(a) of the Bankruptcy Code, which provides for the abandonment of property that is burdensome to the estate or of inconsequential value.

The court acknowledged that a better definition of “termination of the estate” might be the closing of the case, but it refused to adopt this position. The court was concerned that if a “closing of the estate” definition was followed, no tax liability would be imposed if the property were left in the estate at the close of the case. The court noted, however, that a tax liability would be imposed if the property were abandoned during the administration of the case. The court could see no reason why abandonment during administration of a case should have a different tax effect and, thus, found that abandonments during administration of a case also should be covered by I.R.C. section 1398. Based on this logic, it would appear that the court would conclude in a situation as illustrated, where the estate has the funds to pay the taxes and the debtor does not, that the abandonment should be taxable.

On appeal, the district court and the Eighth Circuit in In re Olson112 held that abandonment is not a sale and therefore is not a taxable event for the State of Iowa.

In both McGowan and Olson, the court refused to apply the analysis made in Yarbro, where the court identified three things that are required for an exchange:

A giving, a receipt, and a causal connection between the two. In the case of abandonment of property subject to nonrecourse debt, the owner gives up legal title to the property. The mortgagee, who has a legal interest in the property, is the beneficiary of this gift, because the mortgagee’s interest is no longer subject to the abandoning owner’s rights.113

In both McGowan and Olson, the bankruptcy court refused to apply the Yarbro analysis to abandonments of property during bankruptcy. The courts took the position that, although the trustee receives relief from the obligation to administer property which, if overencumbered, would provide no assets for distribution in the bankruptcy case, that kind of benefit is not the kind of benefit necessary to an exchange. Because the trustee did not receive anything by virtue of the abandonment, one of the essential elements of an exchange is missing.

Madoff noted that the courts’ conclusion that the “trustee’s relief from the obligation to administer property is not a sufficient benefit to warrant an ‘exchange’ indicates a misunderstanding of the exchange analysis by focusing on the trustee as the exchanging party instead of the estate.”114 A careful analysis of the components of the exchange indicates that the abandonment of encumbered property from an estate to a debtor does meet the requirements for an exchange.

Madoff provides the following analysis of the courts’ ruling regarding Yarbro:

Prior to the abandonment of property, a creditor with an undersecured claim has a secured claim against the estate up to the fair-market value of the property and an unsecured claim against the estate equal to the excess of the amount of debt over the fair-market value of the property. For example, if property has a fair-market value of $30 and is subject to debt of $40, that creditor has a secured claim against the estate for $30 and an unsecured claim against the estate for $10. By abandoning the property to the debtor, the estate transfers legal title to the property to the debtor in exchange for relief from the $30 secured debt. There is clearly a causal connection between the abandonment of the property and relief from the secured claim because relief from the liability could not occur but for the transfer of the property. [Footnotes omitted]115

Madoff then noted that there is a difference in the transfer of the property to the estate and the transfer of the property to the debtor:

When property is abandoned by the estate to the debtor, the estate is giving legal title to the property, receiving relief from the obligation to pay the secured claim, and there is a causal connection between the two. Compare this to what happens when property is transferred from a debtor to the estate at the commencement of the case. In that situation, the debtor is still giving legal title to the estate; however, unlike in the abandonment situation, the transferor is not receiving relief from the indebtedness. All that happens upon the commencement of the case is that an automatic stay is imposed on claims against the debtor and the debtor’s property. The debtor will not receive any relief from indebtedness until the date of discharge at the close of the case. Moreover, even if the debtor were receiving relief from indebtedness, there is no causal connection between the transfer of the property to the estate and the relief of indebtedness. Any relief from indebtedness occurs by virtue of operation of the bankruptcy law. It operates independently of any transfers of property by the debtor to the estate.116

In In re A. J. Lane & Co.,117 the bankruptcy court examined the issue of property abandonment and raised some interesting questions. Stanley Miller, the chapter 11 trustee in several consolidated cases, requested authority to abandon three properties: the Chapel Hill Apartments in Framingham, Massachusetts; the Cliffside Apartments in Sunderland, Massachusetts; and the partnership interest of the principal debtor, Andrew J. Lane, in Fountainhead Associates of Westborough, a partnership that owns the Fountainhead Apartments in Westborough, Massachusetts. The debtor objected on two grounds:

At the time of the trustee’s notice of intention to abandon, First Mutual Bank of Boston (First Mutual), the holder of second mortgages with recourse rights, had been granted relief from the automatic stay and had scheduled foreclosure sales of all three apartment complexes. The trustee’s sole reason for abandoning the properties was to avoid the substantial income tax liability that would be incurred by the bankruptcy estates, should the estates be considered owners at the time of the foreclosure sales. At the hearing, it was estimated that the properties had a total fair market value of $53 million and a present tax basis of $12.1 million, so that the foreclosure sales would produce a gain of $40.9 million and a tax liability for the estates of $3.27 million considering the tax benefit of a substantial operating loss carryforward available to the estates. It was also pointed out in the hearing that if the debtor bore the tax consequences, the tax liability would total around $13 million because the NOL carryforwards would not be available to the debtor until the bankruptcy estates were closed.

After the hearing, the trustee and the debtor were able to obtain refinancing for the Fountainhead and Chapel Hill Apartments and avoid the foreclosure. Thus, the trustee accordingly withdrew his request to abandon those two properties.

The court concluded that an abandonment of property is a transfer that is taxable. First, the bankruptcy court cited Yarbro v. Commissioner.118 Second, the court relied on Commissioner v. Court Holding Co.,119 where the Supreme Court treated the corporation as having made the sale for tax purposes even though its stockholders actually transferred title to the purchaser to decide that the estate is responsible for the tax. The court noted:

The Trustee seeks to accomplish here what was attempted in Court Holding—to transfer property already the subject of a sales transaction to another party for the sole purpose of having the other taxed on the sale. Here, a foreclosure sale rather than a negotiated sale was pending, but there is no difference in the sale. Here, a foreclosure sale rather than a negotiated sale was pending, but there is no difference in substance. As in Court Holding, the purchaser and the terms of the sale remained unchanged.120

The bankruptcy court then examined I.R.C. section 1398(f)(2) and concluded that the plain meaning of the section is that it applies only to a transfer from the estate to the debtor at the termination of the estate. The court noted that the design statute is clear:

The party holding the property, whether the debtor or the estate, is also entitled to any available net operating loss carryover, so that if that party incurs a taxable gain in the disposition of the property he can use the net operating loss carryover to offset the gain. The Trustee’s proposed abandonment would destroy this symmetry. If the proposed abandonment here were considered to run to the Debtor for title and tax purposes and be tax-free, so that the Debtor would acquire the same low basis in the property as that enjoyed by the estate, the Debtor would incur a large gain from the foreclosure sale without having the net operating loss carryover available to offset that gain. That would be particularly unfair here. The Debtor estimated that imposition to the estate of the gain on foreclosure of all three properties would have resulted in a tax of $3.27 million, whereas if the Debtor were charged with the gain he would have to pay a tax of about $13 million. Although we do not have the parties’ estimates of the tax that would be payable by the Debtor if foreclosure on the Cliffside Apartments alone is taxable to him, it is conceded that the tax would be substantial. The doctrine of either Yarbro or Court Holding would avoid this. Under Yarbro, abandonment is considered a taxable event; under Court Holding, the estate is treated as the seller in the foreclosure. In either case, the estate could use the net operating loss carryover to offset its gain.121

The Lane court was the first court that concluded that the estate will be taxed if the property is abandoned. Judge Queenan’s analysis of I.R.C. section 1398 (which was discussed in detail previously) deserves careful consideration. Why should the entity with the tax attributes be able to force the other party to pay the tax on abandoned property? I.R.C. section 1398 avoids this problem by indicating that only on termination of the estate will transfers back to the debtor not be taxed.

In In the matter of Donovan Feilmeier,122 the bankruptcy court held that once property is no longer the property of the estate due to the release of the stay in a chapter 11 case, any taxes arising from the sale of the debtor’s property is the obligation of the debtor, not the obligation of the estate.

The bankruptcy court in In re Larry F. and Mary A. Laymon123 refused to allow the abandonment in a special situation.

Larry and Mary Laymon farmed several parcels of agricultural land in Minnesota. On July 20, 1987, they filed a chapter 7 petition. Two nonhomestead parcels of farmland had a basis of only $1,500 and a value of approximately $100,000 with a mortgage of $196,000. After the petition was filed, the chapter 7 trustee rented out the farmland in 1987 and 1988 for approximately $22,000. The holder of the mortgage obtained a lift of the automatic stay and commenced foreclosure proceedings. It appeared that the first attempt to sell the property was deficient in some aspect, and a second foreclosure sale was noticed. Before the second sale, a new trustee was appointed to administer the estate. He determined that the sale of the property would result in a capital gains tax of approximately $17,000 if the estate possessed the property at the time of the sale. As a result, he sought to abandon the property before the sale. Prior to the sale of the property, the bankruptcy court approved the abandonment of the property.

In Laymon, the trustee claimed that the property was burdensome because the capital gains tax would reduce the assets which otherwise would be available for creditors. The Laymons objected to abandonment as improper and inequitable because the estate enjoyed a great benefit from the property before abandonment, such as the receipt of $22,000 in the form of rental income. The district court noted that, in In re Wilson,124 it was stated that a court looking at the abandonment issue should consider whether the decision “reflects a business judgment made in good faith, upon a reasonable basis and with[in] the scope of his authority under the code.”

The trustee argued that abandonment is consistent with his fiduciary obligation to creditors—to preserve for the creditors the largest possible estate. The district court noted “[t]hat is not a trustee’s sole fiduciary obligation, however. As a successor to the debtor’s interest in estate property, the trustee has duties to all the parties, such as administering the estate fairly and closing it expeditiously.” The court also noted that the trustee has a more general duty not to burden unduly the debtor’s opportunity for a fresh start. In citing In the Matter of Esgro, Inc.,125 the court noted that “a primary goal of the Bankruptcy Code is to relieve debtors from the weight of oppressive indebtedness.”

The court also noted that the “impact that abandonment would have upon debtors is one aspect to consider on the issue of burdensomeness.” The court concluded that “[i]n the circumstances presented, it was erroneous for the bankruptcy court to approve the trustee’s report of abandonment and that order should be reversed.”

This case does not necessarily indicate that if the tax burden interferes with the ability of the debtor to obtain a fresh start, the property should not be abandoned. It does indicate that some consideration in making the abandonment decision should be given to the impact that the action will have on the debtor. This case may also suggest that if abandonment is to take place, the trustee should abandon the property shortly after the chapter 7 petition is filed rather than making the abandonment just prior to sale to avoid the tax. This decision should encourage trustees to determine at the beginning of the case those properties that have a low basis relative to value. Properties that may result in a significant tax burden for the estate should be abandoned at the beginning of the case unless the benefits in holding them outweigh the tax costs. In Laymon, the estate was burdened with the potential tax liability because the value of the rents received exceeded the tax.

In In re Nevin,126 the bankruptcy court ordered the trustee to abandon to the debtors their respective partnership interests in the limited partnerships. The order came after the IRS filed a motion for abandonment. The limited partnership filed a chapter 7 petition and ceased operating its restaurant. The bankruptcy court approved the sale of the restaurant which resulted in a federal tax liability of approximately $100,000 to the partners.

The partners are in chapter 7 in a “no asset” case, and there are no funds in the estates of the individuals to pay the tax liability, but there are funds in the partnership to pay the taxes.

The court noted that the Bankruptcy Code requires that the trustee in a chapter 7 liquidation case expeditiously liquidate the property of the estate or abandon it.127 Citing Mason v. Commissioner,128 the court noted that the abandonment of property relates back to the inception of the bankruptcy case and will revest title in the debtor as though the trustee never owned it. The court noted that the debtors chose the partnership form of business organization when they formed the restaurant and that, if they had selected a corporate form of ownership, they would not have been faced with the present dilemma. The court also noted that they had apparently chosen the partnership form in order to obtain the tax benefits of partnership.

Generally, in determining if property should be abandoned, the trustee need only consider if the asset has value to the estate. It is not necessary for the trustee to consider any adverse tax consequences to the debtor resulting from abandonment of the property.129

(iv) Abandonment to Debtor or Creditor

In In re Popp,130 the bankruptcy court held that the trustee may abandon the property to the debtor only because the debtor has a possessory interest in the assets that is superior to all third parties. Section 554(b) of the Bankruptcy Code states: “On request of a party in interest . . . the court may order the trustee to abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate.” The legislative history of section 554 of the Bankruptcy Code states: “Abandonment may be to any party with a possessory interest in the property abandoned.”131 The bankruptcy court in In re Popp noted that in Black’s Law Dictionary132 a “possessory interest” is defined as a “right to exert control over specific land to the exclusion of others” or a “right to possess property. ”

As a result of section 554(b) of the Bankruptcy Code and the related legislative history, courts have generally held that abandonment should be to the party with the superior possessory interest.133 The bankruptcy court in Popp also relied on the rule that the Supreme Court first presented in O’Keefe, when analyzing the rights of the parties under the Bankruptcy Act of 1898. The Supreme Court noted that once the trustee abandons property of the estate, the property is treated as though no bankruptcy had been filed, and interest in the property reverts back to the party that held such interest prepetition.134 As a result of these cases, it is generally concluded that the party that has the right to possession at the filing of the bankruptcy will reassume the same status when the asset is abandoned. As a general rule, that will normally be the debtor. However, a creditor may be entitled to possession if, by the exercise of its contractual or other rights, it held a possessory interest prior to the filing of the bankruptcy. For example, in the case of In re A. J. Lane & Co.,135 the bankruptcy court held that a secured creditor had a superior possessory interest because the creditor had already been granted relief from the automatic stay and was free to foreclose on its mortgage.

In order for the creditor to have a superior possessory interest over the debtor, it may be necessary for the secured lender to be in possession of the property prior to the filing of the petition. For example, in In re Service,136 the bankruptcy court held the debtors could not propose to abandon property to the secured party because the secured party was not in possession of the property prepetition. Likewise, in Popp, the bankruptcy court held that the bank did not have possession of the assets at the filing date and that, as a result, the trustee may not abandon to the creditor but must abandon to the debtor. The court concluded that the debtor will retain title and all other benefits and detriments concerning the equipment that is abandoned by the trustee.

However, in In re Terjen,137 the bankruptcy court held that the individual and not the bankruptcy estate was liable for taxes where the trustee abandoned property after creditors were afforded relief from the bankruptcy stay but before a foreclosure sale was held. The decision by the district court does not examine who has possessory interest in the property before it is abandoned or at the time the petition is filed.

(k) Abandonment of Proceeds

If the trustee sells the property and then abandons the proceeds, it would appear that any gain that might be realized on the sale is reported by the estate. In In re Bentley,138 the trustee sold collateral (grain) for an undersecured claim (apparently hoping that the estate might have some equity) and held the proceeds of the sale for three years. Then the trustee abandoned the proceeds. The bankruptcy court held that the sale did not result in “gross income of the debtor to which the estate is entitled” under I.R.C. section 1398(e). The court concluded that the estate was not entitled to and ultimately did not retain the property and received no benefit from the property. Thus, this was not a taxable event to the estate. On appeal by the IRS, the district court reversed the bankruptcy court’s decision and held that abandonment of grain sale proceeds by a trustee in bankruptcy may not relate back three years so as to constitute a retroactive abandonment of the grain itself, which would have absolved the bankruptcy estate of tax liability. The court further stated that the taxable event occurred when the grain was sold.139 The In re Bentley140 case was affirmed by the Court of Appeals for the Eighth Circuit, which ruled that the gain on sale of the corn does not give rise to a tax obligation of the individual debtor.

The bankruptcy court ruled that a trustee may not abandon the proceeds of sales of estate property to avoid the tax consequences of the sales. The individual debtor filed a chapter 7 petition in 1991 owning an interest in a partnership. The partnership owned an interest in a wrap-around mortgage encumbering real property, and an equity interest in an apartment complex. The partnership had sold its interest in two other properties prior to debtor’s bankruptcy filing. In 1992, the bankruptcy court authorized the sale of the wrap-around mortgage and the apartment complex, netting over $47,000 for the debtor’s estate in 1992. The trustee filed a motion to abandon the proceeds from those sales because the estate might incur substantial tax liabilities resulting from the sales. The IRS objected to the motion.

Citing In re Bentley,141 where the Eighth Circuit held that the trustee’s sale of estate assets was a taxable event for which the bankruptcy estate was liable and the trustee’s abandonment of the sale proceeds did not abrogate the tax consequences of the sale, the bankruptcy court held that the trustee could not retroactively abandon the estate’s interest in the partnership. The court noted that the estate’s interest in the partnership could have been abandoned prior to the sales under section 554(a) of the Bankruptcy Code without any tax consequences and rejected as irrelevant the trustee’s argument that he did not know the tax consequences would be so significant because the debtor’s records were in disarray and the debtor had not filed prior year’s tax returns.142

§ 4.4 ACCOUNTING FOR THE DEBTOR (INDIVIDUAL)

Section 1398 provides guidelines for the tax treatment of the individual debtor during the time period in which bankruptcy proceedings are pending and for the handling of items at the conclusion of the bankruptcy proceedings.

(a) Individual Debtor’s Taxable Year

One of the questions that always arises in considering an individual’s tax liability in bankruptcy proceedings is what impact the event of bankruptcy will have on the debtor’s taxable year. Individual debtors have an election to close their taxable year as of the day before the date bankruptcy commences.143 This election is available only to individuals in either chapter 7 or chapter 11 proceedings. Also, this election should be available to an individual that filed a chapter 12 petition, if it is assumed that a new entity is created (see § 4.3(a)). However, since I.R.C. section 1398 was not modified to include this provision, such an election is not available for federal tax purposes because a separate estate is not created.

If the taxpayer does make the election to close the taxable year, the taxpayer’s taxable year is divided into two “short” taxable years. For example, if a calendar-year taxpayer filed a petition on July 15, the first “short” year would be from January 1 through July 14 and the second “short” year would be from July 15 through December 31. The tax liability computed for the first short year is collectible from the bankruptcy estate. The tax is considered a liability before bankruptcy and thus payable by the estate. In the event the estate does not possess enough assets to pay the tax, the remaining liability, as is true with any priority tax, is not discharged but is collectible from the individual after the case terminates.144 If the individual has earned income up to the date the petition is filed and has NOLs, the individual could file the short tax return and then offset the income earned during the short year against the NOL. Then the balance of the NOL after this adjustment would be carried over to the estate as of the date the bankruptcy petition is filed (see § 4.3(c)).

If the debtor does not make the election, courts have held that the tax liability for the entire tax year is an obligation of the debtor. For example in In re Mirman,145 the court noted that, under sections 502(i) and 507(a)(7)(A) of the Bankruptcy Code, the taxes are not a liability until the end of the year even though the source of income that gave rise to the taxes was received prior to the filing of the bankruptcy petition. The court held that “the Internal Revenue Service is not a creditor of the debtors’ bankruptcy estate. The IRS holds a valid claim against the debtors individually for the taxable year 1982, but since the debtors failed to make an election under 26 U.S.C. 1398(d) to divide their taxable year, no part of the debtors’ tax liability for the year is collectible from the estate.” It is also the position of the IRS that taxes on income earned before the petition was filed, but in the year of filing, where the debtor does not make the section 1398 election are not subject to discharge, and the IRS may initiate collection procedures against the debtor outside bankruptcy after the automatic stay terminates.146

Also, in In re Turboff,147 the court refused to allow the estate to make estimated tax payments to avoid interest and penalties for taxes of the individual due in the year a bankruptcy petition was filed. The debtor failed to make the timely election under I.R.C. section 1398(d)(2) to close the taxable year the day before the case was commenced. However, in In re Eith,148 where the debtor timely prepared the tax return making the short-year election under I.R.C. section 1398(d)(2) and gave it to the trustee, who did not timely file it, the court allowed the estate to pay the prepetition taxes that were the personal liability of the debtor. The trustee had demanded that the return be sent to him for filing, arguing that any tax refund was that of the estate. The trustee, for reasons unknown, did not file the return before the deadline had passed. The taxes were allowed as an administrative expense of the estate.149

The Tax Court held that a couple could not use an NOL to reduce their income for the year in which the husband filed a voluntary bankruptcy petition, because the husband did not elect to adopt a short taxable year ending on the date before his filing.

A bankruptcy court150 held that no part of a debtor couple’s tax liability from the sale of a restaurant is collectible from their bankruptcy estate because they failed to make an election under section 1398 for the estate to have liability for taxes incurred during the year before the date the petition was filed. Even though both the trustee and the debtor were unaware of the section 1398 election, and the debtor stated that the trustee agreed to pay the tax the debtor incurred on the sale when the proceeds were turned over to the trustee, the court still ruled that because the debtor failed to make the section 1398 election, the tax obligation is that of the individual and not the bankruptcy estate, and the debtor must pay without receiving any proceeds from the estate.

(i) Procedures for Election

The election to close the taxable year as of the day before the date bankruptcy commences is available to an individual taxpayer who files a chapter 7 or chapter 11 petition. Treas. Reg. section 301.9100-14T provides that a taxpayer to whom the election is available makes the election by filing a return for the short taxable year ending the day before commencement of the case (the “first short taxable year”) on or before the 15th day of the fourth full month following the end of that first short taxable year. The spouse of such a taxpayer makes the election by making a joint return with the taxpayer for that first short taxable year within the time prescribed in the preceding sentence. To facilitate processing, Treas. Reg. section 301.9100-14T directs the taxpayer to write “SECTION 1398 ELECTION” at the top of the return. A taxpayer may also make the election by attaching a statement of election to an application for extension of time for filing a return that satisfies the requirements under I.R.C. section 6081 for the first short taxable year. With the changed procedures that now permit taxpayers to electronically file a request for an automatic extension of time to file a tax return, there is no way to indicate that the request is a section 1398 election, so taxpayers must file a paper request with the IRS instead of an electronic request if they want to make the election. The application for extension must be submitted under I.R.C. section 6081 on or before the due date of the return for the first short taxable year. The statement must state that the taxpayer elects, under I.R.C. section 1398(d)(2), to close the taxable year as of the day before commencement of the case. If the taxpayer’s spouse elects to close his or her taxable year, the spouse must join in the application for extension and in the statement of election. If a joint return is not filed for the first short taxable year, the election of the spouse made with the application is void.

Treas. Reg. section 301.9100-14T provides that the election, once made, is irrevocable.

A debtor’s spouse who subsequently files a chapter 7 or chapter 11 petition in the same taxable year can make the election even if the spouse joined in the debtor’s earlier election. Also, the debtor, provided otherwise eligible to file a joint return with the spouse, may join in the election. The following example was provided in Treas. Reg. section 301.9100-14T.

(ii) Electing “Short” Tax Year

In most cases, it is presumed that the debtor will make the short tax year election if income was earned as of the date the petition was filed and generally will not make the election if there was a loss for this time period. If the debtor makes the election and, as a result of filing the short-period return, ends up with a loss or a refund, it would appear that the refund would be property of the estate. If the debtor incurs a loss in the short period that could be carried back to request a refund from a prior period, it might be beneficial to make the election and file a loss carryback to generate a refund that can be used to pay creditors. The debtor cannot be forced to make the election, but once the election is made, then it would seem that he would lose all rights to the tax refund.

If the debtor is married, the spouse can join in the election. Under these conditions, a joint return would have to be filed for the short taxable year ending when the petition was filed. A spouse joining in the filing of the short tax return would transfer any individual tax liability to that of the bankruptcy estate.

In making a decision as to whether a short tax return should be filed, the debtor will need to consider the fact that the basis of assets is transferred over to the estate as of the first day of the taxable year in which the petition was filed. Thus, if the short tax return is not filed, the individual, it appears, would not have any depreciation deduction for the assets that were transferred to the estate. To obtain the depreciation deduction, the individual would have to file a short tax return (see § 4.3(c)). Another factor to consider in electing whether to file a short tax return is the method by which tax liability is determined. If a short tax return is filed, any litigation associated with the taxes due under that return could be handled by the bankruptcy court. However, if the debtor elected not to file a short tax return, any dispute concerning the tax for the year the case commenced would be handled by the Tax Court (see § 8.5(b)). In filing a return for either short period—the one up to the date the bankruptcy petition was filed or the period from the date the bankruptcy petition was filed to the end of the tax year—the debtor must annualize income and make the other adjustments that are required under I.R.C. section 443.151

(b) Tax Refunds and Estimated Tax Payments

Even if a short tax return is not filed, there may be a question as to whether the estate or an individual is entitled to a tax refund that is primarily based on postbankruptcy activities. Under the prior bankruptcy law, the Supreme Court held in Segal v. Rochelle152 that the loss carryback refund claim was property of the bankruptcy estate at the petition date. Other courts have held that the refunds due the individual debtor should be apportioned between the debtor and the estate.153 The basis of the apportionment was the salary earned and the normal withholding exemptions during the year in which the bankruptcy petition was filed. The bankruptcy court may be inclined to take this position, especially if the tax refund is due to tax deposits made by the debtor prior to the filing of the bankruptcy petition. In a memorandum to district counsel, Michael R. Arner, senior technician reviewer, branch 1 (general litigation), required the IRS to turn over part of a debtor’s tax refund to a bankruptcy trustee, even though the debtor’s stipulation with the bankruptcy trustee did not include the IRS. In the memorandum, it was noted that the debtor did not have the right to make an election regarding the tax refund because it belonged to the estate.154

A district court held that a bankruptcy estate was entitled to a refund under section 1341 of the I.R.C. arising from the carryover due to the deduction of a debtor’s repayment of fraudulently obtained funds.155

In In re Barowsky,156 Todd Allen Barowsky and Kody Sirentha Barowsky filed a joint chapter 7 bankruptcy petition on July 24, 1987. On December 3, 1987, the bankruptcy court discharged the debtors upon a stipulation from the trustee that it was a no-asset estate. In early 1988, the Barowskys filed their federal income tax returns for the calendar year 1987. The Barowskys were entitled to a refund of $1,092.74. The trustee claimed that the portion of the refund attributable to the prepetition part of the Barowskys’ tax year belonged to the estate. The Barowskys claimed that the refund did not constitute property of their estate and that, therefore, they were entitled to the entire refund. The Tenth Circuit held that the taxes should be prorated as suggested by the trustee.

The court relied on Kokoszka v. Belford.157 In this case, the debtor filed for bankruptcy in January 1972; in February 1972, the debtor filed his income tax return for 1971 and later received a refund. The trustee claimed that the refund was property of the estate. The Supreme Court held that the refund was property of the estate. The Court held that the refund was “sufficiently rooted in the prebankruptcy past and so little entangled with the bankrupt’s ability to make an unencumbered fresh start that it should be regarded as property.”158

This case was decided under the Bankruptcy Act. In Barowsky, the court concluded that the concept of property under the Act also applied to the Bankruptcy Code. The Tenth Circuit noted that section 541 of the Bankruptcy Code adopted the Supreme Court’s analysis of property as contained in Segal.

The court may also review estimated tax payments or overpayments in a prior year that are applied to next year’s tax liability. In In re Simmons,159 the trustee attempted to recover a 1987 overpayment of $7,799 that Simmons applied to his 1988 estimated tax on three bases:

The Tenth Circuit Bankruptcy Appellate Panel (BAP) affirmed a bankruptcy court decision that denied a bankruptcy trustee’s motion for turnover of a debtor couple’s prepetition tax refund that they opted to apply to the following year’s taxes, finding that the funds were not in the couple’s possession, custody, or control. The issue addressed by the BAP was whether a prepetition tax refund that the debtors elected to apply in prepayment of a subsequent year’s tax liability is properly subject to turnover under section 542 of the Bankruptcy Code. The court noted that in In re Simmons160 the debtor elected to have an overpayment of taxes applied to his next year’s tax liability. Six days later, a chapter 7 bankruptcy petition was filed. The trustee in bankruptcy filed an adversary proceeding against the IRS seeking turnover of the prepaid funds. This outcome was based, in part, on section 6513(d) of the Internal Revenue Code, which provides that, where an overpayment of tax is applied as a credit on the next year’s taxes, “no claim for refund of such overpayment shall be allowed for the taxable year in which the overpayment arises.”

The Tenth Circuit BAP referenced several cases in reaching its decisions. Among them was the Ninth Circuit Court of Appeals,161 which upheld a bankruptcy court’s determination that the “debtors’ prebankruptcy application of their right to tax refunds to postbankruptcy tax obligations constitutes an asset that must be turned over to the bankruptcy trustee,” pursuant to section 542.

The trustee in In re Weir162 attempted to obtain prepaid taxes from the IRS, asserting claims for turnover, voidable preference, and fraudulent conveyance. The court rejected all three claims. With respect to the turnover claim, the court noted that, once the prepayment election had been made, “debtor retained only the right to have the payment credited against his 1985 tax liability and to have any excess refunded to him.” However, the court did note that, although the estate was not entitled to recover the prepayments as property of the estate, it “would be entitled to share in any refund due the debtor.”

In In re Middendor,163 the court held that “the portion of Debtors’ tax refund attributable to pre-petition withholdings and payments is Estate property” and that the debtors’ “contingent reversionary interest” vests “once the ultimate tax liability is assessed and satisfied.”164

In In re Weir III,165 the trustee also claimed that an estimated payment was a preference under section 547(b) of the Bankruptcy Code. The court concluded that the estimated payment made before the bankruptcy petition was filed was not a preference because the debtor’s tax was not due until April 15, even though the debtor was required to make estimated payments.

In a third case,166 the court did allow the recovery of part of a prior year refund that was credited to the next year’s estimated payment. The court concluded that since the amount of the debtor’s prepayment over and above taxes actually owed on the date he filed his bankruptcy petition was property of the estate, it should not have been credited to the debtor’s account. Since what was done was merely as a bookkeeping entry, “the IRS will merely be directed to reverse the entry and pay the $3,257.35 to the Trustee.” In this case, the court suggested that the way to determine the amount of refund due to an estate is to compare the estimated tax payments, withholdings, and so on, that have been applied to the current year with the tax liability that would arise from the earnings to the date the petition is filed. Thus, in cases where there are refunds, the Lavelle decision suggests that this type of adjustment will achieve the same result as if the debtor elects the short tax year under I.R.C. section 1398(d)(2). Considerable conflict still exists as to how to handle these estimated tax payments, withholdings, and so on, when the debtor does not elect the short tax year.

In In re David Browning Canon,167 the trustee was allowed to recover an over payment that the debtor and his wife elected to have credited to their estimated tax liability for the year in which the taxpayer filed a chapter 7 petition based on the U.S. Supreme Court’s ruling in Segal v. Rochell.168

In In re Halle,169 because neither the IRS nor the debtor elected to raise the issue of allocating the payments, the court ruled against this.

The failure of the debtor to elect under section 1398(d)(2)(A) to bifurcate that tax year prepetition and postpetition resulted in the estimated tax payments being considered property of the estate and not available for the debtor to use.

(c) Income and Deductions

Income not reported in the estate and received by the debtor would normally be income that must be reported by the debtor on the individual tax return filed. Any income that is earned by the debtor from the estate would be reported as an expense of administration of the estate and would be picked up as income of the debtor on his or her individual tax return. Thus, in a bankruptcy proceeding, if the trustee pays a salary of $500 a week for the debtor to work for the estate during the bankruptcy proceeding, then the $500 a week would be an expense of administration and income to the debtor. This same provision would apply if the debtor was a debtor in possession and the court had authorized payment of this salary to him or her out of the estate. In some cases, the bankruptcy court may approve a disbursement for the individual for monthly living expenses. It would appear that the estate would deduct these disbursements on its return and the individual would report them as income (see § 4.3(e)). As noted earlier, amounts allowed to a debtor for living expenses are not treated as wages for tax withholding purposes, so the debtor needs to make estimated tax payments or be faced with a tax obligation when he or she files a return the following year.

Any deductions that are not allowed by the estate would be allowed by the individual (see § 4.3(e)).

(d) Attribute Carryover to Debtor

Upon termination of the estate in a chapter 7 or chapter 11 case, the debtor succeeds to (inherits) and takes into account these seven tax attributes:

Passive activity losses and credits follow the property. Therefore, Treas. Reg. sections 1.1398-1 and 2 provide that the individual debtor succeeds to the unused passive activity losses and credits under I.R.C. section 469 for any passive activity property that is returned to the debtor at the termination of the bankruptcy estate. The same would apply to the unused losses from at-risk activities under I.R.C. section 465 remaining at the termination of the bankruptcy estate.

Treas. Reg. section 1.1398-3 provides that the individual debtor succeeds to the exclusion from income the gain on the sale of a residence under section 121.

I.R.C. section 1398 does not address the issue of what date to use when the attributes are transferred back to the individual. It appears that the final tax return of the estate ends on the date the estate terminates and that the attributes are transferred to the individual as of that date subject to any writedown required for any indebtedness excluded from income during the administration of the case. In a chapter 11 case, this date will, it seems, be the date the plan is confirmed, unless the plan provides otherwise, and not the date when all provisions of the plan are carried out. In a chapter 7 case, it would also appear that the date to use is the effective date of the discharge. Most likely this “termination” date will be prior to the time the trustee will make a final report and file a final accounting of the administration of the estate as required by Bankruptcy Code section 704(9). In cases where the trustee has not timely “closed out the estate,” the individual should not necessarily assume that the estate still exists for tax purposes. As a practical matter, in both chapter 7 and chapter 11 cases, administrative activities of the estate carry on beyond the date the debtor receives a discharge. Consequently, the attributes that are involved may be difficult to ascertain with any certainty until a later date.

(i) Method of Accounting

One of the items that is carried over to the estate, but is not listed among the attributes that are carried over to the debtor, is the method of accounting. Thus, it would appear that the debtor would not be required to use the method of accounting (cash, accrual, or otherwise) used by the estate.

(e) Loss Carryback

I.R.C. section 1398(j)(2)(B) provides the following:

Carrybacks from Debtor’s Activities—The debtor may not carry back to a taxable year before the debtor’s taxable year in which the case commences any carryback from a taxable year ending after the case commences.

Thus, an individual incurring an NOL cannot carry back these losses to the year that preceded the year in which the chapter 7 or chapter 11 case was commenced. The term “carryback” would include not only NOLs but also the other credit carried over from the estate. This provision would also prohibit the debtor from carrying back any subsequent NOLs after the case closes to prepetition bankruptcy years. Even though it may appear that there is no justification for this provision, Klee suggests that there are very important reasons why the debtor would not want to carry back the loss even if allowed to do so. The main reason is that any benefit gained by a carryback belongs to the estate. If the estate is reopened, it will be administered for the benefit of the creditors. On the loss that is carried back, the creditors would reap the benefit rather than the debtor. If the losses were carried forward, then they would be to the benefit of the debtor and not the creditors.171

Additionally, it would appear that a debtor could not carry back to a postpetition year an NOL that the debtor succeeds to upon termination of the estate, where income was reported to obtain a refund. For example, assume a petition was filed on August 1, 20X2, and the estate was terminated on December 31, 20X4. Upon termination of the estate, the debtor could not carry back the NOL that the debtor succeeded to from the estate in 20X4 to receive a refund of taxes the individual paid in 20X3.

The Tax Court held that an individual taxpayer may use net operating carryovers not used by the bankruptcy estate beginning in the year the bankruptcy activity commenced. The Tax Court disallowed the use of any NOL carryover that may remain for year’s end prior to the commencement of the case. The Tax Court also held that in chapter 11, the termination date under I.R.C. section 1398 is the date the plan is confirmed.172

In a subsequent summary judgment, the Tax Court addressed an additional issue not fully resolved in the prior summary judgment.173

The Tax Court again concluded that the taxpayer may not use an NOL carryover that existed prior to the filing of the petition during the period after the petition was filed and before confirmation of the plan. These NOL carryovers may be used in subsequent periods following confirmation. The court, however, held that NOLs attributable to $84 million suspended passive losses are usable by the individual during the pending of the bankruptcy case, if the NOL created from the transfer of the property occurred after the petition was filed.

The Tax Court described the use of the passive losses as follows:

In general, when a taxpayer disposes of an entire interest in a passive activity to an unrelated person in a fully taxable transaction, all passive losses from the activity, both suspended and current, are deductible from the taxpayer’s income whether passive or nonpassive. The loss available upon that type of disposition is no longer treated as passive to the extent of: (1) any loss from the activity for the tax year (including any losses suspended in prior years), over (2) any net income or gain for the tax year from all other passive activities (determined after application of any losses suspended in prior years). Sec. 469(g)(1)(A). Hence only upon the Benton estate’s transfer of its interest in a passive activity to the liquidating trustee—a transfer deemed a taxable disposition by reason of the settlement—would any suspended passive loss from that activity, pursuant to section 469(g)(1)(A), qualify as a generally deductible nonpassive loss. Id.; sec. 1.469-2 T(d)(2)(v), Temporary Income Tax Regs., 53 Fed. Reg. 5716 (Feb. 25, 1988). Therefore, any NOLs generated by the Benton estate’s suspended passive activity losses arose during the administration of the estate in bankruptcy, when the passive activity assets were transferred into the liquidation trust, and would not have been prebankruptcy NOLs of petitioner.

The approximately $80 million in NOLs attributable to the $84 million in suspended passive activity losses may be carried to the debtor’s 1995, 1996, and 1997 tax years—years between the filing date and confirmation of the plan. However, the Tax Court pointed out that an NOL carryforward deduction may result in the reduction or elimination of additions and/or penalties. But an NOL carryback deduction does not result in the reduction or elimination of such additions and/or penalties.174

In an unpublished opinion, the Sixth Circuit held that a bankruptcy estate property reverted to a couple on the plan’s effective date and that any gain on a sale of property after that date was the couple’s responsibility.175

In another case, the Tax Court allowed on a joint return filed by the wife as administratrix of her husband’s estate the use of the benefit of the NOLs from the bankruptcy estate even though the individual debtor died before the bankruptcy estate was terminated. The Tax Court noted that “Congress put no limitation on the succession, and that death does not necessarily alter the identity of the debtor in bankruptcy proceedings strongly, we hold that petitioners are entitled to deduct on their joint return for 1994 the NOLs in question.”176

In a private letter ruling,177 the IRS looked at two key issues dealing with the carryback of the NOL of an estate and reached two conclusions:

The IRS noted:

[B]ecause an NOL of a bankruptcy estate which is carried back to an individual debtor’s prior taxable year is allowable as an NOL deduction to the debtor under section 172 of the Code, such amount must also be included in computing the alternative tax net operating loss (ATNOL) deduction of the debtor for such carryback year under section 55(d). Thus, section 1398(j)(2) allows the ATNOL of a bankruptcy estate to be carried back to a taxable year of the individual debtor which is prior to the first taxable year of the estate in the same manner that a regular tax NOL of the estate is allowed as a carryback in a prior taxable year of the debtor.

I.R.C. section 1398(i) provides that, in the case of a termination of the bankruptcy estate, the individual debtor shall succeed to and take into account certain tax attributes of the estate, including NOL carryovers. Thus, at the termination of the estate, I.R.C. section 1398(i) would allow any carryover NOL of the estate to be allowed as a deduction by the debtor.

Neither I.R.C. section 1398(i) nor the legislative history to the Bankruptcy Tax Act of 1980 prohibits a debtor from carrying back an NOL of an estate to a debtor’s taxable year that is prior to the termination of the estate. The IRS concluded, however, that to allow such a carryback would be inconsistent with the legislative intent of I.R.C. section 1398 to treat the estate and debtor as separate taxable entities. The IRS noted that allowing the debtor to carry back the estate’s NOL would, with regard to the NOL deduction, effectively combine the estate and the debtor into a single taxpayer for the carryback year. There is nothing in I.R.C. section 1398 or the legislative history that suggests this result was intended. In the opinion of the IRS, NOL carryover to which a debtor succeeds on termination of a chapter 7 or chapter 11 case cannot be carried back and deducted by the debtor for a taxable year that corresponds to a taxable year of the estate.

(f) Automatic Stay

Section 362(a)(8) of the Bankruptcy Code provides that the filing of a stay operates as a stay against “the commencement or continuation of a proceeding before the United States Tax Court concerning the debtor.” Considerable uncertainty exists as to the impact that this provision might have on a debtor that files a chapter 7 or chapter 11 petition and incurs tax obligations separate from those of the bankruptcy estate resulting from income earned in the same taxable year but prior to the filing of a petition in a case where the election is not made to file a short tax return, or in subsequent taxable years of the individual debtor. Because these taxes are not subject to discharge and are not a liability of the bankruptcy estate, it might be concluded that the automatic stay is not applicable. In fact, for claims other than tax claims, there is no stay regarding actions that may be brought against the individual separate from the bankruptcy estate.178

In Halpern v. Commissioner,179 the court noted that the automatic stay under section 362(a) of the Bankruptcy Code generally operates to bar actions against or concerning the debtor or property of the debtor if the actions could have been brought before the bankruptcy petition was filed or if the actions represent efforts to collect on claims arising before the commencement of the bankruptcy case. Taxes falling under this general observation would be postpetition taxes. Under section 362(c)(1) of the Bankruptcy Code, the automatic stay also prohibits acts against property of the estate regardless of whether the claim may be characterized as prepetition or postpetition.180

Unless relief from the automatic stay is granted by the bankruptcy court under section 362(d) of the Bankruptcy Code, the automatic stay generally remains in effect until the earliest of the closing of the case, the dismissal of the case, or the grant or denial of a discharge.181

In Halpern v. Commissioner, the court examined the issue as to whether the automatic stay applies to collection by the IRS of postpetition tax claims by the individual taxpayer.

The Tax Court noted that section 362(a)(8) of the Bankruptcy Code, by its terms, expressly bars the commencement or continuation of a proceeding before the Tax Court concerning the debtor, and that the codification of this provision clarifies that the Tax Court should “no longer exercise wholly concurrent jurisdiction with the bankruptcy court with respect to the resolution of tax issues.” The court then concluded that the automatic stay bars actions against the debtor in the Tax Court regardless of whether the underlying deficiency may be characterized as arising prepetition or postpetition. In reaching this conclusion, the Tax Court realized that the IRS is in a less advantageous position than that enjoyed by private creditors. The court noted, however, that the IRS is not without a remedy. If the IRS believes there is cause for the removal of the stay, it may seek relief from the bankruptcy court. While not addressed by the Tax Court, it would appear that the IRS would request the removal of the stay for the Tax Court to determine the tax liability, because it is doubtful that the bankruptcy court would have the authority to rule on the claim separate from that of the estate. In In re Mirman,182 the bankruptcy court noted that it generally lacks jurisdiction over postpetition tax liabilities.

There are at least two situations where the bankruptcy court might determine the consequence of tax obligations that might be attributable to the debtor. Where taxes were earned during the taxable year prior to the filing of the petition, the bankruptcy court, in Mirman, concluded that it has jurisdiction to determine the tax if an election is made to file a short tax return. Additionally, postpetition tax liabilities may be pursued in chapter 13 bankruptcy proceedings if provided for in the plan and if the IRS files a proof of claim.

The stay under section 362(a)(8) is revised to apply only to a tax liability for an individual for a taxable period ending before the order for relief or for a corporation for a period the bankruptcy court may determine the tax. Generally, the bankruptcy court may determine both prepetition and postpetition taxes for a corporation. In Halpern v. Commissioner,183 the Tax Court held that the filing of a petition for relief under the Bankruptcy Code activates an automatic stay that precluded the commencement or continuation of a case because the Tax Court did not have jurisdiction to hear a case in a postpetition year. The amendment limited the stay for individuals to tax incurred before bankruptcy. The 2005 Act indicates that automatic stay continues to apply to both prepetition and postpetition tax liabilities of a corporation so long as it is a liability that the bankruptcy court may determine.

§ 4.5 SUMMARY

There are several issues that the trustee or debtor in possession should consider in tax planning for the estate or for the individual debtor. These issues are:184

1 882 F.2d 1507 (10th Cir. 1989).

2 1990 Bankr. LEXIS 709 (Bankr. N.D. Cal. 1990).

3 26 U.S.C. § 6601(a).

4 91 B.R. 932 (Bankr. D. Kan. 1988).

5Elkins v. Commissioner, 88-1 USTC (CCH) 9338 (Bankr. D.D.C. 1988).

6 Knudsen, 581 F.3d 696, (CA8, 2009; Ficken, 430 BR 663 (2010); Hall, 617 F.3d 1161 (2010) and Gene R. Smith 107 AFTR 2d. 1300 (Bankr. Penn 2011).

7 11 U.S.C. § 346(a).

8 11 U.S.C. § 346(b) and (c).

9In re Shank, 240 B.R. 216 (Bankr. D. Md. 1999).

10United States v. Redmond, 36 B.R. 932, 934 (D. Kan. 1984).

11Holywell Corporation v. Smith, 503 U.S. 47, 52, 112 S. Ct. 1021 (1992).

12Shank, supra note 9 at 221.

13United States v. Ruff, 179 B.R. 967 (M.D. Fla. 1995), aff’d, 99 F.3d 1559 (11th Cir. 1996).

14 323 F.2d 197 (5th Cir. 1963).

15 F.2d 270 (5th Cir. 1976).

16 11 U.S.C. § 346(h).

17 I.R.C. § 1398.

18 11 U.S.C. § 346(f).

19 See In re Knudsen, 581 F.3d 696; In re Ficken, 430 B.R.663 (CA 10 BAP); and In re Hall, 617 F.3d 1161.

20 P.L.R. 8928012 (Apr. 7, 1989).

21Supra note 19.

22United States v. Hall (CA 9 8/16/2010 10-6 AFTR 2d 2010-5848), cert. granted June 13, 2011.

23 46 B.R. 333 (Bankr. Md. 1985).

24 167 B.R. 436 (Bankr. W.D. Texas 1994).

25 14 B.R. 833 (Bankr. 9th Cir. 1981).

26 IRS Announcement 81-96, May 7, 1981.

27 Csontos, The IRS and the Trustee: Tax Return Filing Issues (mimeographed) (Sept. 28, 1988), at 3.

28 I.R.C. § 1398(g).

29 S. Rep. No. 1035, 96th Cong., 2d Sess. 26 (1980).

30Langdon M. Cooper, et al. v. United States, No. 3:97CV502-V (W.D. N.C. May 17, 2000).

31Id.

32 67 FF 78358, TD 9030 (Dec. 24, 2002).

33 N(35)000-162, LTRServ, Aug. 23, 1999, p. 6663.

34 See In re Antonelli, Jr., 92-2 USTC (CCH) 50,619, 140 B.R. 5 (Bankr. D. Md. 1992); In Di Stasio v. United States, 90-2 USTC (CCH) 50,577 (Cl. Ct. 1990); In re Rueter, 158 B.R. 163 (N.D. Cal. 1993).

35 59 T.C.M. (CCH) 93 (1990).

36Luciano Popa, 218 B.R. 420, 81 A.F.T.R.2d (RIA) 1282 (Bankr. N.D. Ill. 1998), aff’d Popa v. Peterson, 238 B.R. 395 (N.D. Ill. 1999); In re Godwin, 230 B.R. 341 (Bankr. S.D. Ohio 1999); In re Kerr, 1999 U.S. Dist. LEXIS 2310, 99-1 USTC Par. 50,310, 83 A.F.T.R.2d (RIA) 1490 (W.D. Wash 1999); In re Williams, 235 B.R. 795 (Bankr. D. Md. 1999); In re Bradley, 222 B.R. 313 (Bankr. M.D. Tenn. 1998), aff’d 245 B.R. 533 (M.D. Tenn., 1999); In re Sevy, 1999 U.S. Dist. LEXIS 3087 (W.D. Wash. 1999); In re Slye, 1999; Bankr. LEXIS 937 (Bankr. D. Md. 1999). It appears that only one case has held otherwise: In re Winch, 226 B.R. 591 (Bankr. S.D. Ohio 1998).

37 N(35)000-162, LTRServ, Aug. 23, 1999, p. 6663.

38 Exempt property may be removed from the estate on petition by the spouse.

39Weiner v. United States, 88-2 USTC (CCH) 9466, 15 Cl. Ct. 43 (1988).

40 I.R.C. § 441(e).

41 P.L.R. 9522046 (Mar. 7, 1995).

42In re Feiler, 218 F. 3d 948 (9th Cir. 2000).

43 402 B.R. 56 (Bankr. S.D. Florida 2008).

44See In re Feiler, 218 F.3d at 955–56; In re Russell, 927 F.2d 413, 416–17 (8th Cir. 1991).

45 383 U.S. 375 (1966).

46 981 F.2d 277 (7th Cir. 1992).

47Id.

48In re Prudential Lines, 928 F.2d 565 (2d Cir. 1991); see In re Russell, 927 F.2nd 413 (8th Cir. 1991).

49See also In re Phar-Mor, Inc., 152 B.R. 924 (Bankr. N.D. Ohio 1993) (carryforward held property of estate and protected by both automatic stay and injunction against sale of stock causing reduction of NOL); In re Beery, 116 Bankr. 808, 810 (D. Kan. 1990).

50In re Madden, 1996 Bankr. LEXIS 439, 96-1 USTC (CCH) 50,263 (Bankr. D.NJ. 1996).

51 11 U.S.C. § 346(i)(3).

52 I.R.C. § 1398(e)(1).

53 11 U.S.C. § 1115(a)(2).

54 400 U.S. 18 (1970).

55 P.L.R. 9304008 (Jan. 29, 1993).

56 303 U.S. 493 (1938).

57 H. R. Rep. No. 1337, 83d Cong., 2d Sess. A225-226 (1954).

58 Federal Taxation of Partnerships and Partners, 11.03 (1990).

59 T.C. Memo 1995-406, 70 T.C.M. (CCH) 483 (1995).

60 P.L.R. 8728056 (Apr. 15, 1987).

61Infra note 75.

62See comments of Kenneth N. Klee, A Conference on the Bankruptcy Tax Act of 1980, 39 Inst. on Fed. Tax’n (NYU), § 57.09[8] (1981).

63 S. Rep., supra note 29, at 31.

64 11 U.S.C. § 503(b)(4).

65Scofield v. Commissioner, T.C. Memo 1997-547, 74 T.C.M. (CCH) 1536.

66 54 T.C.M. (CCH) 122 (1987).

67 S. Rep., supra note 29, at 29.

68 ILM 200630016, 2006 TNT 157-20 (June 30, 2006).

69 252 B.R. 110 (Bankr. E.D. Tex 2000).

70 S. Rep., supra note 29, at 30.

71 182 B.R. 612 (Bankr. S.D. Fla. 1995).

72 804 F.2d 84 (7th Cir. 1986).

73 89 T.C. 287 (1987).

74Supra note 72.

75 11 U.S.C. §§ 1222 and 1228.

76 27 B.R. 156 (W.D. Mo. 1982).

77 182 B.R. 612 (Bankr. S.D. Fla. 1995).

78 The court cited In re Maropa Marine Sales, 92 B.R. 547 (Bankr. S.D. Fla. 1988); In re Hutchinson, 132 B.R. 827 (Bankr. M.D.N.C. 1991), aff’d in part F.3d 750 (4th Cir. 1993); and In re Reich, 54 B.R. 995 (Bankr. E.D. Mich. 1985).

79Martin v. United States, 97-2 U.S. Tax Cas. (CCH) 50,731, 80 A.F.T.R.2d (RIA) 6363 (E.D. La. 1997).

80 370 U.S. 65 (1962).

81Martin v. United States, No. 97-31277 (5th Cir., Nov. 12, 1998).

82 11 U.S.C. § 346(f).

83 474 U.S. 494 (1986).

84 Madoff, A Reappraisal of the Tax Consequences of Abandonments in Bankruptcy, 50 Tax Notes 785, 788. Madoff cited these cases: In re Lindberg, 735 F.2d 1087, 1090 (8th Cir.) (“one of the main goals of the Bankruptcy Code [is] to provide honest debtors with a fresh start”), cert. denied, 469 U.S. 1073 (1984); In the Matter of Snider, 102 B.R. 978, 989 (Bankr. S.D. Ohio 1989) (“the importance of the debtor’s discharge is central to an individual’s bankruptcy”); In re Weatherspoon, 101 B.R. 533, 541 (Bankr. N.D. Ill. 1989) (citing Lines v. Frederick, supra note 54); In re Montoya, 95 B.R. 511, 513 (Bankr. S.D. Ohio 1988) (“discharge . . . to be broadly construed to preserve the debtors’ fresh start”); In re Brzezinski, 65 B.R. 336, 339 (Bankr. W.D. Wis. 1985) (“The essence of the Bankruptcy Code is to provide debtors with a fresh start”). 50 Tax Notes at 791.

85 133 B.R. 264 (Bankr. D.C. Mass. 1991), aff’d 50 F.3d 1 (1st Cir. 1995).

86 292 U.S. 234, 244–245 (1934).

87 Fed. Reg. S3300 (Nov. 9, 1992).

88 382 U.S. 375, 379–380 (1966).

89Supra note 85, at 269–270.

90 737 F.2d 479 (5th Cir. 1984), cert. denied, 469 U.S. 1189 (1985).

91Supra note 85 at 270.

92Id.

93Id. at 270–271.

94 324 U.S. 331 (1945).

95Id. at 334.

96Supra note 85, at 271.

97 354 F.2d 974 (1st Cir. 1965).

98 56 T.C. 600 (1971).

99Supra note 85, at 272.

100Id.

101Id.

102See Rev. Rul. 78-134, 1978-1 C.B. 197.

103 Carryover of passive activity losses and credits and at-risk losses to bankruptcy estates of individuals.

104Supra note 85.

105 1989 U.S. Dist. LEXIS 17345 (D.C. Minn. 1989).

106 P.L.R. 9245023 (Aug. 7, 1992).

107 P.L.R. 8918016, (Jan. 31, 1989).

108 95 B.R. 104 (Bankr. S.D. Iowa 1988).

109Id.

110Id. at 107.

111 100 B.R. 458 (Bankr. N.D. Iowa 1989), aff’d, 121 B.R. 346( N.D. Iowa 1990).

112 121 B.R. 346 (Bankr. N.D. 1990), aff’d, 930 F.2d 6 (8th Cir. 1991).

113Supra note 90, at 483–484.

114Supra note 84, at 790.

115Id. at 790–791.

116Id. at 791.

117Supra note 85.

118Supra note 105.

119Supra note 94.

120Lane, supra note 85, at 272–273.

121Id. at 223.

122 No. BK85-2889 (Bankr. D. Nebr. Nov. 25, 1991).

123Supra note 105.

124 94 B.R. 886, 888–889 (Bankr. E.D. Va. 1989).

125 645 F.2d 794, 748 (8th Cir. 1981).

126 135 B.R. 652 (Bankr. D. Hawaii 1991).

127See, e.g., In re Groves, 120 B.R. 956 (Bankr. N.D. Ill. 1990); and as noted in In re Wilson, 94 B.R. 886, 889 (Bankr. E.D. Va. 1989).

128 68 T.C. 163 (1977), aff’d, 646 F.2d 1309 (9th Cir. 1980).

129Johnston v. Webster, 49 F.3d 538 (9th Cir. 1995).

130 166 B.R. 697 (Bankr. D. Neb. 1993).

131 H.R. Rep. No. 595, 95th Cong., 1st Sess. 377 (1977); S. Rep. No. 989, 95th Cong., 2d Sess. 92 (1978).

132Black’s Law Dictionary 1049 (5th ed. 1979).

133In re Perry, 29 B.R. 787, 793 (D. Md. 1983), aff’d 729 F.2d 982 (4th Cir. 1984); In re Cruseturner, 8 B.R. 581, 591 (Bankr. D. Utah 1981).

134Brown v. O’Keefe, 300 U.S. 598 (1937); Wallace v. Lawrence Warehouse Co., 338 F.2d 392, 394 n.l (9th Cir. 1964).

135 133 B.R. 264, 269 (Bankr. D. Mass. 1991), aff’d 50 F.3d 1 (1st Cir. 1995).

136 155 B.R. 512, 515 (Bankr. E.D. Mo. 1993), aff’d 1994 U.S. App LEXIS 20711 (4th Cir. 1994).

137 154 B.R. 456 (E.D. Va. 1993), aff’d, 30 F.3d 131 (4th Cir. 1994).

138 79 B.R. 413 (Bankr. S.D. Iowa 1987).

139 89-2 USTC (CCH) 9597.

140 916 F.2d 431 (8th Cir. 1990).

141Id.

142In re Penman, 188 B.R. 704 (Bankr. S.D. Fla. 1995).

143 I.R.C. § 1398(d)(2)(A).

144 11 U.S.C § 523(a)(1).

145 98 B.R. 742 (Bankr. E.D. Va. 1989).

146 ILM 199910005; LTRServ, Mar. 22, 1999, p. 2103.

147 93 B.R. 523 (Bankr. S.D. Tex. 1988).

148 111 B.R. 311 (Bankr. D. Haw. 1990).

149Kahle v. Commissioner, T.C. Memo. 1997-91; 73 T.C.M. (CCH) 2080.

150Gary v. Skiba v. Cecil Keith Knee, 2006 TNT 203-6 (No. 05-13485) (Bankr. WD Penn., 2006).

151 Berenson and Honecker, The Bankruptcy Tax Act of 1980 (Part III), 12 Tax Adviser 277, 279 (1981).

152 382 U.S. 375 (1966). See also In re C. A. Searlies, 445 F. Supp. 749 (D.C. Conn. 1978).

153In re James, 337 F. Supp. 620 (D.C. Minn. 1971); In re Griffin, 1 B.R. 653 (Bankr. M.D. Tenn. 1979); In re DeVoe, 5 B.R. 618 (Bankr. S.D. Ohio 1980).

154 ILM 199941002; 1999 TNT 200-52; LTRServ, Oct. 25, 1999, p. 7727.

155Cooper v. United States, 2005 TNT 32-11, No. 3:97CV502 (W.D. N.C. 2005).

156 946 F.2d 1516 (10th Cir. 1991).

157 417 U.S. 642 (1974).

158Id. at 647 (quoting Segal v. Rochelle).

159 124 B.R. 606 (Bankr. M.D. Fla. 1991).

160Id.

161Nichols v. Birdsell, 491 F.3d 987, 988 (9th Cir. 2007).

162 No. 85-40456-7, 1990 WL 63072 (Bankr. D. Kan. Apr. 3, 1990).

163 381 B.R. 774 (Bankr. D. Kan. 2008).

164Id. at 778–79.

165 1990 Bankr. LEXIS 778: 90-1 USTC (CCH) 50,229 (Bankr. D. Kan. 1990).

166In re Lavelle, 1991 Bankr. LEXIS 604 (Bankr. N.D. Cal. Apr. 17, 1991).

167 130 B.R. 748 (Bankr. N.D. Texas 1992).

168 382 U.S. 375 (1966).

169 132 B.R. 186 (Bankr. D. Col. 1991).

170 I.R.C. § 1398(i).

171 Klee, supra note 62, at § 57.09[5].

172Benton v. Commissioner, 122 T.C. 353; 122 T.C. No. 20 (2004) (the Tax Court decision contains a detailed analysis of an appropriate date to use for purpose of terminating the bankruptcy).

173Benton v. Commissioner, T.C. Memo. 2006-198 (No. 7602-02) (United States Tax Court).

174 The court referenced the following cases: Rictor v. Commissioner, 26 T.C. 913, 914-915 (1956) (denying the use of an NOL carryback deduction to reduce an addition to tax for failure to file and addition to tax for substantial underestimation of estimated tax); Auerbach Shoe Co. v. Commissioner, 21 T.C. 191, 196 (1953) (denying the use of an NOL carryback deduction to reduce an addition to tax for fraud), aff’d. 216 F.2d 693 (1st Cir. 1954); C.V.L. Corp. v. Commissioner, 17 T.C. 812, 816 (1951) (denying the use of an NOL carryback deduction to reduce a delinquency penalty); Pusser v. Commissioner, a Memorandum Opinion of this Court dated December 7, 1951 (denying the use of an NOL carryback deduction to reduce a negligence penalty).

175In re Linsenmeyer, 2003 TNT 226-49 (6th Cir. 2003).

176Lassiter and Estate of Lassiter v. Commissioner, T.C. Memo 2002-25; 2002 Tax Ct. Memo LEXIS 26; 83 T.C.M. (CCH) 1139; T.C.M. (RIA) 54629.

177 P.L.R. 8932002 (Apr. 19, 1989).

178See In re Petruccelli, 113 B.R. 5, 6 (Bankr. S.D. Cal. 1990); In re Harvey, 88 B.R. 860, 862 (Bankr. N.D. Ill. 1988); In re York, 13 B.R. 757, 758 (Bankr. D. Me. 1981).

179 96 T.C. 895 (1991).

180In re Petruccelli, 113 B.R. 5, 6 (Bankr. S.D. Cal. 1990).

181Smith v. Commissioner, 96 T.C. 10, 14; Neilson v. Commissioner, 94 T.C. 1, 8 (1991).

182 98 B.R. 742, 745 (Bankr. E.D. Va. 1989).

183 96 T.C. 895 (1991).

184See 11 U.S.C. § 1305(a)(1), (b); In re Hester, 63 B.R. 607, 609 (Bankr. E.D. Tenn. 1986).