Carryover of passive losses and other tax attributes to an individual bankruptcy estate.

When an individual bankruptcy, a separate taxable entity--the bankruptcy estate--is created. Both the Bankruptcy Code and the Internal Revenue Code provide for the bankruptcy estate to succeed to certain of the debtor's tax attributes. While the Bankruptcy Code provides a list of tax attributes that are to carry over, the statute states that the list is not exhaustive; see Bankruptcy Code Section 346(i)(1). However, an Internal Revenue Code provision takes precedence over the tax provisions of the Bankruptcy Code. A bankruptcy estate must look to Sec. 1398(g) to determine which attributes pass from the debtor. Sec. 1398(g) allows for the carryover of seven specific attributes and any other attributes to the extent provided in regulations. The question arises as to whether an individual debtor's unused passive activity losses and credits, suspended at-risk losses and other tax attributes not specifically listed in Sec. 1398(g) pass in bankruptcy to the bankruptcy estate or remain with the debtor.

On Nov. 6, 1992, the U.S. Bankruptcy Court (Md.) held, in The Official Committee of Unsecured Creditors of D.F. Antonelli Jr., that a bankruptcy estate did not succeed to an individual debtor's passive activity losses and credits, because there were no regulations under Sec. 1398 specifically providing that such losses and credits pass from the individual debtor to the bankruptcy estate.

On the same date as the Antonelli decision, the Service issued Prop. Regs. Sec. 1.1398-1(c), providing that a bankruptcy estate does succeed to the unused passive activity losses and credits of an individual debtor in a Chapter 7 or Chapter 1 1 case; the proposed rules also offer parallel treatment for losses suspended under the at-risk rules. Note that the proposed regulations deal only with suspended at-risk losses and passive activity losses and credits. Following the Antonelli court's reasoning, other tax attributes not specifically listed under Sec. 1398(g) (e.g., investment interest carryovers, percentage depletion carryovers, losses suspended under Secs. 704(d) and 1366(d)) should remain with the debtor.

The proposed regulations and the Antonelli case may create refund opportunities for individual debtors. Furthermore, to the extent bankruptcy estates can benefit from a debtor's unused passive activity losses and credits and suspended at-risk losses, the proposed regulations may provide an opportunity to reduce estate tax liabilities.

Antonelli

The unsecured creditors of a bankruptcy estate asked the Bankruptcy Court to rule that a debtor's prepetition passive activity losses and credits were tax attributes of the bankruptcy estate. The creditors relied heavily on In re Prudential Lines, Inc., 928 F2d 565 (2d Cir. 1991), cert. denied, in which the court concluded that a subsidiary's net operating loss (NOL) carryforward was the property of the corporate debtor's estate. However, the Bankruptcy Court, noting that Sec. 1398(g) applies only to individual debtors, concluded that Prudential did not apply. Although admitting that Congress intended a broad range of property (including tax attributes) to be transferred to a bankruptcy estate, the court decided Sec. 1398(g) should be strictly construed. It stated that Sec. 1398(g) is unambiguous and that only tax regulations may add to the specific list of tax attributes that carry from the individual debtor to the bankruptcy estate. (See also DiStasio, 22 Cl. Ct. 36 (1990).)

Proposed regulations

Prop. Regs. Secs. 1.1398-1 and -2 provide that a bankruptcy estate succeeds to the unused passive activity losses and credits and the suspended at-risk losses (Sec. 465) of an individual debtor in Chapter 7 or Chapter 1 1 bankruptcy cases. The unused or suspended losses and credits to which the estate succeeds would be determined as of the first day of the debtor's tax year in which the bankruptcy case commences.

To the extent the bankruptcy estate transfers property to the debtor other than by sale or exchange (e.g., the debtor identifies "exempt" property or property is abandoned by the estate to the debtor), the transfer is not treated as a disposition. Under the proposed regulations, the debtor would succeed to the estate's unused or suspended passive activity losses and credits and at-risk losses allocable to the transferred activity or property. This is different than the treatment of NOLs. The preamble to the proposed regulations points out that NOLs remain with the estate even if the loss-producing assets are transferred from the estate to the debtor before the estate's termination. The preamble indicates this treatment is to continue for NOLs.

On termination of the bankruptcy estate, the debtor succeeds to the estate's unused passive activity losses, unused passive activity credits and suspended at-risk losses.

Effective dates: The regulations are proposed to be effective for bankruptcy cases commencing on or after Nov. 9, 1992. For cases commenced before and terminating on or after Nov. 9, 1992, the proposed regulations apply only if a joint election is made by the debtor and the estate. In Chapter 7 bankruptcy cases, the election is valid only with the written consent of the bankruptcy trustee. In Chapter 11 cases, the election is valid only if incorporated into a bankruptcy plan that is confirmed by, or incorporated into an order of, the Bankruptcy Court.

Making the pre-Nov. 9 election: For cases commenced before and ending on or after Nov. 9, 1992, the individual debtor and bankruptcy estate must do the following to make a valid joint election to apply the proposed regulations:

* The debtor and bankruptcy estate must place "ELECTION PURSUANT TO [Sections]1.1398-1" for passive activity losses and credits and/or "ELECTION PURSUANT TO [Sections]1.1398-2" for suspended at-risk losses prominently on the first page of each tax return affected.

* The debtor and estate must amend all "open" tax returns filed before the date of the election, to the extent necessary to provide that no claim of a deduction or credit is inconsistent with the succession for unused credits and losses provided under the proposed regulations. It appears that all open return must be amended, regardless of whether there is any actual change in taxable income or tax.

* To the extent the election applies to a case that commenced in a "closed" year, the estate succeeds to the debtor's unused or suspended passive activity losses and credits and at-risk losses as of the first day of the debtor's tax year in which the case commenced. However, these attributes are reduced by any amounts allowed to the debtor in a closed year.

* For Chapter 7 cases, a copy of the bankruptcy trustee's written consent must be filed with the debtor's and estate's tax returns for their first tax years ending after Nov. 9, 1992. For Chapter 11 cases, a copy of the confirmed bankruptcy plan or court order must be filed with the debtor's and estate's tax returns for their first tax years ending after Nov. 9, 1992. Note that, once made, the election is binding on both the debtor and the estate, and is irrevocable.

Other considerations

Other tax attributes: The tax attributes specifically enumerated in Sec. 1398(g) and the corresponding regulations do not include such attributes as investment interest expense carryovers, percentage depletion carryovers, partnership losses suspended under Sec. 704(d) or S corporation losses suspended under Sec. 1366(d). Following Antonelli, any tax attributes not specifically listed in the Code or regulations should not be transferred from the individual debtor to the bankruptcy estate.

State and local tax consequences: A special provision in the Bankruptcy Code governs the state and local tax consequences of a noncorporate bankruptcy filing. This provision generally parallels the applicable provisions in the Internal Revenue Code. However, there are several important differences. The Bankruptcy Code provides that the bankruptcy estate succeeds to all of a debtor's tax attributes. Therefore, for cases commencing before Nov. 9, 1992, for which the joint election is not made, it is possible for a bankruptcy estate to succeed to the debtor's unused passive activity losses and credits and suspended at-risk losses for state and local tax purposes, but not for Federal income tax purposes. Likewise, the same situation can occur for items such as investment interest expense carryovers, percentage depletion carryovers and losses suspended under Sec. 704(d) or 1366(d).

Update on Lane case: The preamble to the proposed regulations notes that treating the transfer of an asset (other than by sale or exchange) from the estate to the debtor before the termination of the estate as a nontaxable disposition is consistent with case law, citing Samore v. Olson, 930 F2d 6 (8th Cir. 1991). However, this statement ignores A. J. Lane & Co., 133 Bkrptcy. Rptr. 264 (Bkrptcy, DC Mass., 1991), in which the Bankruptcy Court held that abandonment was a taxable event.