Good advice (Bankruptcy Abuse Prevention & Consumer Protection Act of 2005): what you need to know about the Bankruptcy Act of 2005.

The recent passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 is the culmination of more than a decade of bankruptcy reform debate in Congress. For CPAs, the act means they may find that their financially challenged clients will have an increasing need for timely tax advisory and preparation services.

Further, tax return information now can have a greater impact on future payments that are required by a debtor who files for bankruptcy protection, as it will be used to evaluate future income and expenses.

While much of the discussion on the new act has centered on the more stringent requirements on individuals to qualify for relief, the legislation impacts a wide range of bankruptcy provisions beyond the consumer and individual tax issues discussed here.

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A summary of changes under the act can be viewed at http://thomas.loc.gov/cgi-bin/bdquery/z?d109:SN00256:@@@L&summ2=m&.

CHAPTERS 7,11,12 AND 13

The Bankruptcy Code, Title 11 of the United States Code, contains alternative paths for individual bankruptcy proceedings.

Under the new act, far fewer debtors will qualify for Chapter 7 liquidations after Oct. 16, 2005, when the act takes effect. Many more individuals will have to avail themselves of the Chapter 13 repayment plan route and more high-income debtors with assets or debt exceeding the Chapter 13 limitations will be pushed toward the Chapter 11 plan of reorganization. Eligibility for filing under the Chapter 12 farmer and fisherman repayment plan provisions has been expanded.

The act also prohibits an individual debtor from filing a petition under federal bankruptcy law unless the individual has received a briefing from an approved nonprofit budget and credit counseling service.

INCREASED EMPHASIS ON TAX RETURNS

The act expands a debtor's duties to file the following documents with the bankruptcy court: federal tax returns; evidence of employer payments received; monthly net income projections; and anticipated income or expenditure increases.

The act requires dismissal of a Chapter 7 or Chapter 13 case upon a debtor's failure to provide to the bankruptcy trustee--within seven days before the initial date of the first meeting of creditors--a tax return for the latest taxable period prior to filing, unless the debtor demonstrates that the failure is due to circumstances beyond the debtor's control.

This increased emphasis on tax returns means CPAs need to be extra vigilant in meeting deadlines and providing timely returns to their debtor clients.

At the request of the court or any interested party, the debtor shall file with the court, when filed with the taxing authority, a copy of each federal income tax return or, at the election of the debtor, a transcript of such tax returns for each tax year ending while the case is pending. This also holds for each year that had not been filed as of the date of the commencement of the case and was subsequently filed for any tax year ending in the three-year period ending on the date of the commencement of the case; and for amendment to any federal income tax return.

Failure to provide such information may lead to dismissal of the case.

The information contained in the pre-petition return may impact the amount of repayment required under a plan and may impact whether the plan's duration is three or five years.

The act conditions court confirmation of a Chapter 13 bankruptcy plan when the debtor files all pre-petition tax returns, as well as--before the day the first meeting of the creditors is convened--all tax returns for taxable periods ending in the four-year period that ends on the date of the filing of the petition.

If a debtor fails to meet these deadlines, the act directs the court to dismiss the Chapter 13 plan or convert it to Chapter 7, whichever is in the best interests of the creditors and the estate.

For Chapter 11 post-petition disclosure and solicitation purposes, the debtor must discuss the potential material federal and state tax consequences of the plan to the debtor and to a hypothetical investor that is representative of the holders of claims or interests in the case.

The act permits a taxing authority to petition the court to convert or dismiss a case, whichever is in the best interests of creditors and the estate, if the debtor fails to timely file a tax return or obtain an extension.

The act also prohibits a court from granting a discharge in a Chapter 7 case, or from confirming a reorganization plan in a Chapter 11 or Chapter 13 case, unless requested tax documents have been provided to the court.

NON-DISCHARGEABLE CLAIMS

Title VII of the act contains numerous bankruptcy tax provisions that impact the administration, priority and dischargeability of tax claims.

A significant benefit of filing for bankruptcy is the ability to discharge some or all of the debtor's debts or claims. A debtor remains liable for non-dischargeable claims even after the successful fulfillment and closing of a bankruptcy case.

Income tax claims generally are dischargeable if the return was timely filed and the due date was more than three years before the petition date. This period is extended when an offer-in-compromise, installment agreement or stay from a prior bankruptcy filing is pending.

Prior to the act, installment agreements did not extend the three-year period.

The act also increased the number of exceptions to dischargeable listed under Bankruptcy Code Sec. 523, and now includes exceptions for cash advances of more than $750 obtained within 70 days of filing; debt arising from personal injury or death from operation of a vessel or aircraft while under the influence; debt incurred to pay non-federal non-dischargeable taxes; and certain loans from retirement plans.

BANKRUPTCY PETITIONS AND AUTOMATIC STAYS

The act denies an automatic stay, unless specified conditions are met, to the setoff of an income tax refund for a taxable period that ended before the order for relief against an income tax liability for a taxable period that also ended before the order for relief.

The filing of a bankruptcy petition generally creates an automatic stay, which stops the collection efforts of creditors. Collection efforts include collection calls to the debtor and the recording of a lien or filing of a lawsuit against the debtor. A violation of the stay can lead to a damage award against the creditor by the bankruptcy court.

IRC SEC. 1398 UNCHANGED

The income tax situation of an individual debtor after filing for Chapter 7 or Chapter 11 is driven in large part by Internal Revenue Code Sec. 1398, which was not amended by the recent law. However, CPAs working with a client who owns non-exempt property and is considering a Chapter 7 or Chapter 11 bankruptcy filing should have a thorough understanding of the regulations outlined in IRC Sec. 1398.

Upon the filing of a petition, a separate taxable estate is created. This estate is comprised of all the debtor's non-exempt assets and claims as they exist on the petition date. Further, most of the debtor's tax attributes are transferred to the estate, including net operating loss carryovers; capital losses carryovers; passive loss carryovers; and tax basis and character of assets.

As a result of Sec. 1398 provisions, if a debtor files a Chapter 7 bankruptcy and an appointed trustee sells the debtor's rental property, that property sale is not reported on the debtor's 1040. The trustee prepares a return for the estate reporting the disposition and pays income tax on gain after taking into account the attributes of the debtor as they existed as of the last day of the debtor's tax year that proceeded the petition date. Alternately, if the sale occurs during a Chapter 13 proceeding, the gain is included on the debtor's 1040.

Under Sec. 1398, the debtor may terminate its tax year as of the day preceding the petition date. If the debtor makes this short-year election, the trustee will succeed to the tax attributes as of the day prior to the petition date. Most commonly, this election is advantageous to the debtor if taxable income and a resulting tax balance due will arise on the petition year return if the election is not made.

For instance, if the debtor sold stock that generated a $100,000 gain in March 2005, and files a Chapter 7 petition in June 2005, and if the debtor had a $120,000 capital loss carryover from 2004, the election would allow the debtor to avoid incurring a post-petition 2005 year tax liability since the short-year election will cause the carryover to be applied against the gain.

If the election is not made, and the bankruptcy estate has assets to administer, causing it to remain open through 2006, the debtor will not be able to use the capital loss carryover on the 2005 full-year return and a greater capital loss would be available to the bankruptcy estate.

An election must be filed with the IRS by the fifteenth day of the fourth month following the petition date. Thus, it is critical for tax advisers to provide timely assessment of the election's impact. The debtor and not the tax preparer must sign the election. An extension form filing by a tax adviser containing the election will fail if not signed by the debtor.

STATE INCOME TAX PROVISIONS

The act eliminates many federal and state income tax reporting differences that can arise upon the filing of Chapter 7 or Chapter 11 cases. Under the old law, the debtor's tax year automatically terminated on the petition date for state income tax purposes whereas the debtor had to file an election to terminate the year for federal purposes.

Under the new act, most of the special tax provisions that relate to state income taxes have been replaced with provisions that cause the state tax reporting to follow federal provisions, including most of the IRC Sec. 1398 provisions. However, the state law provisions still apply if not over-ridden by the federal bankruptcy provisions.

For instance, in California, the net operating loss carryover limitations still apply and are not expanded by the IRC provisions. Thus, the two-year federal NOL carryback provision does not become available to the bankruptcy estate for California tax filing purposes.

CONCLUSION

The new act will make it more difficult for debtors to qualify for bankruptcy relief. Any relief obtained may be reduced as a result of the new limitations on the automatic stay and failure to maintain financial reporting compliance by debtors will lead to dismissal of their case, a loss of debt relief and termination of the automatic stay.

The key for CPAs is timely preparation of tax returns and financial reports for self-employed individuals that will be necessary to obtain and maintain the benefits of bankruptcy.

RELATED ARTICLE: What the Act Says

AMONG OTHER FEATURES, THE ACT:

* Increases the focus of "needs-based bankruptcy," directing the court to assume abuse of the Chapter 7 liquidation process if the debtor's monthly income--after reduction for certain living costs based upon IRS tables and required payment on priority debt, multiplied by 60--exceeds 25 percent of non-priority unsecured debt;

* Imposes a duty on creditors that hold consumer debt to engage in repayment plan negotiations or face up to a 20 percent claim reduction;

* Designates U.S. attorney and FBI agents to implement enforcement on fraud and abuse;

* Provides priority treatment for domestic support and exception to the automatic stay for domestic support obligations;

* Expands exemption (i.e. retention) of certain retirement plan funds;

* Restricts public access to information to reduce risk of identity theft;

* Limits relief for certain repeat bankruptcy filers;

* Increases the duration required to establish domicile from 180 days to 730 days, (sometimes used to gain the larger homestead exemptions available in certain states, including Florida and Texas) and further limits homestead exemptions if the debtor is guilty of certain crimes;

* Reduces the debtor's ability to defer eviction from residential property;

* Reduces the amount of luxury goods, electronic entertainment equipment, jewelry and other personal property that can be exempted;

* Expands non-dischargeable debts in Chapter 13 cases to include amounts incurred to pay certain taxes, and criminal or willful act restitution;

* Requires a debtor who served as administrator of an employee benefit plan to continue to perform the obligations incumbent upon such service; and

* Increases the priority wage claim limit from $4,850 to $10,000.

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BY JAY CROM, CPA 

Jay Crom, CPA is managing partner at San Francisco-based Bachecki, Crom & Co. LLP. You can reach him at [e-mail].