Individual bankruptcy - state and local income tax treatment can greatly differ from federal.
The Internal Revenue Code The Internal Revenue Code is the body of law that codifies all federal tax laws, including income, estate, gift, excise, alcohol, tobacco, and employment taxes. These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq. (Code) and the Bankruptcy Code Bankruptcy Code may refer to:
1. unary + and - signs
3. multiplication and division
4. . However, for determining the state and local tax treatment of bankrupt debtors, the BC takes precedence. Therefore, the state/local tax treatment of a bankrupt debtor can vary significantly from the Federal income tax treatment.
The Bankruptcy Reform Act of 1978 made substantial changes to the BC. As originally drafted, it contained many tax provisions relating to relating to relate prep → concernant
relating to relate prep → bezüglich +gen, mit Bezug auf +acc the treatment of can-cellation-of-debt (COD) income, tax-attribute carryovers, the commencement and termination of bankruptcy estates and the responsibility for filing income tax returns. However, during the legislative process, language was inserted to give the Code precedence over the BC with respect to Federal income taxes. Hence, bankrupt taxpayers find themselves with one set of rules for Federal tax purposes (contained in the Code) and another set of rules for state/local tax purposes (contained in the BC).
Several of the most important differences between the Code and BC for individual bankruptcy are summarized in the comparison chart on pages 680-682. It should not be used, however, as a substitute for a thorough reading of the Code, BC and applicable state/local tax laws.
Comparison of Federal With State/Local Individual Bankruptcy Tax Rules
Reduction of tax attributes
To the extent COD income is excluded under Sec. 108(a)(1)(A), (B) or (C) in a tax year beginning before Jan. 1, 1994, five tax attributes are reduced in the following order:
* Net operating losses Net operating losses
Losses that a firm can take advantage of to reduce taxes. (NOLs) (including any NOL NOL - Never Offline for the year of discharge and any NOL carryover carryover n. in taxation accounting, using a tax year's deductions, business losses or credits to apply to the following year's tax return to reduce the tax liability. (See: carryback) to such year).
* General business credits.
* Capital loss carryovers.
* Foreign tax credit carryovers.
For tax years beginning after Dec. 31, 1993, the Revenue Reconciliation Act of 1993 added minimum tax credit carryovers and passive activity loss and credit carryovers to the attributes subject to reduction. Attribute reduction takes place after computing tax for the year of discharge (i.e., on the first day following the end of the year that includes the date of discharge). If basis is reduced, the regulations under Sec. 1017 indicate the order in which the reduction is applied against 'different types of assets. Debtors may elect to reduce basis in depreciable depreciable
Of, relating to, or being a long-term tangible asset that is subject to depreciation. property before reducing the other attributes (Sec. 108(b)).
BC/state & local
Reduce only two attributes, in the following order:
* NOLs (including current NOLs and any NOL carryforward).
(BC Section 346(j)(3) and (5).)
Unlike the Code, however, the BC does not indicate the time at which attribute reduction occurs. Presumably pre·sum·a·ble
That can be presumed or taken for granted; reasonable as a supposition: presumable causes of the disaster. , the reductions should be made on the date of discharge and, for NOLs, could be based on either a closing of the books or a daily proration Proration
A situation during a corporate action in which the available cash or shares are not sufficient to satisfy the offers tendered by shareholders. Therefore, a proportion of both cash and shares is granted for each offer tendered. .
For reducing NOLs, debtors should consider using the method (i.e., closing of the books or proration) that provides for the smallest reduction, until further guidance is issued.
Debtors may not elect to first reduce basis in depreciable property; ordering rules Ordering Rules
The order in which Roth IRA assets are distributed. Assets are distributed from a Roth IRA in the following order:
1. IRA participant contributions
2. Taxable conversions
3. Non-taxable conversions
4. for reducing basis of different types of assets do not exist. Debtors may elect to recognize COD income rather than reduce basis (BC Section 346(j)(6)). With respect to applying the basis reduction to different types of assets, absent any guidance to the contrary, debtors should consider following the ordering rules prescribed in the regulations under Sec. 1017. Another alternative might be to reduce all property proportionally.
Reducing NOLs or basis is not required to the extent the discharged debt consisted of "items of a deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). nature" not deducted de·duct
v. de·duct·ed, de·duct·ing, de·ducts
1. To take away (a quantity) from another; subtract.
2. To derive by deduction; deduce.
v.intr. by the debtor (similar to Sec. 108(e)(2)). Attribute reduction is not required if the discharged debt resulted in an expired NOL carryover or other deduction that did not offset income for any tax period and did not contribute to a current NOL or NOL carryforward (BC Section 346(j)(4)).
Creation of bankruptcy estate
When an individual files bankruptcy under either Chapter 7 or 11, a separate taxable entity--the bankruptcy estate--is created and taxed as a married person filing a separate return. The commencement of a bankruptcy estate does not terminate the individual debtor's tax year unless the debtor elects to do so. If a "short-year" election is made, the first tax year ends on the day before the bankruptcy petition is filed. The short-year election is not available if the bankruptcy estate has no assets (Sec. 1398(d)).
BC/state & local
A separate bankruptcy estate is created under Chapter 7, 11 or 12. The bankruptcy estate is taxed as an estate, not as a married person filing a separate return (BC Section 346(b)(1)). In addition, the BC requires a split tax year for the debtor, in which the first tax year ends on the day the petition is filed (BC Sections 728(a), 1146(a) and 1231(a)).
Transfer of property and tax attributes to bankruptcy estate
The transfer of property, other than by sale or exchange, from the individual debtor to the estate is not treated as a disposition for any provision of the Code (e.g., gain or loss, recapture of depreciation recapture of depreciation
The extent to which the price received from selling a depreciated asset represents recovery of depreciation taken in prior years. , recapture recapture n. in income tax, the requirement that the taxpayer pay the amount of tax savings from past years due to accelerated depreciation or deferred capital gains upon sale of property. (See: income tax)
RECAPTURE, war. of investment tax credits, etc.) (Sec. 1398(f)(l)). Tax attributes specifically enumerated This term is often used in law as equivalent to mentioned specifically, designated, or expressly named or granted; as in speaking of enumerated governmental powers, items of property, or articles in a tariff schedule. in Sec. 1398(g) and the regulations thereunder are also transferred from the debtor to the estate.
BC/state & local
Neither gain nor loss is recognized on the transfer of property to the estate (BC Section 346(g)(l)(A)). However, the recapture of investment tax credits and the recognition or acceleration of income (e.g., from installment sales Installment sale
The sale of an asset in exchange for a specified series of payments (the installments).
A sale in which the buyer is scheduled to make a series of payments over a period of time. , etc.) are not discussed. Consequently, the transfer of property from the debtor to the estate could trigger income or the recapture of credits for state/local purposes.
All tax attributes of the debtor are transferred to the bankruptcy estate (BC Section 346(i)(l)). Therefore, depending on the date on which the bankruptcy petition is filed, whether the debtor elects a short year for Federal purposes and the type and amount of tax attributes, the bankruptcy estate may have tax attributes for Federal purposes significantly different from the tax attributes for state/local purposes.
Transfer of property and tax attributes to debtor
A transfer of assets The conveyance of something of value from one person, place, or situation to another.
The law recognizes that persons are generally entitled to transfer their assets to whomever they wish and for whatever reason. The most common means of transfer are wills, trusts, and gifts. , other than by sale or exchange, from the estate to the debtor is not a taxable disposition if done at the termination of the estate. Furthermore, Regs. Secs. 1.1398-1(d)(l) and -2(d)(l), finalized See finalization. on May 12, 1994, provide that a transfer of assets, other than by sale or exchange, before termination of the estate (i.e., the debtor identifies "exempt" property or property is abandoned by the estate to the debtor) is also not a taxable disposition. In addition, at termination the debtor succeeds to the estate's tax attributes to the extent the attributes are specifically enumerated in Sec. 1398(g) and the regulations thereunder.
BC/state & local
Neither gain nor loss is recognized on a transfer of property, other than by sale, from the estate to the debtor (BC Section 346 (g)(l)(B)).
All tax attributes of the estate are transferred to the debtor at the termination of the estate (BC Section 346(i)(2)). Any time limitations associated with such tax attributes are suspended during the bankruptcy proceeding (BC Section 346(h)).
BC/state & local
Filing requirements: If a bankruptcy estate does not have cumulative net taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. for the entire time the bankruptcy case is open (i.e., without regard to each separate tax year), the bankruptcy estate is not required to file a return for any year of its existence (BC Section 728(b)).
State/local transfer taxes: State/local taxing authorities may not impose any stamp or similar tax on the issuance, transfer or exchange of a security, or the making or delivery of an instrument of transfer under a Chapter 11 plan (BC Section 1146(c)).
tr.v. dis·al·lowed, dis·al·low·ing, dis·al·lows
1. To refuse to allow: "[The government] of deductions: An additional attribute-reduction provision disallows deductions with respect to a canceled liability in the year of discharge and any future year (BC Section 346(j)(2)). For example, if a liability is incurred to purchase a building and part of the liability is discharged, depreciation deductions are limited. This additional limitation appears to apply to the extent attribute reduction is prevented under the general rules previously discussed.
Out-of-court workouts: As the BC is a Federal statute and has priority over state/local laws, any state/local law that conflicts with the BC is not enforceable. However, the BC only covers bankrupt debtors. Therefore, the state/local consequences of out-of-court workouts are governed by the applicable state/local laws, many of which parallel Federal treatment.