Individual bankruptcy - state and local income tax treatment can greatly differ from federal.
The Bankruptcy Reform Act of 1978 made substantial changes to the BC. As originally drafted, it contained many tax provisions relating to 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 (NOLs) (including any NOL for the year of discharge and any NOL carryover 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 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, 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.
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 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 nature" not deducted 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 investment tax credits, etc.) (Sec. 1398(f)(l)). Tax attributes specifically enumerated 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, 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, 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 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 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)).
Disallowance 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.