Tax issues for bankruptcy trustees.

A joint petition filed with the U.S. Bankruptcy Court by a husband and wife does not result in a single taxable estate for income tax purposes, according to Knobel, 167 B.R. 436 (1994). This case, decided by the U.S. Bankruptcy Court for Texas, was a case of first impression.

James and Leigh Knobel filed a joint petition under Chapter 7 of the U.S. Bankruptcy Code on Sept. 19, 1991. In so filing, they paid one filing fee, their case was assigned a single case number, one trustee was appointed, and the Service issued only one employer identification number. When it came time for filing the income tax returns, the trustee computed the tax liability using a standard deduction and one personal exemption for the bankruptcy estate of James Knobel and also a standard deduction and one personal exemption for the bankruptcy estate of Leigh Knobel. The trustee filed one Form 1041, U.S. Fiduciary Income Tax Return, and two Form 1040s to report the income of the estates and compute their tax liabilities. On examination, the IRS disallowed one of the exemptions and one of the standard deductions taken on the original returns filed. The Service's position was that there was only one taxable estate; therefore, only one standard deduction and one exemption were allowable. The IRS contended that, because a joint petition was filed with the Bankruptcy Court and one trustee was appointed to administer the case, the case was in substance handled as one estate (although an order to consolidate the estates was never entered by the court).

The trustee asserted that although the estates were jointly administered and a joint petition was filed with the court, Section 302 of the Bankruptcy Code indicates that a joint filing creates two estates that remain separate and distinct (taxable) entities until the estates are consolidated pursuant to court order.

The court agreed with the trustee, and allowed an exemption and standard deduction for each estate. It refuted the Service's argument that Bankruptcy Code Section 541(a)(2) and Sec. 1398 indicated that only one estate and one taxable entity are created on the filing of a joint petition to the bankruptcy court. The court also disagreed with the IRS's argument of substance over form; even though the estates were substantively handled as one, that did not override Bankruptcy Code Section 302.

This decision by the Bankruptcy Court could provide tax savings opportunities to some trustees. However, many bankrupt estates pay little, if any, income tax due to substantial tax attributes that carry over from the debtor, such as net operating losses, passive activity losses and credits, etc. For this reason, many trustees may continue (arguably with the Service's blessing) to file one income tax return for a bankrupt estate of a husband and wife who have filed under a joint petition. This would most likely ease administration of the estate by the trustee.

It has been just over a year since the IRS resolved the issue of the transfer of certain tax attribute carryovers from an individual debtor to his bankruptcy estate, namely passive activity losses and credits and at-risk losses (TD 8537, 5/12/94).

Regs. Sec. 1.1398-1 states that a bankruptcy estate succeeds to the passive activity losses and credits of the debtor only if the debtor is an individual filing under Chapter 7 or 11 of the Bankruptcy Code. The amount of any carryover is determined as of the beginning of the tax year in which the debtor files a petition with the Bankruptcy Court (unless the debtor makes an election under Sec. 1398(d) to cut off his tax year as of the day prior to filing his petition).

Regs. Sec. 1.1398-2 states that bankrupt estates that meet these requirements also succeed to any Sec. 465 (at-risk) losses of the debtor. This amount is determined in the same manner as the passive loss carryovers and credits previously discussed.

Both of these regulations are consistent with existing rules that state that the transfer of an activity between the debtor and his estate is not a taxable event. These regulations are effective for bankruptcy estates commencing on or after Nov. 9, 1992. However, there is an elective provision in the regulations that would allow a trustee to apply these rules to cases begun before that date.

To claim these benefits for preenactment cases (presumably on an amended return), written consent of the bankruptcy trustee must be obtained and attached to the return for the year in question. Also, the caption "ELECTION PURSUANT TO [sections]1.1398-1" (or Regs. Sec. 1.1398-2, if applicable) must be shown on the first page of such return. To ensure that all of the carryovers will be allowed, all open tax years must be amended. A trustee is barred from amending prior year returns if they have already received a prompt assessment from the District Director; the tax year would be considered closed (as defined in Regs. Sec. 1.1398-1(f)(2)(iv)(D)). However, if there are passive activity losses, credits or at-risk losses that were not claimed in a closed year, these can be used in full on returns filed for subsequent open years; the carryovers are not decreased by the amount that would have otherwise been allowed had they been applied consistent with the present rules.

The issuance of these regulations (arguably prompted by the Service's wish not to litigate this matter anymore; see Antonelli, U.S. Bankr. Ct., Md., 1992) clears up many issues on the use of passive activity losses, credits and atrisk losses incurred by the debtor prior to filing with the Bankruptcy Court.

From Donald G. Morrison, CPA, South Bend, Ind.