Tax Collection and Bankruptcy Tax

Staying IRS Enforced Collection Action Through Bankruptcy

An advantage of filing for bankruptcy is that it can stop certain collection actions by the IRS.  For example, suppose that a taxpayer has been under heavy fire from the IRS revenue officer for the past several years.  The IRS recently discovered a bank account that Max owns in Reno, Nevada, and served a Notice of Levy, levying $25,000 from the account.  Max plans to file a petition under Title 11 to prevent further collection action.  The IRS has indicated that it may audit the taxpayer’s Form 1040.  Which of the following actions will the filing of the petition operate as a stay?

• An audit to determine tax liability

• The issuance to the debtor of a notice of deficiency

• A demand for tax returns

• The making of an assessment for any tax and the issuance of a notice and demand for payment of such an assessment

• All of the above.

The answer is all of the above.  See 11 U.S.C. § 362(b)(9); 26 U.S.C. § 6503(h).

Reduction of Tax Attributes

A taxpayer does not always get to eat cake and keep it too. When discharge of indebtedness (other than real property business debt) is excluded from gross income, corresponding reductions must be made to the taxpayer’s tax attributes. See Checkpoint EXP ¶1084.02 Reduction of tax attributes; 26 U.S.C. § 108(b)(1).

1. Net operating loss

2. General business credit

3. Minimum tax credit

4. Capital loss carryover

5. Basis reduction (see below)

6. Passive activity loss and credit carryovers

7. Foreign tax credit carryovers

26 U.S.C. § 108(b)(2); Reg §1.108-7(a)(1).

There are ordering rules that come into play.  26 U.S.C. § 108(b)(4).

The debtor can elect to alter the sequence in which tax attributes are reduced, by first applying any portion of the excluded debt discharge income against the bases of depreciable assets. 26 U.S.C. § 108(b)(5)(A); See Checkpoint EXP ¶1084.02 Reduction of tax attributes 26 U.S.C. § 1017 provides additional rules regarding the reduction of basis of property held by the taxpayer.

Bankruptcy Estate

The taxation of the bankruptcy state is not always obvious, and below are the key highlights for debtors to keep in mind.  The IRS is well versed with these rules, and running afoul can lead to tax controversy issues, such as an audit.

Property of the Bankruptcy Estate

• All legal or equitable interests of the debtor in property as of the commencement of the case. 11 U.S.C. Sec. 541.

• Ask who is the debtor (single individual, married couple, or married individual).

• Ask what type of property (exempt property, community property, after-acquired property, abandoned property).

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Taxation of the Bankruptcy Estate

• Separate bankruptcy estate – chapter 7 and 11

• Success to assets, liabilities, and tax attributes

• Trustee files Form 1041

• No separate taxable entity for chapter 13

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Section 1398 Short-Period Election

• If an election is made under section 1398, the debtor’s tax year is divided into two short tax years:

• The first short tax year starts when the debtor’s tax year would have started had the election not been made (Jan. 1 for most individuals) and ends the day before the bankruptcy petition is filed.

• The second short tax year begins the day the bankruptcy petition is filed and ends when the debtor’s tax year would have ended had the election not been made (Dec. 31 for most individuals).

• In certain circumstances, it’s advantageous to make the election. See homework problems for details.