Challenging a Tax Liability in Bankruptcy

Bankruptcy Code Section 505(a)(1) authorizes the Bankruptcy Court to rule on the merits of any claim involving an unpaid tax, fine, or penalty relating to a tax, or any addition to tax, of the debtor or the bankruptcy estate. The Court has this authority whether or not the tax has been previously assessed. Thus, this section provides an alternative pre-payment forum, which can be utilized when the taxpayer has failed to timely petition an income tax deficiency and is thereby barred from litigating in the Tax Court. It also allows a trust fund tax to be challenged without the requirement of payment and a subsequent refund suit in the District Court or Court of Claims. Section 505(a)(2) however, specifically provides that the Bankruptcy Court cannot rule on the merits of any tax claim that has been previously adjudicated. Also, the statutory language granting jurisdiction to the Bankruptcy Court is permissive, not mandatory and the Court can choose to abstain from making such determination.

I.R.C. SECTION 1398 AND THE SPLIT YEAR ELECTION

Under the Bankruptcy Code, when a bankruptcy petition is filed, a separate entity referred to as the bankruptcy estate is formed. Under section 1398 of the Internal Revenue Code, when an individual files a chapter 7 or 11, the bankruptcy estate is treated as a separate taxable entity. The taxable income of the bankruptcy estate under these circumstances is computed in the same manner as the taxable income of the individual. The estate is allowed the personal exemption and the standard deduction. The tax rate applicable to the estate is the same rate applicable to married taxpayers filing separate returns under I.R.C. section 1(d).

Under I.R.C. section 1398(d), an individual debtor is entitled to one irrevocable election to close his or her taxable year as of the day before the commencement of the bankruptcy. If this election is made, the taxable year of the individual is divided into two short taxable years. The first year runs from the first day of the individual’s normal taxable year to the day before the filing of the bankruptcy petition. The second short year runs from the date of commencement to the end of the individual’s regular taxable year. The election is not available in a no-asset case and must be made on or before the 15thy day of the fourth full month following the date of bankruptcy. If the election is not made, the taxable year of the individual is not affected by the bankruptcy filing.

The reason that an election would be made is that the IRS will not sever a tax year otherwise. Thus, for example, if an individual files bankruptcy on November 31, 1998, any tax liability for the 1998 year will be treated as if it was due after December 31, 1998. Since the liability is therefore due post-petition, it is not a liability claimable by the I.R.S. against the bankruptcy estate. Instead, it will be a liability owed by the individual after bankruptcy and funds from assets that were liquidated in the bankruptcy can not be applied to these liabilities. Absent the election, creditors who would have been discharged without any payment may receive distributions, while the tax liability for the year of the bankruptcy is totally unpaid. Having this liability waiting for the debtor after he or she emerges from bankruptcy may significantly hinder a “fresh start”.

Section 1398(g) provides that the bankruptcy estate succeeds to the debtor’s tax attributes as of the first day of the debtor’s taxable year in which the bankruptcy case is commenced. These attributes include: NOL’s Capital loss carryovers, credit carryovers charitable contribution carryovers, recover exclusion under section 111, debtor’s basis, holding period, and character of any assets acquired from the debtor other than by sale or exchange, the debtor’s accounting period, and passive and at-risk activity losses and credits. Under section 1398(i) , the tax attribute enumerated above are succeeded to by the debtor upon termination of the bankruptcy estate. In a case where the debtor has losses during the tax year of the bankruptcy that can be utilized, a section 1398 election may not be beneficial, since an election will cause the losses from the first day of the debtor’s taxable year, to the date of bankruptcy, to belong to the bankruptcy estate.

A detailed discussion of the impact of section 1398 is beyond the scope of this material. Reference is made to this issue however, since it may have significant tax impact and the average bankruptcy attorney is completely unaware of the existence of the provision. Thus it may present an area that accountants could play an active role in advising the bankruptcy counsel of the tax implications of and in preparing the short year return where an election is appropriate

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