Building Blocks: Bankruptcy Taxation Fundamentals

Bankruptcy Taxation Fundamentals
Coordinating Editor:
Thomas M. Horan
Womble Carlyle Sandridge & Rice LLP
Wilmington, Del.
[email protected]
Also Written by:
Georgiana I. Nertea
EisnerAmper LLP; New York
[email protected]
Ira Spiegel
EisnerAmper LLP; New York
[email protected]
T
axes are always in the headlines, a
political hot potato, and an issue
that we deal with daily in our
personal and business lives. There are
significant issues in bankruptcy taxation
that are necessary to a basic understanding of the issues found at the intersection of bankruptcy and tax law. These
issues include the Bankruptcy Abuse
Prevention and Consumer Protection
Act of 2005’s (BAPCPA) elimination of § 728 of the Bankruptcy Code
and its implementation of the “prompt
determination” request under § 505 of
the Code, along with a discussion of
certain critical foundational tax issues
in bankruptcy cases.
The End of § 728
BAPCPA affected
the work required
in many areas of
our professions.
Specifically, it eliminated § 728’s “special tax provisions”
and rewrote § 346 of
the Code, which, in
Thomas M. Horan
certain sections, had
previously deferred
to § 728. This changed the requirements
regarding the filing of tax returns and,
by implication, the paying of the related
taxes. It also impacted cases filed under
or converted to chapter 7 and the accountants retained by the chapter 7 trustees.
Until BAPCPA became effective on
Oct. 17, 2005, § 728 allowed a trustee to
forego the annual filing of state and local
tax returns as measured by income for
the entire period during which the trustee’s case was pending, subject to a final
determination as to whether there was net
taxable income for the estate for the case
beginning with the order for relief through
to the pending closure of the case. If it
was determined that the estate resulted in
56 February 2012
About the Authors
Tom Horan is an attorney in Womble
Carlyle Sandridge & Rice’s Wilmington,
Del., office and serves as co-chair of
ABI’s Commercial Fraud Committee.
Georgiana Nertea is a senior manager
and Ira Spiegel is a director in
EisnerAmper’s Restructuring and
Bankruptcy Group. Ms. Nertea, a
certified insolvency and restructuring
adviser, and Mr. Spiegel are certified
public accountants.
net taxable income, state and local returns
would be required to be filed.
The elimination of
§ 728 equalized the
treatment regarding
the annual filing of
state and local tax
returns for cases
under chapter 11
and 7. Therefore,
under the BAPCPA
Georgiana I. Nertea
revisions to the
Additionally, as
each year of an
individual’s or business’ estate must
now stand alone,
taxes may have to
be remitted one year
and then require an
amended return in a
Ira Spiegel
future year resulting
from a loss that can
be carried back to recover the earlier
income tax payment. The end result,
possibly already felt by trustees, is
that professional fees increase, tax
payments increase, and distributions
to creditors decrease.
Prompt Determination
under § 505(b)(2)
A key tool for all trustees—but primarily chapter 7 trustees—as they seek
to file their closing reports with a final
tax statement is provided by § 505(b)(2)
of the Code. As revised by BAPCPA,1
§ 505(b)(2) permits a trustee to request
Building Blocks
Bankruptcy Code, all business and individual debtor tax returns measured by
income (federal, state and local) must be
timely filed. Please note that cases under
chapter 11 were and still are required
to timely file all income/franchise tax
returns, but also such returns as, but not
limited to, sales tax and payroll tax.
As many states’ annual business tax
returns are identified as “franchise” tax
returns in lieu of income tax returns,
they require an annual franchise tax
and/or minimum income tax payment
even in the absence of net taxable
income. The same can be said for states
identifying their returns as income tax
returns. Prior to BAPCPA, in estates
with no net taxable income, chapter 7
trustees usually filed only a final federal
tax return to demonstrate no outstanding tax issues. Under BAPCPA, state
and local returns are filed and accompanied by the required franchise tax and/
or minimum income tax payment annually. While these minimum payments
may not adversely affect individual
estates, the accumulated impact for an
individual state may have sparked the
end of § 728.
a prompt determination by mailing a
request to proper taxing authorities at a
special address designated for service of
requests under § 505(b)(2), or, if the taxing authorities do not designate such an
address, to their regular address for filing
of a tax return.2
The Internal Revenue Service (IRS)
requests that each return requesting
§ 505(b)(2) status be filed with the normal office for such return and that two
copies of the return be forwarded to the
Centralized Insolvency Operation, P.O.
Box 7346, Philadelphia, PA 19101-7346.
Although not required, as best practice,
it is recommended that state and local
returns be sent to the related bankruptcy
department and the regular address for
filing returns.
After service of a request for prompt
determination under § 505(b)(2), the
estate, the trustee, the debtor and any
successor to the debtor are discharged
from liability for such tax once the
1 For a fulsome discussion of the BAPCPA revisions to § 505(b),
see James I. Shepard and Larry Strauss, “The § 505(b) Prompt
Determination of Post-Petition Tax Liability: An Update,” ABI Journal,
Vol. XXVI, No. 1, page 50, February 2007.
2 11 U.S.C. § 505(b)(1).
ABI Journal
60 days that is allowed for the IRS to
notice an objection or desire to audit has
lapsed.3 Discharge will not be granted
if the return is fraudulent or has a material misrepresentation, payment of the
tax shown on such return is not remitted
or the return is designated for examination by the taxing authority within the
60 days immediately following service.
Several recent cases have interpreted § 505(b)(2). In Ogle v. IRS (In re
Agway Inc.),4 the court reversed a bankruptcy court decision holding that it
lacked post-plan confirmation jurisdiction to make findings under § 505(b)‌(2).
In Agway, a liquidating plan was confirmed in April 2004 and effective on
May 1, 2004.5 The plan provided that
the “Liquidating Trustee may request
an expedited determination of taxes of
the Liquidating Trust...under section
505(b)(2)...for all returns filed for, or
on behalf of, the Liquidating Trust for
all taxable periods through dissolution
of the Liquidating Trust.” 6 The plan
further provided that the bankruptcy
court retained jurisdiction to hear and
determine matters under § 505. 7 The
bankruptcy court held that it lacked
subject-matter jurisdiction over a taxdetermination issue that arose post-confirmation.8 The district court reversed,
finding in part that the plan properly
provided for jurisdiction, and noted that
the taxes sought to be determined arose
during the administration of the liquidating trust created under the plan.
There are two significant elements
to this ruling. The first affirms that
§ 505(b)‌( 2), by its opening statement
“[a] trustee may request,” extends the
benefits of this section to all trustees
resulting from the filing of a bankruptcy, confirmation of a plan or its conversion to a chapter 7. Chapter 7 trustees,
trustees appointed during the chapter
11 case’s administration, and those created and appointed through a plan are
all afforded equal access to the provisions of the section. The second is that
the plan properly may provide for the
bankruptcy court to retain jurisdiction
over § 505(b) issues.
In In re PT-1 Communications, 9
the IRS sought to contest the trustee’s
attempt to carry back net operating losses
for the 2002 tax year.10 The trustee contended that § 505(b) operated to shift
3 11 U.S.C. § 505(b)(2).
4 447 B.R. 91 (N.D.N.Y. 2011)
5 Id. at 92.
6 Id. (citing Plan § 7.01(f)).
7 Id. at 92-93.
8 Id. at 94.
9 447 B.R. 115 (Bankr. E.D.N.Y. 2011).
10 Id. at 136.
ABI Journal the burden to the IRS with respect to the
carryback.11 The IRS in turn argued that
§ 505(b) was no bar to contesting the
carryback.12 The court held, based on the
plain meaning of § 505(b), that while it
barred the IRS from seeking payment of
additional tax, the statute had no application to a tax refund claim and did not
shift the burden to the IRS.13
For an individual chapter 11 debtor
who has confirmed a reorganization
plan, all earnings post-confirmation
remain property of the estate and are
reported on the estate’s tax return
until the final decree is entered.
The relevant issue is that the burden to file the appropriate tax return
rests with the trustee as the party seeking a refund, which is the benefit of a
net operating loss (NOL) carryback. It
also reinforced that the IRS, within the
restraints imposed by § 505(b), is not
barred from contesting the issues raised
by such a filing.
A clear example of the implementation of these rulings can be found in
S&K Famous Brands Inc.14 The liquidating trustee for the liquidating trust created by S&K’s reorganization plan filed
a motion for an order granting the trust’s
rights to tax refunds.15 As stated in the
trustee’s motion, the plan—as is typical—expressly provided for the court’s
continuing jurisdiction over the S&K
case from the effective date of the plan
through to the entry of a final decree.16
It also cited §§ 346, 505 and 1146 of the
Bankruptcy Code as to the bankruptcy
court’s jurisdiction to hear and determine
matters concerning state, local and federal taxes.17
At issue in S&K was the tension
between § 505(b)(2) and the Tax Code
provisions that permit the IRS to file
suit to recover a refund within two
years 18 or, in the event of fraud, five
years. 19 Specifically, the bankruptcy
court was called upon to decide wheth11 Id. at 136-37.
12 Id. at 137.
13 Id.
14 In re S&K Famous Brands Inc., Case No. 09-30805 (KRH) (Bankr. E.D. Va.).
15 Id., Motion of Liquidating Trust for an Order Pursuant to § 505(a) of the
Bankruptcy Code Granting the Trusts Rights to Tax Refunds [D.I. 874,
filed Nov. 24, 2010].
16 Id., ¶ 16.
17 Id.
18 26 U.S.C. § 7405.
19 26 U.S.C. § 6532(b).
er the prompt determination provision
of § 505(b)(2) trumped the Tax Code’s
provisions for filing suit for the recovery of a refund.
The debtor, utilizing NOL carrybacks, had filed the proper return(s)
and had received the requested refunds.
Under the applicable Tax Code provisions, the IRS retained the right to
review the returns, object to the calculations, and request a return of proceeds should they amend the return(s)
until at least mid-2012. On the other
hand, under § 505(b)(2), the IRS’s
time to examine the return(s), 180 days
from the time of the request for prompt
determination, had already expired. If
the Tax Code provisions governed, the
potential delay on the trustee’s ability
to distribute the funds to the beneficiaries of the trust would prolong the life
of the trust and therefore delay entry of
the final decree. The liquidating trust
argued that this would run counter to
the terms of both of the plans and could
cause the cases to outlast the term of the
liquidating trust agreement.
The bankruptcy court granted the
motion, finding that the trust possessed
the rights to the tax refunds, and was
empowered under the plan and liquidating trust agreement to keep and distribute those refunds.20 Furthermore, the
court held that the IRS lacked any claim
or interest in the tax refunds, cutting off
the IRS’ recourse for recovery of the tax
refunds under the Tax Code.
Tax Tidbits
The filing of a business chapter 11
or chapter 7, while creating a bankruptcy estate, does not create a new entity.
The business continues under its existing employer identification number
(EIN), method of accounting and tax
year. Pursuant to 26 U.S.C. § 1339, the
corporation is the same entity after the
filing of the petition as it was pre-petition. As discussed above, businesses
continue to file all tax returns as they
were required to prior to filing; however, regardless of how they did or did
not file prior to the bankruptcy, returns
during the administration of the case
are required to be filed by the regular
due date, or as allowed by a timely
filed extension.
The filing of an individual bankruptcy creates a bankruptcy estate that
20 In re S&K Famous Brands Inc., Case No. 09-30805 (KRH) (Bankr. E.D.
Va.), Order Granting Motion of Liquidating Trust for an Order Pursuant
to § 505(a) of the Bankruptcy Code Granting the Trusts Rights to Tax
Refunds [D.I. 890, filed Dec. 17, 2010].
continued on page 74
February 2012 57
Building Blocks: Bankruptcy Taxation Fundamentals
from page 57
is required to obtain its own taxpayer
identification number (TIN), separate
and distinct from the individual’s Social
Security number (SSN). Joint filings
require each spouse to obtain his or
her own estate TIN. The debtor(s) will
continue to file federal, state and local
income tax returns under his or her SSN
if required. Each debtor estate will file,
for federal purposes, Page 1 of Federal
Form 1041 (U.S. Income Tax Return for
Estates and Trusts) as a transmittal cover
sheet identifying the bankruptcy estate,
which is attached to a pro forma federal
Form 1040, and indicating whether there
is tax due or an amount to be refunded.
Form 1040 is prepared by the debtor as
“married filing separately.”
For an individual chapter 11 debtor
who has confirmed a reorganization
plan, all earnings post-confirmation
remain property of the estate and are
reported on the estate’s tax return until
the final decree is entered. There is an
exception whereby the income can be
allocated between the SSN and TIN.
The exception arises when the confirmed plan and/or the confirmation
order contains an exact formula/procedure for such determination.21
The administrative costs of a bankruptcy estate are deductible against
income of the estate for both business
and individual debtors. For federal purposes, an individual debtor will deduct
these expenses “above the line” on Page
1 of Form 1040 before arriving at adjusted gross income.22 Taxes for post-confirmation trusts will be determined by the
nature of the trust created. n
21 See, e.g., In re Vick, Case No. 08-50775 (Bankr. E.D. Va.).
22 See IRS Publication 908 for a more complete overview of the federal tax
situation for individual debtors.
Copyright 2012
American Bankruptcy Institute.
Please contact ABI at (703) 739-0800 for reprint permission.
74 February 2012
ABI Journal