Are You Insolvent Or Not?

There is a case called Hamilton v Commissioner. It was recently decided in the 10^th Circuit, and it caught my eye.

Since it went to a Circuit court, you may correctly assume that this case was on appeal.

Frankly, I do not see a win condition for the taxpayer here. It does, however, give us an opportunity to discuss the concept of a tax nominee.

The patriarch of our story – Mr Hamilton – borrowed over $150,000 to send his son to medical school.

Mr Hamilton injured his back in 2008 – and badly.

I presume that translated into loss of income and a difficult time servicing debt.

Mrs Hamilton finally got the student loan discharged in 2011.

A key point is that the student loan belonged to Mr Hamilton – not the son. When the loan was discharged, the tax effect is therefore analyzed at Mr Hamilton’s level, as he was the debtor.

Before the discharge, Mrs Hamilton transferred approximately $300 grand into a rarely used savings account owned by her son. He in turn gave her the username and password so she could access the account. Throughout 2011, for example, she withdrew close to $120,000 from the account.

COMMENT: There you have the issue of a nominee: whose account is it: Mrs Hamilton’s, the son’s, or both? Granted, it the son’s name is on the account, but is he acting as the face man – that is, a nominee – for someone else?

The issue in the case is whether the discharged debt of $150 grand was taxable to the Hamiltons in 2011.

In general, if your recourse debt is discharged, you have taxable income. There are several exceptions, of which one of the better known is bankruptcy. File for bankruptcy and the tax Code allows you to exclude the debt from taxable income.

But … it requires you to file bankruptcy.

There is a similar – but not quite the same – exception that has to do with insolvency. For tax purposes, one is insolvent if one’s debts exceeds one’s assets.

EXAMPLE: You have assets (house, car, savings, etc.) of $400,000. You owe $500,000. You are insolvent to the extent that your debts exceed your assets ($500,000 – 400,000 = $100,000).

Mind you, you are not filing for bankruptcy. I suppose it is possible that you could power through this stretch, cutting back personal expenditures to a minimum and applying everything else to debt. Still, you are technically insolvent.

The tax Code lets you exclude debt forgiveness from taxable income to the extent that you are insolvent.

EXAMPLE: Let’s continue with the above example. Say that $50,000 is forgiven. You are $100,000 insolvent. $50 grand is less than $100 grand, so $50 grand would be excluded under the insolvency exception.

NEXT EXAMPLE: What if $125 grand was forgiven? You could exclude $100 grand and no more. That last $25,000 would be taxable, as you are no longer insolvent.

The insolvency calculation puts a lot of pressure on what to include and what to exclude in the calculation. Do you include a 401(k) account, for example? Do you include someone else’s loan on which you cosigned?

In the Hamilton case, do you include that savings account?

Under state law, the son did own the account. Tax law however will rarely allow itself to be trapped by mere formality. This judicial doctrine is referred as “substance over form,” and it means what it says: tax law will generally look at the players and on-field performance and resist being distracted by the school band and T-shirt cannons.

The Court made short work of this case.

The taxpayers argued, for example, that the son could change the username and password at any time, so it would be a leap to call him an agent or nominee for his parents.

Yep, and a delivery spaceship for intergalactic deep-dish pizza could land on Spaghetti Junction in Atlanta during rush hour.

If you can log-in with impunity and move $120,000 grand, then you have effective control over the bank account. The mother’s name was not on the account, but it may as well have been because the son was his mother’s agent – that is, her nominee.

I have no problem with that. I would have done the same for my mother, without hesitation.

What the Hamiltons could not do, however, was leave-out that bank account when they were counting assets for purposes of the insolvency calculation. It was, after all, around $300 hundred – less than a Bezos but a lot more than a smidgeon.

Did it affect the insolvency calculation?

Of course it did. That is why the case went to Court.

The Hamiltons were not insolvent. They had income from the debt discharge.

They had to try, I guess, but I doubt whether they ever had a win condition.

Taxpayer Fail On Discharging Taxes Through Bankruptcy

I have an IRS notice sitting on my desk. I meant to call the IRS about it on Friday, but it got away from me. I will call on Monday. It disgruntles me, as I have already called and considered the matter resolved.

There you have why practitioners get upset with the IRS about hair-trigger or bogus notices: one has only so much time.

My partner brought in this client. They were chronic nonfilers, and we prepared the better part of a decade’s worth of returns for them. I lost humor with them when the husband insulted one of my accountants. Granted, it is unlikely that a younger accountant would know what I know, but the incident was uncalled for. The husband and I had a very different and blunt conversation.

They spoke with my partner about discharging the taxes through bankruptcy, which is one reason I was brought in.

Short answer: forgetaboutit, at least for a while.

There are four basic requirements to discharging taxes in bankruptcy. I have not often seen the fourth reason, but I was recently reading a case involving that elusive fourth.

Here are the four requirements:

(1)  The taxes were due at least three years ago. Obtain an extension and you must include the extension period in the three years.

(2)  Fail to file and the taxes are not dischargeable until at least two years after filing.

(3)  The IRS must have assessed the taxes at least 240 days before filing for bankruptcy.

(4)  The return must not be fraudulent, and the taxpayer(s) cannot willfully have attempted to avoid the tax.

Let’s go through an example.

(1)  Let’s say we are talking about your 2016 tax return. If you filed on April 15, 2017, the first rule gives you a minimum date of April 15, 2020.

(2)  Let’s say you filed that 2016 return on July 21, 2018. The second rule gives you a minimum date of July 21, 2020.

(3)  Let’s say the IRS posted (that is, assessed) the 2016 return shortly after filing – perhaps July 31, 2018. There is no problem with the 240-day rule.

(4)  Let’s also say there was no attempt to evade tax. It was irresponsible not to file, but there is nothing there other than irresponsibility.

Seems to me that the earliest you can file for discharge via bankruptcy would be July 22, 2020 – the latest of the above dates.

Let’s talk about a case involving the fourth requirement.

There is a doctor. Her husband was a CPA – he lost his license after a conviction for tax evasion.

She let her husband prepare the returns for years 2004 through 2014.

I would not have done that, but - to me – a CPA losing his license for tax evasion is a HUGE dealbreaker, husband or not.

The entered into a payment plan. They missed some payments.

Like night follows day.

They were living the high life. They had an expensive house (Newport), but they wanted a more expensive house (Dwight). They bough Dwight on a land contract, hoping to sell Newport.

They then carried two houses, as Newport did not sell.

Now they were tight on cash, and they fell behind with the IRS.

Mind you, that did not stop them from sending their kids to a private school, racking up $325,000 in the process. They also took trips to Mexico and Puerto Rico, as well as parking a Jaguar and a Lexus in the driveway.

Newport was foreclosed.

In 2016 we have the bankruptcy.

The IRS moved to exercise its lien on the Dwight property.

Husband came up with a brilliant scheme.  He sold Dwight for a swan song to a former client.  He would pay the IRS the few dollars that came his way from the “sale,” and he and his wife would rent the Dwight property back from the former client.

Puuhleeeese, said the IRS.

The Court agreed with the IRS. It spotted a willful attempt to evade or avoid, thereby nixing any discharge of taxes although the couple had filed for bankruptcy.

Why? They failed the fourth requirement.

The case for the home gamers is re Harold 2020 PTC 58 (Bankr. E.D. Michigan 2020)

You Got Repossessed And The Bank Says You Have HOW MUCH Income?

I ran into a cancellation-of-debt issue recently.

You may know that – should the bank or finance company cancel or agree to reduce your debt – you will receive a Form 1099. The tax Code considers forgiveness of debt to be taxable income, as your “wealth” has increased - supposedly by an amount equal to the debt forgiven. There are exceptions to recognizing income if you are insolvent, file for bankruptcy and several other situations.

Let me give you a situation here at galactic headquarters:

Married couple. Husband is a doctor. Husband buys a boat. He puts both the boat and the promissory note in the wife’s name, presumably in case something happens and he gets sued. They divorce. It is understood that he will keep the boat and make the bank payment. He does not. The boat is repossessed and then sold for nickels on the dollar. Wife (who was never taken off the note) receives a Form 1099-C. She has cancellation-of-debt income, which is bad enough. To make it worse, income is inflated as the bank appears to have sold the boat at a fire-sale price.

Our client is – of course – the wife.

The person who signs on the note receives the 1099 and reports any cancellation-of-debt income. If the debt “belongs” to your spouse and not to you, you better have your name removed from the debt before you get out of divorce court. The IRS argues that – if you receive a 1099 that “belongs” to your ex-spouse - you should seek restitution by repetitioning the court. This makes it a divorce and not a tax issue. The IRS is not interested in a divorce issue.

It all sounds fine until real life.

The wife received a $100,000-plus Form 1099-C from that boat.

Let’s reflect on how she there:

(1)  The wife doesn’t have a boat and never did. Hubby wanted a boat. She signed on the note to keep hubby happy.

(2)  The wife’s divorce attorney forgot to get that note out of her name. Alternatively, the attorney could have seen to it that wife also wound up with the boat.

(3)  For whatever reason, husband let the boat be repossessed.

(4)  The bank issued a Form 1099-C to the wife. The income amount was simple math: the debt less whatever the bank received for the boat.

Let’s introduce real life:

• What if the bank makes a mistake?
• What if the bank virtually gives the boat away?

The IRS has traditionally been quite inflexible when it comes to these 1099s. If the bank reports a number, the IRS will run with it.

You can see the recipe for tragedy.

Fortunately, the IRS pressed too far with the 2009 Martin case.

In 1999 Martin bought a Toyota 4-Runner. He financed over $12 thousand, but stopped making payments when the loan amount was about $6,700. The Toyota was repossessed. He received a Form 1099-C for the $6,700.

… which meant that the bank received zero … zip… zilch… on the sale of the 4-Runner.

Doesn’t make sense, does it?

The IRS did not care. Go back to the lender and have them change the 1099, they said.

COMMENT: Sure. I am certain the lender will jump right on this.

Martin did care. He told the Court that the Toyota was worth roughly what he owed on it when repossessed, and that the 1099-C was incorrect.

Enter Code section 6201(d):

(d) Required reasonable verification of information returns In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return filed with the Secretary under subpart B or C of part III of subchapter A of chapter 61 by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary), the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return. 

Normally, the IRS has the advantage in a tax controversy and the taxpayer has the burden of proof. 

Code section 6201(d) provides that – if you can assert a reasonable dispute with respect to an item of income reported on an information return (such as a 1099-C), you can shift the burden of proof back to the IRS.

The Tax Court decided that Martin had shifted the burden of proof. The 4-Runner had to be worth something. The ball was back in the IRS’ court.

Granted, Martin was low-hanging fruit, as the bank reported no proceeds. The IRS should have known better than to take this case to court, but they did and we now have a way to challenge an erroneous 1099-C.  

In our wife’s case, I am thinking of getting a soft appraisal on the value of the boat when repossessed. If it is materially different from the bank’s calculation (which I expect), I am considering a Section 6201(d) challenge.

Why? Because my client should not have to report excess income if the bank gave the boat away. That was a bank decision, not hers. She had every reasonable expectation that the bank would demand and receive fair market value upon sale. Their failure to do so should not be my client’s problem. 

Which will be like poking the IRS bear.

But she has received a questionable $100,000-plus Form 1099-C. That bear is already chasing her.

Can You Have Cancellation Of Debt Income If You Are Still Paying On The Debt?

Harold is a native Hawaiian. He has worked in the telecommunications industry for more than 40 years. In 1996 he founded Summit Communications, Inc (Summit), which he served in the capacity of president, chief executive officer and director.

Al has a background similar to Harold's, but his company was called Sandwich Isles Communications, Inc (SIC). In 1997 he desperately needed a telecommunications executive. Al met Harold and wanted Harold to come work for him.

Harold was already involved with Summit, which was having business issues. Harold felt a commitment to the company and his employees.

But Al was not going to let go easily.

In 1998 Al sweetened the offer by including a $450,000 loan. He knew that Harold would immediately loan the monies to Summit. In fact, that is why Al offered the deal. He wanted to loan to be to Harold so that he and SIC did not have to deal with Summit's board of directors.

SIC also wanted to contract with Summit for operations and technical support.

Harold signed on with SIC, and Al let him stay on as Summit's director and chief executive officer.

They signed a note, stipulating that Harold had to repay the loan if he ever left SIC's employment.

The relationship went well, and by the end of 1999 Summit was booming, although - granted - SIC represented 60% of its revenues. It was growing so much that it need Harold back. Al, basically being a good guy, agreed that Harold should return.

No one remembered that Harold had to repay the loan.

SIC then received a large loan from the U.S. Department of Agriculture, which it used to upgrade its operations and technical staff. As it did, SIC's reliance on Summit decreased. By 2002 Summit filed a bankruptcy petition. By 2005 Harold had gone back to work for Al.

In 2010 the IRS audited SIC.

In 2011 Al met with Harold and reminded him that the loan was still due. Harold arranged for payroll deductions - first for $300 per month, then $600 and finally a $1,000 a month - to repay the loan.

The IRS sent a notice to Harold. The IRS said that SIC had discharged his loan, and he had cancellation of indebtedness income.

Think about this for a moment. The IRS wanted taxes from Harold because he had been let off the hook for a $450,000 loan. The problem is that Harold was still paying on the loan. Both cannot be true at the same time, so what was the IRS' reasoning?

It primarily had to do with how many years SIC had to pursue collection before the statute of limitations ran out. Remember: Harold did not start paying the loan until 2011. According to the IRS, there was no enforceable loan at that time, as SIC had gone too long without any evident collection activity. That was the triggering event for income to Harold: when the debt was no longer enforceable.

The IRS had a good point.

The IRS also argued that Harold starting repaying on the loan because it had noticed the defaulted loan on audit and Harold did not want to pay taxes on it.

Harold and Al appeared before the Court and testified that they both considered the loan outstanding, and the Court found them both to be "honest, forthright, and credible."

The Court could not help but notice that Harold and Al were on separate sides with respect to the loan.

 ... respondent argues that any repayment activity taken after the commencement of the examination should be discounted. We disagree. The testimony suggests instead that [Harold] sought to repay the SIC loan because he understood that it was his obligation to repay it. Additionally, a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against [Harold's] economic interests."

The Court agreed that cancellation of income requires a triggering event, but it disagreed that the expiration of the statute automatically rose to that level.

... the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor."

The Court decided that Harold owed the debt. He did not have income.

Why did the IRS pursue this? It certainly did not put a smiley face on their public persona.

I suspect the IRS considered themselves backed into a corner. If the loan really was uncollectible AND the IRS did not pursue, then the regular three-year statute on tax assessments would close on Harold's tax year. At that point, the IRS could not reach Harold again if it wanted to. If however the IRS went to Court - even if it lost - it would mean that the loan was either still in place or discharged in a later year. In either case, the IRS could reach Harold.

Difference Between An Advance And A Loan

Do you remember when the Washington Redskins and the Miami Dolphins went to the Super Bowl? It was 1983, and I was living in Florida at the time. I am pretty sure I was rooting for the Florida team. The Redskins had a hard-charging fullback named John Riggins. His nickname was “Diesel” and he scored a touchdown on a forty-something yard run. Blocking for him was (among others) George Starke, an offensive tackle. The Washington offensive linemen, the ones who block for the quarterback and running back, were known as The Hogs.

George Starke is second from the left.

George was very much on the backside of his career at that point. He shortly thereafter left football and opened a car dealership in Maryland. He couldn’t help but notice that the dealership had difficulty recruiting service technicians. He helped establish a technical school to educate and train technicians. He also hoped that - by providing a realistic hope for a better life – the school would also help with the poverty and violence in the area.

He eventually sold the dealership and cofounded the Excel Institute, a nonprofit program that provided a two-year reading, writing, arithmetic and technical skills curriculum. The program was free of charge, but one had to commit.

Starke received a salary and housing allowance, as well as a credit card. He would charge business and personal expenses on the card. The personal charges were segregated on the books and records. George discontinued any personal charges in 2006, and from 2007 onward the only activity relating to the credit card was a payroll deduction to repay the balance.

There was a change in the Board, and Starke did not like the new direction of things. He stopped fundraising. He left the Excel Institute altogether in 2010.

Excel put the remaining balance due from George of $83,698 on a Form 1099, sent a copy to George, a second to the IRS and figured that was that.

George did not include the $83 grand on his individual tax return, however.

The IRS noticed and insisted that George do so. George said no.

And off to Tax Court they went.

Before proceeding, tell me: do you think George has a prayer?

As you know, forgiveness of a loan triggers income. The tax issue is whether these monies were ever a loan.

Your first thought is: of course they were! Heck, he was paying it back, wasn’t he?

Let’s walk through this.

Just because someone gives you money does not mean that there exists a loan. A loan implies that both sides anticipate the monies will be repaid. It would also be swell if there were some attention to the basic formalities, like perhaps a loan agreement and repayment terms.

And – just to dream – maybe interest could be charged on the whole affair.

There was no loan agreement. Excel itself gave mixed messages to the Court on whether it thought the monies were a loan. George told the Court that he never had any intention of paying back the money, and that he thought the payroll deductions were for health insurance or something like that.

If not a loan, then what were the monies to George?

They were advances, akin to nonrecoverable draws.

Advances are more easily understood in a draw-against-commission environment. Draws are intended to provide some predictable cash flow to the salesperson. Say that a salesperson receives commissions, and against the commissions is a $5,000 monthly draw. There are two types of draws - recoverable and nonrecoverable. A nonrecoverable draw does not have to be paid back should a saleperson fail to meet quota. A recoverable draw does have to be paid back. Granted, a salesperson who fails on a continuous basis to meet quota would soon be unemployed, but that is a different conversation.  For our purposes, the key is that a nonrecoverable draw represents income upon receipt.

Back to our courtroom drama.

The IRS pulled his 2010 tax year.

George received no advances in the 2010 tax year.

George last received advances in 2006.

There was nothing to tax in 2010 because George received no monies in 2010.

The IRS should have pursued his 2006 tax year. They did not, nor could they under the statute of limitations.

The Court dismissed the case. George won. The IRS got embarrassed.

I am curious why the IRS even bothered. The only thing I can figure is that they were hoping for a miracle play. Maybe like John Riggins running that football for a touchdown in Super Bowl XVII with George Starke blocking for him.

What Does Insolvency Mean To The IRS?

Shepherd v Commissioner is a pro se case before the Tax Court. “Pro se” means that the taxpayer is representing himself/herself, without a professional. Technically that is not correct, as a taxpayer can go into Tax Court with a professional and still be considered “pro se.” This happens if the professional (say a CPA) has not passed the examination to practice before the Court. The CPA can then “advise” but not “practice,” and the taxpayer is considered “pro se.”

Today we will be talking about cancellation-of-debt income. Tax pros commonly refer to this is “COD” income. For many years I rarely saw a COD issue. In recent years it seems to be endemic. There are two common ways to generate COD: a home is foreclosed or a credit card is settled. If one pays less than the balance of the debt, the remaining balance is considered to be income to the debtor.

How can that be, you may ask. Let’s use an example. Say you go to your bank and borrow $50,000. When the loan is due, you cannot afford to pay in full. The bank agrees to accept $36,000 as full payment on the loan. From the IRS’ perspective, you received and kept a net $14,000. Perhaps you bought a car, went on vacation, or paid for a kid’s college, but you had an accession to wealth. The IRS considers the $14,000 to be income to you.

There are exceptions, and Shepherd involves the “insolvency” exception. This is different from the bankruptcy exception. Granted, in both cases you are likely insolvent, but for the insolvency exception you do not have to file with a bankruptcy court.

Let’s quickly take a look at the wording for insolvency in the tax code:

   108(d)(3) INSOLVENT.— For purposes of this section, the term “insolvent” means the excess of    liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.

An easy way to understand insolvency is the following formula:

·        Add the fair market value of everything you own, then

·        Subtract everything you owe

If the result is negative, you are insolvent. You owe more than you own. You are negative or upside-down. There are special rules for assets such as a pension, but you get the concept.

The IRS says that – if you are insolvent – then COD income not be taxable to you to the extent you are insolvent. Let’s use numbers to help understand this:

·        You own $160,000

·        You owe $175,000

·        Visa forgives $22,000

Your COD income is $22,000 (what Visa forgave).

Your insolvency is $15,000 (175,000 – 160,000).

Therefore $7,000 of your COD income (22,000- 15,000) will be taxable to you. The rest is not taxable.

The tax law requires you to do the calculation of what you own and what you owe as of the date the debt is forgiven. It is not two years later or 18 months before. Remember: this is tax law not a tax suggestion.

Let’s swing over to Shepherd. He and his wife lived in New Jersey and owed Capital One Bank approximately $10,000. In 2008 they settled for approximately $5,500, leaving COD income of $4,500.

The Shepherds claimed insolvency and did not report the $4,500 as 2008 income. The IRS looked into it and found that the key to the insolvency calculation was the value Shepherd attached to two houses.

The first was his beach house. Shepherd received a property assessment of $380,000 for the 2010 tax year. He appealed the assessment, claiming a value closer to $340,000. He presented this as evidence before the Court. The Court had two immediate issues:

·        There is a long-standing tax doctrine that the value of property for local tax purposes is not determinative of fair market value for federal income tax purposes. This is the Gilmartin case, and it clearly established the tax code’s preference for an appraisal over property tax bills.

·        Shepherd did not present to the Court the methodology, procedures or analysis, including comparable sales, for thinking that the value was closer to $340,000. At that point it was just an opinion, and the Court was not bound by his opinion.

The Court pointed out that these events took place two years after the debt forgiveness and said fuhgeddaboudit to Shepherd’s valuation of the beach house.

The second was his principal residence.

·        Shepherd showed the Court a tax bill. The Court duly dismissed that under the Gilmartin doctrine.

·        Shepherd applied for a loan modification in 2011. Chase Home Finance showed a value of $380,000 in a modification letter. The Court wasn’t buying into this, noting that Chase’s letter did not show any analysis or procedures used in arriving at value, such as comparable sales. That is, it was not an appraisal. Oh, and by the way, the letter was three years after the debt discharge.

What is a tax pro’s take? Folks, Shepherd had virtually no leg to stand on. How can one read the tax code stating “immediately before the discharge” and reason that three years later – and after one of the worst housing markets in U.S. history – would constitute “immediately before”? This is simply not reasonable. You are going to lose this if challenged by the IRS. Shepherd’s position is so preposterous that I suspect he was truly “pro se” and did not have a professional, either when he prepared his return or when he was presenting his arguments in Court.

Chapter 7 Bankruptcy and Taxes

It was one of the last individual tax returns I saw this year going into October 15, so the topic is on my mind.

The topic is bankruptcy. It seems that I have seen or discussed bankruptcy more in the last three years than in the balance of my career years combined. There are peculiar tax rules to bankruptcy. Today I want to talk about chapter 7, also known as liquidation, as that is the type of bankruptcy that I have been seeing the most.

Chapter 7 is the classic bankruptcy. Your assets and liabilities pass to the bankruptcy trustee. The trustee sells what he/she can and pays what is possible to the creditors. When done the judge discharges the bankruptcy and one is free of all debts. Depending on the state you may retain certain types of assets. The example I am familiar with is the primary residence in Florida. Some debts may follow you out of bankruptcy. An example is the loan on your car. You reaffirm the debt because you want, or need, to keep the car. If you want the car you have to keep the debt.

Upon filing a Chapter 7, your assets and liabilities past to the bankruptcy estate, which is normally represented by a trustee. It may be that some assets do not pass, but let’s not include that issue in our discussion. The estate also succeeds to one’s tax attributes. Think of attributes as tax benefits waiting to happen: a net operating loss or a general business tax credit, for example. When they finally kick-in, there is a benefit – meaning a reduction in tax – to you.

Why is this important? Because the estate is a separate taxpaying entity. When calculating its tax, the trustee can use your tax attributes to offset the estate’s tax. So, if you have an NOL, the trustee can use it to offset the estate’s taxable income. When you remember that the NOL can only be used once, this has meaning to you. If the trustee uses it, then you cannot.

There is another important tax consideration to bankruptcy. You may already know that debt discharged in bankruptcy is not taxable to you. Did you know, however, that you have to reduce your tax attributes to the extent that you have discharged debt? If you have $56,000 of debt discharged and have a $61,000 NOL carryforward, you have to reduce that NOL carryforward to $5,000 ($61,000 – 56,000).

What is the estate taxed on? Remember that one’s assets move to the estate upon filing Chapter 7. If the income can be traced to the asset, then the income is taxable to the estate as long as the asset is inside the estate. Examples include:

·         Dividends on stocks

·         Interest on bonds

·         Royalties on mineral rights or patents

·         Rental income on rental real estate

·         Capital gains or losses from selling stocks and bonds

What is not taxable to the estate? The classic example is your paycheck. It cannot be traced to an asset inside the estate, so it is not taxable to the estate. It is however taxed to you.

So the estate files a tax return for interest and dividends. You file a tax return for your wages. You now have two tax returns where there used to be just one.

And that is how the estate uses up your tax attributes. When the estate is discharged, it should tell you what is left on the tax attributes, because now you can use what is left. There may be nothing left.

This works well if the estate is large enough to have its own tax return. Frankly, what I have seen in recent years (at least the last 5 years) are small bankruptcy estates. These estates generally do not file a separate estate return, although technically they are supposed to. Rather all the estate numbers (think dividends and the sale of the stock that generated them) are combined with the taxpayer’s other non-bankruptcy numbers (think W-2) and reported on taxpayer’s individual income tax return. Now it becomes important for the CPA to remember the tax attribute rule, because there is no separate estate return to remind him/her.

This past weekend I met with a client who had $79,901 discharged in Chapter 7. There was no separate bankruptcy estate tax return. We did not make an election to end the client’s tax year upon the date of the Chapter 7 filing. She did have tax attributes to reduce. The client’s tax consequence went as follows:

                Debt discharged                                              79,901

                Net operating loss carryover                     ( 43,268)

                Capital loss carryover                                   ( 11,045)

                                                                                              25,588

                Note receivable                                              ( 25,588)

                                                                                                    -0-

The client lost the NOL and capital loss carryovers to the debt discharge. The amount left over reduced the client’s basis in a note receivable from a partnership. Think about this for a moment. What happens when our client is repaid the note in the future? Our client would receive more money than the client has basis in the note. Is this a taxable event? You bet. Why did we select the note? Because the note is in a partnership that is unlikely to ever repay our client in full. We considered the risk of the “phantom income” to be slight.

The IRS does not intend for bankruptcy to be “free.” From a tax perspective, what the IRS wants is for the bankruptcy to be tax-neutral over a period of time. In the above example, our client was not taxed on the $79,901, but the IRS has immediately eliminated $54,313 of tax benefits. The IRS further hopes that our client is repaid the note in full, because that will trigger $25,588 of phantom income. At that point $54,313 + 25,588 equals $79,901, which was the discharged income the IRS did not tax. To the IRS this would constitute a “push,” as it was out only the time value of the tax but not the tax itself.

Is there an order how the tax attributes are to be used up? Of course. The order is as follows:

·         Net operating loss carryover

·         General business credit carryover

·         Minimum tax credit carryover

·         Capital loss carryover

·         Basis of property

·         Passive activity loss and credit carryovers

·         Foreign tax credit carryover

There are other types of bankruptcy than Chapter 7. There is Chapter 13, which is a reorganization of debt for an individual. Chapter 12 is for farmers and Chapter 11 is for businesses. Perhaps we will talk about them – on another day.