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.

Taxes on IRS-Prepared Returns Are Not Discharged in Bankruptcy

A recent bankruptcy case gave me pause. The case is Cannon v U.S.

The Cannons did not file tax returns for 1999 through 2001. The IRS audited and made income tax assessments based on the audit. This is known as a substitute return.

The Cannons later filed for bankruptcy. The IRS said that their taxes for 1999 through 2001 were nondischargeable.

What is the issue here? To be dischargeable in bankruptcy, a debtor’s taxes must meet several tests:

* The returns are due more than three years before bankruptcy
* The tax must be assessed more than 240 days before bankruptcy
* A return must have been filed more than 2 years prior to bankruptcy
* The return must not be fraudulent
* The taxpayer must not have attempted to evade tax

The issue is the definition of “return.” In 2005 the Bankruptcy Code was amended to include the following gem of wordsmithing:

...the term ‘return’ means a return that satisfies the requirements of applicable nonbankruptcy law (includ­ing applicable filing requirements.) Such term includes a return prepared pursuant to § 6020(a) of the Internal Revenue Code of 1986, or similar State or local law, or a written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal, but does not include a re­turn made pursuant to § 6020(b) of the Internal Revenue Code of 1986, or a similar State or local law.”

So a return under IRC Section 6020(a) will qualify. What does Sec 6020(a) say?

6020(a) Preparation of Return by Secretary.—

If any person shall fail to make a return required by this title or by regulations prescribed thereunder, but shall consent to disclose all information necessary for the preparation thereof, then, and in that case, the Secretary may prepare such return, which, being signed by such person, may be received by the Secretary as the return of such person.

The Bankruptcy Code will accept the above but will not accept the following under Sec 6020(b):

6020(b)(1)Authority of secretary to execute return.—

If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.

The problem is that a substitute return is a Sec 6020(b) return. If you owe tax with this IRS-prepared substitute return, you are facing the possibility that this tax is nondischargeable, even if the 2-year period has expired.

The question I have is whether amending an IRS-prepared Sec 6020(b) return will constitute filing a tax return and thereby begin the 2-year period. I am looking at Judge Easterbrook’s language in Payne, and Payne’s descendants, such as Creekmore and Links. I must admit, it as clear as mud.

The tax planning for this is pretty straightforward however: file your returns before the IRS catches you.

Losing Bankruptcy Protection On Your IRA

You probably know that monies in your IRA are protected from bankruptcy. No one intends to go there, but it’s nice to know that you have that safeguard.

What do you have to do to void that protection?

Enter Ernest Willis and his IRAs (Willis v Menotte).

Willis opened a self-directed IRA with Merrill Lynch in March, 1993. On December 20, 1993 he withdrew $700,000to help him with a real estate transaction. On February 22, 1994 he put the $700,000 back in the IRA.

NOTE: Let’s count the days… 12 + 31 +22 = 65 days. You may remember that you can withdraw money from your IRA and not have it count as a distribution IF you replace it within 60 days. Looks like Willis missed his count.

In January, 1997 Willis had problems with the stock market. He had to put money into his brokerage account (I presume he was on margin), so he wrote checks back and forth between his IRA and the brokerage account. The settlement takes a few days, so he could keep the brokerage account afloat by swapping checks. Since he was replacing the IRA monies within 60 days, he did not have a distribution.

Somewhere in here Willis partially rolled-over his Merrill Lynch account to AmTrust and Fidelity.

In February, 2007 Willis filed for bankruptcy. The creditor wanted his IRA. Willis said NO NO and NO. The IRA is protected by Bankruptcy Code Section 522(b) (4) (A). “Go away” says Willis.

The bankruptcy court takes a look at the IRA transactions. An IRA is not allowed to participate in certain transactions (called “prohibited transactions”) with its fiduciary. Guess what? If you direct a self-directed IRA, you are a “fiduciary.” Willis tapped into his IRA and did not replace the money within 60 days. The 60 days is not a suggestion; it is the statute. He didn’t make it. He put the money back in there, but this was not horseshoes. This was a prohibited transaction.

The court was also not too amused with the check swapping scheme and his brokerage account. The court observed that this had the effect of a loan between Willis and his IRA. An IRA cannot loan money, and it especially cannot loan money to its fiduciary. This was a prohibited transaction.

The bankruptcy court held against Willis. He appealed to the district court. That court sustained. Willis next appealed to the Eleventh Circuit, and the circuit court has just sustained the district court. Willis has lost.

How much money was in these IRAs? The Merrill Lynch account alone was over $1.2 million.

I have known clients to “borrow” from their IRA, and I especially remember one doing this while Rick and I worked together at another firm a few years ago. I remember counting down and sweating the 60 days. This was a sensitive client, and – if it blew up – I was going to take massive damage. Willis unfortunately did not keep it to 60 days. He must have been strapped, because he wound up borrowing from friends and family. He put the money back into the IRA, but he had missed the window. The later episode with the check swapping was just icing on the cake.

The court pointed out that once the IRA was tainted, the taint followed the partial rolls to the other two IRAs. His three IRAs were unprotected and could be actioned by his bankruptcy creditors.

Willis thought he was clever. He got schooled, and the tuition was expensive.

Will Bankruptcy Protect Against An IRS Lien on Your IRA

It happened this busy season. As you may know, we do our share – and then some – of tax representation work. I would say that, despite our size, we do as much representation work as many firms in Cincinnati.

So what happened? A client wanted to know whether the IRS could lien her IRA.

Do you know the answer?

I’ll give it to you momentarily

I was looking at a tax case called Miles v Commissioner. Corrie Miles ran up past due taxes. The IRS filed liens for 1997 and 1998 which attached to her IRA.

Note: Under Section 6321 if a taxpayer fails to pay a liability after notice and demand, the IRS can file a lien on taxpayer’s property and rights to property.

If it goes to the next step, the IRS is allowed under Section 6331 to seize and sell the property (unless it is exempt) subject to a federal tax lien.

Corrie Miles filed for bankruptcy in 2003. Her 1996, 1997 and 1998 taxes were discharged.

Remember: Taxes more than three years old can be discharged.

Can the IRS go against her IRA?

What is your answer? Did Corrie keep her IRA?

This case went through Appeals and the Supreme Court has just refused to give it cert. But it did go that high up the chain. The IRS won. Why? Although Corrie went through bankruptcy, the IRS had a priority position going in to bankruptcy. The bankruptcy will not wipe out the lien. The IRS could proceed against Corrie’s IRA to the tune of $142,000 – the balance in the IRA before she went into bankruptcy.