When the debts of an individual or business entity exceed the fair market value of assets, one option is to seek protection from creditors under U.S. Bankruptcy laws. There are several forms of bankruptcy actions that may be filed, based on applicable code sections and depending on factors such as whether the non-exempt assets of the debtor will be sold and the proceeds distributed to creditors, or if insead the individual or entity merely needs time to reorganize and repay debts.
Bankruptcy Proceedings and Discharge of Debts
One result of a bankruptcy action can be a "discharge" or cancellation of the debtor's debts in whole or in part. Normally, when a debt is canceled or "forgiven," the amount of the debt is treated for tax purposes as income to the debtor. Under bankruptcy laws, however, the amount forgiven does not become income to the debtor.
After a petition for bankruptcy has been filed, an "estate" is opened, into which the debtor transfers property, as required by law. The estate becomes a separate entity from the individual, and is treated accordingly for federal tax purposes (for a corporation, etc., the estate is not a separate entity, but does have separate tax reporting requirements). The transfer of property into the estate by the debtor does not constitute a sale or other taxable event.
Tax Attributes and Their Effects
Certain actions by the debtor prior to filing for bankruptcy may affect the estate and its assets, such as taking tax deductions for losses, credits, and "carryovers" (where a credit or deduction could not be utilized in full in one year, and was therefore partially taken in a succeeding tax year). Similarly, a piece of real or personal property may have been depreciated over several years. The Internal Revenue Service (IRS) refers to these as the "tax attributes" of the estate and its assets.
As the transfer of property into the bankruptcy estate is not treated as a taxable event, the estate and its assets have the same tax attributes they did when the debtor had them. The debt forgiveness does not become income to the debtor, but it does affect the tax attributes. According to the IRS, it is unfair to allow debtors to obtain forgiveness of debt while retaining the advantages of earlier tax breaks.
Adjustments Prompted by Debt Forgiveness in Bankruptcy
To redress this inequity, there is a mandatory adjustment to the tax attributes of the estate and its assets. The person in charge of the bankruptcy estate (i.e., the trustee or debtor in possession) must elect to treat the debt forgiveness in one of the following methods:
- Apply all or part of the amount to reduce the "basis" of estate assets that are not liquidated, although there are limits to allowable reductions. When a person or entity buys real or personal property, the purchase price usually becomes the asset's "basis." Basis can be increased (e.g., by improvements) or decreased (e.g., by depreciation). Generally, when the property is sold, the difference between the sale price and the basis is "gain" or profit. If property with a basis reduction for debt forgiveness in bankruptcy is later sold or otherwise disposed of for a gain, the portion of the gain attributable to this reduction in basis must be treated as ordinary income, taxed at different rates than the "capital gain" would usually be taxed.
- If none or only a portion of the debt forgiveness amount is used for basis reduction, it or the remainder must be used to offset tax attributes specified by the IRS.
If the debt forgiveness is not (or is only partially) used to reduce basis, the IRS mandates reduction of tax attributes in the following order of priority:
- Net operating loss for the year in which the debt cancellation took place.
- General business credit carryovers to or from the year of cancellation.
- Minimum tax credits available at the beginning of the tax year following cancellation.
- Capital losses for the year of cancellation, plus any "carryovers."
- The basis of both depreciable and non-depreciable property.
- Passive activity loss or credit carryovers from the tax year of cancellation.
- Any carryover to or from the year of cancellation used to determine the foreign tax credit.
If a partnership's debts are canceled in bankruptcy (used for reduction in tax attributes), they are allocated to each individual partner, based on ownership interest. Each partner's share must, therefore, be reported on that partner's return, subject to some exceptions. All of the decisions about reducing basis and tax attributes, and the treatment of property, must be made by the individual partners. This allocation of a portion of the debt forgiveness amount also affects the partner's basis in the partnership interest.
Corporations must generally follow the same rule for debt cancellations and reduction of tax attributes as followed by individuals. If the corporation transfers its stock in satisfaction of its indebtedness, but the fair market value of the stock is less than the debt, the corporation obviously has a gain as a result. All or a portion of this gain can be excluded from income, if the corporation acts through a bankruptcy proceeding, provided it is used to reduce basis in corporation property and/or tax attributes.
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