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Taxation of a Bankruptcy Estate – Personal Bankruptcy Filings

Jun 2, 2014

During the twelve months ended March 31, 2014, there were 1,038,280 new bankruptcy filings in the United States, of which 43,826 (4.2%) were filed in the Second District, which includes Long Island. The majority, (95.5%), were non-business filings.  These statistics are consistent with those for the year ended March 31, 2013 as well.  Non-business bankruptcy petitions are filed by individuals, as opposed to businesses. In this blog post, we will discuss some of their distinguishing characteristics.

As CPA’s, we are retained, with Bankruptcy Court approval to perform a wide range of services. 

One of the less well-known services that we may be engaged to provide is the preparation of income tax returns for Bankruptcy Estates.   The need for this type of filing arises when an individual debtor files a non-business bankruptcy petition under Chapter 7 or 11 of the Bankruptcy Code (either a liquidation or a re-organization). As soon as the bankruptcy petition is filed, a bankruptcy estate consisting of assets and debts is created that is separate from the debtor’s personal financial activities.

After the Chapter 7 filing the individual debtor continues to be responsible to file all regular income tax returns and to pay taxes for the income that he/she earns after the petition is filed, but not for the income and losses incurred from the trustee’s liquidation of the bankruptcy estate assets. 

The Chapter 7 Trustee is responsible for filing separate income tax returns.  In a Chapter 11 filing, the obligation falls to the Debtor-in-Possession if a Trustee is not appointed.  In both instances, a CPA should be engaged.  The bankruptcy estate must have its own separate EIN.  It files an unusual tax return that combines features of both Forms 1040 and 1041. Tax on the estate is computed at the rates applicable to a married person filing separately.  

Transfers to the estate are not considered to be dispositions by the debtor. There is no gain or loss and no change in tax attributes.  Net Operating Loss Carryovers, methods of accounting, cost basis, depreciation, credit carryovers, holding periods and character, passive activity loss carryovers, capital loss carryovers, and other significant tax attributes in existence as of the beginning of the year in which the petition is filed are all transferred to the bankruptcy estate on the date it is created.  They cannot be used on the debtor’s tax returns during this time.  As a result, either or both of the debtor and the estate may owe income taxes which would not be owed had the bankruptcy estate not been created. 
In the course of the bankruptcy proceedings, certain of the tax attributes will be adjusted for the transactions that occur during the proceedings.

At the conclusion of the bankruptcy, the estate is terminated and the remaining assets are transferred back to the debtor, with the tax attributes existing as of the termination date. 

If, however, the Bankruptcy case is later dismissed, the debtor must file amended tax returns to include all of the activity that occurred during the Bankruptcy period as if the bankruptcy estate had not been created.
It is essential that meticulous records be kept.

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Geraldine Wolk

Geraldine Wolk specializes in trusts and estates for high net worth individuals, income taxation and planning for individuals, estates, trusts, business entities and not-for profits.

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