Table of Contents
A separate estate, for tax purposes, is not created for an individual who files a petition under Chapter 12 or 13 of the Bankruptcy Code. You, the individual, should continue to file the same federal income tax return that was filed prior to the bankruptcy petition.
On your return, report all income received during the entire year and deduct all allowable expenses. Do not include any debt canceled (because of bankruptcy) in income on your return. However, you must reduce (to the extent that you have) certain losses, credits or basis in property by the amount of canceled debt. See Debt Cancellation, later.
For information about determining the amount of tax due and paying tax, see Tax Procedures, later.
Note:
Interest on trust accounts In Chapter 13 proceedings. If you are an individual debtor in a chapter 13 wage earner's plan, do not include as income on your return interest earned on amounts held in trust accounts while awaiting distribution to your creditors. This interest is not available either to you or to your creditors. it is available only to the trustees, and is taxable to the trustee as his or her individual income.
If you are an individual debtor who files for bankruptcy under chapter 7 or 11 of the Bankruptcy Code, a separate “estate” is created consisting of property that belonged to you before the filing date. This bankruptcy estate is a new taxable entity, completely separate from you as an individual taxpayer.
If a husband and wife file a joint bankruptcy petition and their estates are jointly administered, treat their estates as separate entities for tax purposes. Two separate tax returns must be filed (if they separately meet the filing requirements).
The estate, under a chapter 7 proceeding, is represented by a trustee. The trustee is appointed by the bankruptcy court to administer the estate and liquidate your nonexempt assets. In chapter 11, the debtor remains in control of the assets as a “debtor-in-possession.” However, sometimes the bankruptcy court will appoint a trustee in a chapter 11 case. In this case, the debtor-in-possession must turn over to the trustee control of the debtor's assets and operations.
The estate may produce its own income as well as incur its own expenses. See The Bankruptcy Estate, later. The creation of a separate bankruptcy estate also gives you a “fresh start” —with certain exceptions, wages you earn and property you acquire after the bankruptcy case has begun belong to you and do not become a part of the bankruptcy estate.
If your bankruptcy case began but was later dismissed by the bankruptcy court, the estate is not treated as a separate entity, and you are treated as if the bankruptcy petition had never been filed in the first place. File amended returns on Form 1040X to replace any returns you previously filed. Include on any amended returns items of income, deductions, or credits that were or would have been reported by the bankruptcy estate on its returns and were not reported on returns you previously filed. However, you may not be able to deduct administrative expenses the former estate could have claimed. Also, the bankruptcy exclusion cannot be used to exclude debt that was canceled while you were under the bankruptcy court's protection. But the other exclusions (such as insolvency) may apply.
You, as the individual debtor, generally must file income tax returns during the period of the bankruptcy proceedings. Do not include on your return, the income, deductions, or credits belonging to the separate bankruptcy estate. Also do not include as income on your return, the debts canceled because of bankruptcy. However, the bankruptcy estate must reduce certain losses, credits, and the basis in property (to the extent of these items) by the amount of canceled debt. See Debt Cancellation, later.
You have the option of ending your tax year on the day before you filed your bankruptcy petition. This allows the tax due on that short period return to be a claim against the bankruptcy estate. See Election to End Tax Year, later.
See Tax Procedures, later, for information about determining and paying the amount of tax due.
If you are an individual debtor and have assets (other than those you exempt from the bankruptcy estate), you may choose to end your tax year on the day before the filing of your bankruptcy case. Then your tax year is divided into 2 “short” tax years of fewer than 12 months each. The first year ends on the day before the filing date, and the second year begins with the filing date and ends on the date your tax year normally ends. Once you make this choice, you may not change it. Any income tax liability for the first short tax year becomes an allowable claim (as a claim arising before bankruptcy) against the bankruptcy estate. If this tax liability is not paid in the bankruptcy proceeding, the liability is not canceled because of bankruptcy and it can be collected from you as an individual.
If you do not choose to end the tax year, then no part of your tax liability for the year in which bankruptcy proceedings begin can be collected from the estate.
Example.
John Doe files a bankruptcy petition on July 10. To have a timely filed election, he must file Form 1040 (or an extension) for the period January 1 through July 9 by November 15.
To avoid delays in processing the return, write “Section 1398 Election” at the top of the return. You may also make the election by attaching a statement to an application for extension of time to file a tax return (Form 4868 or other). The statement must say that you choose under section 1398(d)(2) to close your tax year on the day before the filing of the bankruptcy case. You must file the application for extension by the due date of the return for the first short tax year. If your spouse decides to also close his or her tax year, see Election by debtor's spouse, next.
Example 1.
Paul and Mary Harris are calendar-year taxpayers. A voluntary chapter 7 bankruptcy case involving only Paul begins on March 4.
If Paul does not make an election, his tax year does not end on March 3. If he does make an election, Paul's first tax year is January 1—March 3, and his second short tax year begins on March 4. Mary could join in Paul's election as long as they file a joint return for the tax year January 1—March 3. They must make the election by July 15, the due date for filing the joint return.
Example 2.
Fred and Ethel Barnes are calendar-year taxpayers. A voluntary chapter 7 bankruptcy case involving only Fred begins on May 6, and a bankruptcy case involving only Ethel begins on November 1 of the same year.
Ethel could choose to end her tax year on October 31. If Fred had not elected to end his tax year on May 5, or if he had elected to do so but Ethel had not joined in his election, Ethel would have 2 tax years in the same calendar year if she decided to close her tax year. Her first tax year is January 1—October 31, and her second year is November 1—December 31.
If Fred had not decided to end his tax year as of May 5, he could join in Ethel's choice to close her tax year on October 31, but only if they file a joint return for the tax year January 1—October 31. If Fred had elected to end his tax year on May 5, but Ethel had not joined in Fred's choice, Fred could not join in Ethel's choice to end her tax year on October 31, because they could not file a joint return for that short year. They could not file a joint return because their tax years preceding October 31 were not the same.
Example 3.
Jack and Karen Thomas are calendar-year taxpayers. A voluntary chapter 7 bankruptcy case involving only Karen begins on April 10, and a voluntary chapter 7 bankruptcy case involving only Jack begins on October 3 of the same year. Karen chooses to close her tax year on April 9 and Jack joins in Karen's choice.
Under these facts, Jack would have 3 tax years for the same calendar year if he makes the election relating to his own bankruptcy case. The first tax year would be January 1— April 9; the second April 10—October 2; and the third October 3—December 31.
Karen may (but does not have to) join in Jack's election if they file a joint return for the second short tax year (April 1 0—October 2). If Karen does join in, she would have the same 3 short tax years as Jack. Also, if Karen joins in Jack's election, they may file a joint return for the third tax year (October 3—December 31), but they are not required to do so.
The filing of a bankruptcy petition for an individual debtor under chapter 7 or chapter 11 of the bankruptcy code creates a separate taxable bankruptcy estate. The trustee (for chapter 7 cases) or the debtor-in-possession (for chapter 11 cases) is generally responsible for preparing and filing the estate's tax returns and paying its taxes. The debtor remains responsible for filing returns and paying taxes on any income that does not belong to the estate.
If a bankruptcy case begins, but later is dismissed by the bankruptcy court, the estate is not treated as a separate taxable entity. If tax returns have been filed for the estate, amended returns must be filed to move income and deductions from the estate's returns to the debtor's returns. If no returns have been filed, report all income and deductions on the debtor's returns.
The following discussions provide tax information for the bankruptcy estate.
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Net operating loss carryovers,
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Carryovers of excess charitable contributions,
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Recovery of tax benefit items,
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Credit carryovers,
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Capital loss carryovers,
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Basis, holding period, and character of assets,
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Method of accounting,
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Passive activity loss and credit carryovers,
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Unused at-risk deductions, and
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Other tax attributes as provided in regulations.
The trustee (or debtor-in-possession) must file an income tax return on Form 1041, U.S. Income Tax Return for Estates and Trusts if the estate has gross income that meets or exceeds the amount required for filing. This amount is the total of the personal exemption amount and the basic standard deduction for a married individual filing separately. See the Form 1041 instructions for the current year's amount.
If a return is required, the trustee (or debtor-in-possession) completes the identification area at the top of the Form 1041 and lines 23—29 and signs and dates it. Form 1041 is a transmittal for Form 1040, U.S. individual Income Tax Return. Complete Form 1040 and figure the tax using the tax rate schedule for a married person filing separately. In the top margin of Form 1040, write “Attachment to Form 1041. DO NOT DETACH.” Attach Form 1040 to the Form 1041.
Note:
The filing of a tax return for the bankruptcy estate does not relieve the individual debtor of his or her tax filing requirement.
Note:
The social security number of the individual debtor cannot be used as the EIN for the bankruptcy estate.
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A $100,000 certificate of deposit,
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Commercial rental real estate with a fair market value of $280,000, and
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His personal residence with a fair market value of $200,000.
A separate taxable estate is not created when a partnership or corporation files a bankruptcy petition. The court appointed trustee is, however, responsible for filing the regular income tax returns on Form 1065 or Form 1120.
The filing requirements for a partnership in bankruptcy proceedings do not change. However, the filing of required returns becomes the responsibility of an appointed trustee, receiver, or a debtor-in-possession rather than a general partner.
A partnership's debt that is canceled because of bankruptcy is not included in the partnership's income. It may or may not be included in the individual partners' income. See Partnerships, later under Debt Cancellation.
The following discussion covers only the highlights of the bankruptcy tax rules applying to corporations. Because the details of corporate bankruptcy reorganizations are beyond the scope of this publication, you may want to seek the help of a professional tax advisor.
See Corporations under Debt Cancellation, for information about a corporation's debt canceled because of bankruptcy.
The tax-free reorganization provisions of the Internal Revenue Code apply to a transfer by a corporation of all or part of its assets to another corporation in a title 11 or similar case, but only if, under the reorganization plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction qualifying under IRC section 354, 355, or 356.
A “title 11 or similar case,” for this purpose, is a bankruptcy case under title 11 of the United States Code, or a receivership, foreclosure, or similar proceeding in a federal or state court, but only if the corporation is under the jurisdiction of the court in the case and the transfer of assets is under a plan of reorganization approved by the court. In a receivership, foreclosure, or similar proceeding before a federal or state agency involving certain financial institutions, the agency is treated as a court.
Generally, section 354 provides that no gain or loss is recognized if a corporation's stock is exchanged solely for stock or securities in the same or another corporation under a qualifying reorganization plan. In this case, shareholders in the bankrupt corporation would recognize no gain or loss if they exchange their stock solely for stock or securities of the corporation acquiring the bankrupt's assets.
Section 355 generally provides that no gain or loss is recognized by a shareholder if a corporation distributes solely stock or securities of another corporation that the distributing corporation controls immediately before the distribution. Section 356 provides that in an exchange that would qualify under section 354 or 355 except that other property or money besides the permitted stock or securities is received by the shareholder, gain is recognized by the shareholder only to the extent of the money and the fair market value of the other property received. No loss is recognized in this situation.
The filing requirements of a corporation involved in bankruptcy proceedings do not change. However, the filing of required returns becomes the responsibility of an appointed trustee, receiver, or a debtor-in-possession, rather than a corporate officer.
A corporation that is subject to the jurisdiction of the cout in a title 11 or similar case is exempt from the personal holding company tax, unless the main reason for beginning or continuing this case is to avoid paying this tax. A“ title 11 or similar case” is defined earlier under Tax-Free Reorganizations.
The following section discusses the procedures for determining the amount of tax due from the debtor or the bankruptcy estate, paying the tax claim, and obtaining a discharge of the tax liability.
The first step in the determination of the tax due is filing a return. As an individual bankrupt debtor, you file a Form 1040 for the tax year involved, and the trustee of your bankruptcy estate files a Form 1041, as explained earlier under Individuals in Chapter 7 or 11. A bankrupt corporation, or a receiver, bankruptcy trustee, or assignee having possession of, or holding title to, substantially all the property or business of the corporation, files a Form 1120 for the tax year.
After the return is filed, the Internal Revenue Service may redetermine the tax liability shown on the return. When the administrative remedies within the Service have been exhausted, the tax issue may be litigated either in the bankruptcy court or in the U.S. Tax Court, as explained in the following discussion.
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As determined by the Internal Revenue Service,
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As determined by the bankruptcy court, after the completion of the IRS examination, or
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As shown on the return, if the IRS does not:
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Notify the trustee within 60 days after the request for the determination that the return has been selected for examination, or
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Complete the examination and notify the trustee of any tax due within 180 days after the request (or any additional time permitted by the bankruptcy court).
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The appropriate form for the trustee to use in making the claim for refund is as follows:
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For income taxes for which an individual debtor had filed a Form 1040, Form 1040A, or Form 1 040 EZ, the trustee should use a Form 1 040X, Amended U.S. Individual Income Tax Return.
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For income taxes for which a corporate debtor had filed a Form 1120, the trustee should use a Form 1120X, Amended U.S. Corporation Income Tax Return.
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For income taxes for which a debtor had filed a form other than Form 1040, Form 1040A, Form 1O4OEZ, or Form 1120, the trustee should use the same type of form that the debtor had originally filed, and write “Amended Return” at the top of the form.
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For taxes other than certain excise taxes or income taxes for which the debtor had filed a return, the trustee should use a Form 843, Claim for Refund and Request for Abatement, attaching an exact copy of any return that is the subject of the claim along with a statement of the name and location of the office where the return was filed.
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For excise taxes you reported on Forms 720,730, or 2290, the trustee should use Form 8849, Claim for Refund of Excise Taxes or Schedule C of Form 720, whichever is appropriate.
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For overpayment of taxes of the bankruptcy estate incurred during the administration of the case, the trustee may choose to use a properly executed tax return (for income taxes, a Form 1041) as a claim for refund or credit.
The IRS examination function, if requested by the trustee or debtor-in-possession as discussed later, will examine the appropriate amended return, claim, or original return tiled by the trustee on an expedite basis, and will complete the examination and notify the trustee of its decision within 120 days from the date of filing of the claim.
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An audit to determine tax liability,
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A demand for tax returns,
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The issuance of a notice of deficiency to the debtor, or
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The making of an assessment for any tax and the sending of a notice and demand for payment of the tax assessed (for bankruptcy cases filed after October 22, 1994).
After the filing of a bankruptcy petition and during the period the debtor's assets or those of the bankruptcy estate are under the jurisdiction of the bankruptcy court, these assets are not subject to levy. The Internal Revenue Service may file a proof of claim in the bankruptcy court the same way as other creditors. This claim may be presented to the bankruptcy court even though the taxes have not yet been assessed or are subject to a Tax Court proceeding.
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Income taxes for tax years ending on or before the date of filing the bankruptcy petition, for which a return is due (including extensions) within 3 years of the tiling of the bankruptcy petition.
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Income taxes assessed within 240 days before the date of filing the petition. This 240-day period is increased by any time, plus 30 days, during which an offer in compromise with respect to these taxes was pending, that was made within 240 days after the assessment.
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Income taxes that were not assessed before the petition date, but were assessable as of the petition date, unless these taxes were still assessable solely because no return, a late return (within 2 years of the filing of the bankruptcy petition), or a fraudulent return was filed.
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Withholding taxes for which you are liable in any capacity.
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Employer's share of employment taxes on wages, salaries, or commissions (including vacation, severance, and sick leave pay) paid as priority claims under 11 USC 507(a)(3) or for which a return is due within 3 years of the filing of the bankruptcy petition, including a return for which an extension of the filing date was obtained.
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Excise taxes on transactions occurring before the date of filing the bankruptcy petition, for which a return, if required, is due (including extensions) within 3 years of the filing of the bankruptcy petition. If a return is not required, these excise taxes include only those on transactions occurring during the 3 years immediately before the date of filing the petition.
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In chapter 11, the debtor can pay these taxes over a period of 6 years from the date of assessment, including interest,
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In chapter 12, the debtor can pay such tax claims in deferred cash payments over time, and
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In chapter 13, the debtor can pay such taxes over 3 years (or over 5 years with court approval).
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The tax was incurred before the earlier of the order for relief or (in an involuntary case) the appointment of a trustee, and
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The bankruptcy petition was filed before the due date for the tax retum (including extensions) or the date for imposing the penalty occurs on or after the day the bankruptcy petition was filed.
Debts are divided into two categories; dischargeable and nondischargeable. Dischargeable debts are those that the debtor is no longer personally liable to pay after the bankruptcy proceedings are concluded. Nondischargeable debts are those that are not canceled because of the bankruptcy proceedings. The debtor remains personally liable for their payment.
As a general rule, there is no discharge for you as an individual debtor at the termination of a bankruptcy case for the second and eighth priority taxes described earlier, or for taxes for which no return, a late return (filed within 2 years of the filing of the bankruptcy petition), or a fraudulent return was filed. However, claims against you for other taxes predating the bankruptcy petition by more than 3 years may be discharged. However, if the IRS has a lien on the debtor's property, this property may be seized to collect discharged tax debts.
If a debt is canceled or forgiven, other than as a gift or bequest, the debtor generally must include the canceled amount in gross income for tax purposes. A debt includes any indebtedness for which the debtor is liable or which attaches to property the debtor holds.
There are several exceptions and exclusions from the inclusion of canceled debt in income. The exceptions include:
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The cancellation of a student loan for a student required to work for certain employers. See Cancellation of student loan in Publication 525, Taxable and Nontaxable Income.
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The cancellation of debt that would have been deductible if paid.
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The reduction of a debt by the seller of property if the debt arose from the purchase of the property.
The exclusions are discussed next.
Do not include a canceled debt in gross income if any of the following situations apply:
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The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.
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The cancellation takes place when you are insolvent (see Insolvency exclusion, later), and the amount excluded is not more than the amount by which you are insolvent.
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The canceled debt is qualified farm debt (debt incurred in operating a farm). See chapter 4 of Publication 225, Farmer's Tax Guide.
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The canceled debt is qualified real property business indebtedness (certain debt connected with business real property). See Publication 525, Taxable and Nontaxable Income.
Example.
$4000 of the Simpson Corporation's liabilities are cancelled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation's liabilities totaled $21,000 and the fair market value of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 — $17,500).
The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.
If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain “tax attributes.” Tax attributes include the basis of certain assets and the losses and credits listed next. By reducing these tax attributes, tax on the canceled debt is in part postponed instead of being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation.
If a separate bankruptcy estate was created, the trustee or debtor-in-possession must reduce the estate's attributes (but not below zero) by the canceled debt. See individuals under chapter 7 or chapter 11, later.
If any amount of the debt cancellation is used to reduce the basis of assets as discussed under Reduction of Tax Attributes, the following rules apply to the extent indicated.
If a partnership's debt is canceled because of bankruptcy or insolvency, the rules for the exclusion of the canceled amount from gross income and for tax attribute reduction are applied at the individual partner level. Thus, each partner's share of debt cancellation income must be reported on the partner's return unless the partner meets the bankruptcy or insolvency exclusions explained earlier. Then all choices, such as the choices to reduce the basis of depreciable property before reducing other tax attributes, to treat real property inventory as depreciable property, and to end the tax year on the day before filing the bankruptcy case, must be made by the individual partners, not the partnership.
Corporations in a bankruptcy proceeding or insolvency generally follow the same rules for debt cancellation and reduction of tax attributes as an individual or individual bankruptcy estate would follow.
If a corporation transfers its stock in satisfaction of indebtedness and the fair market value of its stock is less than the indebtedness it owes, the corporation has income (to the extent of the difference) from the cancellation of indebtedness. After 1994, a corporation can exclude all or a portion of the income created by the stock for debt transfer if it is in a bankruptcy proceeding or, if not in a bankruptcy proceeding, it can exclude the income to the extent it is insolvent. However, the corporation must reduce its tax attributes (to the extent it has any) by the amount of excluded income.
The earnings and profits of a corporation do not include income from the discharge of indebtedness to the extent of the amount applied to reduce the basis of the corporation's property as explained earlier. Otherwise, discharge of indebtedness income, including amounts excluded from gross income, increases the earnings and profits of the corporation (or reduces a deficit in earnings and profits).
If there is a deficit in the corporation's earnings and profits and the interest of any shareholder of the corporation is terminated or extinguished in a title 11 or similar case (defined earlier), the deficit must be reduced by an amount equal to the paid-in capital allocable to the shareholder's terminated or extinguished interest.
For S corporations, the rules for excluding income from debt cancellation because of bankruptcy or insolvency apply at the corporate level.
The sample tilled-in Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), shown in this publication is based on the following situation.
Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 1995, he reached an agreement with his creditors, whereby they agreed to forgive $10,000 of the total that he owed them, in return for his setting up a schedule for repayment of the rest of his debts.
Immediately before the debt cancellation, Tom's liabilities totaled $120,000 and the fair market value of his assets was $100,000 (his total basis in all these assets was $90,000). At the time of the debt cancellation, he was considered insolvent by $20,000. He can exclude from income the entire $10,000 debt cancellation because it was not more than the amount by which he was insolvent.
Among Tom's assets, the only depreciable asset is a rental condominium with an adjusted basis of $50,000. Of this, $10,000 is allocable to the land, leaving a depreciable basis of $40,000. He has a long-term capital loss carryover to 1996 of $5,000. He also has a net operating loss of $2,000 and a $3,000 net operating loss carryover from 1994. He has no other tax attributes arising from the current tax year or carried to this year.
Ordinarily, in applying the $10,000 debt cancellation amount to reduce tax attributes, Tom would first reduce his $2,000 net operating loss, next his $3,000 net operating loss carryover from 1994, and then his $5,000 net capital loss carryover. However, he figures that it is better for him to preserve his loss carryovers for the next tax year.
Tom elects to reduce basis first. He can reduce the depreciable basis of his rental condominium (his only depreciable asset) by $10,000. The tax effect of doing this will be to reduce his depreciation deductions for years following the year of the debt cancellation. However, if he later sells the condominium at a gain, the part of the gain from the basis reduction will be taxable as ordinary income.
Tom must file Form 982, as shown here, with his individual return (Form 1040) for the tax year of the debt discharge. In addition, he must attach a statement describing the debt cancellation transaction and identifying the property to which the basis reduction applies. This statement is not illustrated.
You can get help from the IRS in several ways.
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