The Intersection of Bankruptcy and Taxation

By Daniel M. Press and Brett Weiss

The intersection of bankruptcy and taxation is, in many respects, a complicated area of the law, and entire treatises can and have been written about it. 1 This article does not attempt to provide a complete survey of this area of the law, but only to provide information on some of the key points about taxation as it relates particularly to individual chapter 11 debtors.

Separate Taxable Estate

Section 1398 of the Internal Revenue Code ("IRC") (and, for state and local taxes, Bankruptcy Code section 346) provides that for individual debtors in chapters 7 and 11, the bankruptcy estate is a separate taxable entity. This makes perfect sense in chapter 7, where the debtor cedes control of nonexempt assets to the trustee, and it made sense in chapter 11 cases prior to the 2005 amendments, where the debtor's postpetition earnings were not property of the estate. But under the current Bankrutpcy Code, section 1115 makes postpetition earnings of the debtor part of the chapter 11 bankruptcy estate, and thus taxable to the estate and not to the debtor.

This creates significant complications for taxation of individuals in chapter 11. In chapter 13, there is no separate taxable estate under IRC section 1398, so the debtor reports all individual and estate income on Form 1040, just as if there were no bankruptcy case. However, in chapter 11, the Internal Revenue Service ("IRS") takes the position that the estate must file Form 1041, U.S. Income Tax Return for Estates and Trusts, subject to special instructions, which adopt Form 1040 as an attachment to the return. The tax rate for such a return is as married filing separately, which could result in higher taxes....

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