Chapter 7: Federal Income Tax Issues

Carl M. Jenks

Jones Day, New York and Cleveland

When distressed corporations file for bankruptcy, they are almost always losing money. And yet tax considerations play a surprisingly important role in the entire bankruptcy process, from the decision to file, through the day-to-day impact of the filing on the debtor's tax situation, to the tax impact of emerging from bankruptcy. Chapter 7 provides the nontax professional with an introduction to these issues. While not intended as a technical treatise or a substitute for professional tax advice, this chapter will help to alert companies and their advisors to some of the more important tax issues that the debtor will face before, during, and after the case.

The first set of issues arises in connection with the filing itself. What are the tax consequences of filing? How can tax professionals add value during the prefiling period? What prepetition taxes should be paid immediately before filing?

The first-day order raises several important tax issues. What sorts of prepetition taxes should the debtor seek to pay during the case? What sorts of prophylactic measures should the debtor take to protect its tax attributes (principally, its net operating losses) from the impairment that can result from trading in the debtor's stock or debt?

The fact of filing does not relieve the debtor of its usual duty to file tax returns, but it does rather markedly shift the debtor's obligations to pay taxes: as a general rule, the debtor cannot pay prepetition taxes without court order but is required to pay administrative-period taxes in the ordinary course. Telling one type of tax from the other turns out to be surprisingly difficult, and usually requires a conscious change in the operation of the debtor's tax department. The tax treatment of postpetition interest and professional fees incurred in the case also requires careful examination.

The relationship between the IRS and the corporate debtor is something of a two-way street. The IRS may well assert claims against the debtor for prepetition taxes, at the same time that the debtor may be seeking a refund from the IRS for prior taxes. Managing this complex relationship is often a key element of the case, since it can have a material impact on the debtor's current and future cashflow.

Finally, debtors should not assume that emerging from bankruptcy ends all bankruptcy-related tax issues. Attention should be given to the tax treatment accorded to debtor assets held by liquidating trusts or other sorts of funds, and guidance on complex withholding issues may need to be given to disbursing agents in connection with plan distributions.

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