With the enactment of the Small Business Reorganization Act, Chapter 11 is expected to become more accessible and economic for business debtors with debts below the limits. For bankruptcy lawyers taking their first venture into Chapter 11, knowledge of the tax issues in reorganizations becomes critical. So, I’m happy to have attorney Steven Walker of San Jose, California, guide us through the basics of tax obligations of bankruptcy estates. Cathy
Who Files the Tax Returns Under SBRA
Subchapter V of the newly amended Bankruptcy Code is silent on the question as to whether the debtor-in-possession, or the court appointed trustee, must file the entity’s income tax returns on Form 1065, Form 1120, or Form 1120S.
Although the IRS also has not issued any formal guidance, answers can be found by reviewing the Internal Revenue Code, published agency guidance, and case law surrounding the filing obligations in chapter 7, 11, 12 and 13 cases.
Individual Chapter 7 or 11
When an individual files a chapter 7 or 11 case with the assistance from the law firm for bankruptcies, the individual continues to file Form 1040 and a Form 1041 must be filed for the bankruptcy estate. IRS Publication 908 (02/2020), Bankruptcy Tax Guide, p. 3 explains:
When an individual debtor files for bankruptcy under chapter 7 or 11 of the Bankruptcy Code, the bankruptcy estate is treated as a new taxable entity, separate from the individual taxpayer.
The bankruptcy estate in a chapter 7 case is represented by a trustee. The trustee is appointed to administer the estate and liquidate any nonexempt assets.
In chapter 11 cases, the debtor often remains in control of the assets as a “debtor-in-possession” and acts as the bankruptcy trustee. However, the bankruptcy court, for cause, may appoint a trustee if such appointment is in the best interests of the creditors and the estate.
During a chapter 7 or 11 bankruptcy, the debtor continues to file an individual tax return on Form 1040 or 1040-SR. The bankruptcy trustee files a Form 1041 for the bankruptcy estate. However, when a debtor in a chapter 11 bankruptcy case remains a debtor-in-possession, he or she must file both a Form 1040 or 1040-SR individual return and a Form 1041 estate return for the bankruptcy estate (if return filing requirements are met).
See also IRC 6012(b)(4) (“Returns of . . . an estate of an individual under chapter 7 or 11 of title 11 of the United States Code shall be made by the fiduciary thereof.”); In re Vale 204 B.R. 716, 730 (Bankr. N.D. Ind. 1996) (“A trustee or other fiduciary for an individual debtor under chapter 7 or 11 must file a tax return for the individual debtor’s bankruptcy estate”); Rev. Rul. 72-387, 1972-2 C.B. 632 (trustee in bankruptcy is required under IRC 6012 to file a Form 1041 for the estate he is administering; individual must file a Form 1040 for the year in which the bankruptcy occurred).
In the absence of IRS input
Although there is no formal IRS guidance on the issue, the same rules that apply for corporations or partnerships in a chapter 11 should apply where a “small business debtor” initiates a subchapter V case by filing a voluntary chapter 11 petition and making an election to proceed under subchapter V.
Entities in Chapter 11
No separate taxable entity results from the commencement of a bankruptcy proceeding by or against a corporation or partnership.[12] That’s in contrast to tax treatment of individuals in bankruptcy where the estate under Chapter 7 (liquidations) or Chapter 11 (reorganizations) is a separate taxable entity[1] .
Corporations
The trustee in a chapter 11 case, who has possession of or holds title to, all or substantially all of the property or business of a corporation, is required to file the corporate tax returns. I.R.C. §6012(b)(3) states:
6012(b)(3) Receivers, trustees and assignees for corporations.—In a case where a receiver, trustee in a case under title 11 of the United States Code or assignee, by order of a court of competent jurisdiction, by operation of law or otherwise, has possession of or holds title to all or substantially all the property or business of a corporation, whether or not such property or business is being operated, such receiver, trustee, or assignee shall make the return of income for such corporation in the same manner and form as corporations are required to make such returns.
If a corporation files a chapter 11 petition and elects subchapter V status, the court-appointed trustee who has possession of or holds title to all or substantially all the property or business of a corporation, files the corporate tax return; otherwise, the debtor-in-possession files the return.[2]
Partnerships
If a partnership, on the other hand, files a chapter 11 petition and elects subchapter V status, the partnership should continue to file the income tax returns (Form 1065) for the partnership entity.[3]
Also see Treas. Reg. §1.6012-3(b)(4), Corporations (trustee in bankruptcy who has possession of or holds title to all or substantially all of the property or business of a corporation, shall make the return of income for the corporation); Holywell Corp. v. Smith, 503 U.S. 47, 54 (1992) (“As the assignee of ‘all’ or ‘substantially all’ of the property of the corporate debtors, the trustee must file the returns that the corporate debtors would have filed had the plan not assigned their property to the trustee.”).
In cases where a trustee is not appointed, the debtor-in-possession continues business operations and remains in possession of the business’ property during the bankruptcy proceeding.
IRS Publication 908 (02/2020), Bankruptcy Tax Guide, p. 24 explains:
A separate taxable estate is not created when a partnership or corporation files a bankruptcy petition and their tax return filing requirements don’t change. The debtor-in-possession, or court appointed trustee, must file the entity’s income tax returns on Form 1065, Form 1120 or, Form 1120S.
Individuals in Chapter 12 or 13
The filing of a Chapter 12 or Chapter 13 case does not create a separate taxable entity.
IRS Publication 908 (02/2020), Bankruptcy Tax Guide, p. 3 explains:
Only individuals may file a chapter 13 bankruptcy. Chapter 13 relief isn’t available to corporations or partnerships. The bankruptcy estate is not treated as a separate entity for tax purposes when an individual files a petition under chapter 12 or 13 of the Bankruptcy Code. The individual continues to file the same federal income tax returns that were filed prior to the bankruptcy petition, Form 1040 or 1040-SR, U.S. Individual Income Tax Return.
In contrast to an individual chapter 11 case, when an individual files a chapter 12 (relating to family farmers) or chapter 13 (wage earner’s plan), the individual continues to file Form 1040, and there is no Form 1041 filing requirement.
Parting Thoughts
Tax returns should be filed, and the taxes paid, on a timely basis to avoid civil penalties. The IRS imposes civil penalties for failing to timely file or timely pay the tax due.[4]
Disputes between the debtor and trustee surrounding who files the return and pays the tax should be avoided whenever possible. The penalties can be substantial and arguing or contesting the matter with the trustee and creating a tax controversy may not be cost-effective in the long run.
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Disclaimer
The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Taxpayers should consult competent tax counsel. Contact the author at his website or at swalkerATwalk-law.com for further discussion.
[1] IRC §1398 (Rules Relating to Individuals’ Title 11 Cases).
[2] IRC §6012(b)(3); Treas. Reg. §1.6012-3; IRS Publication 908 (02/2020).
[3] 11 Collier on Bankruptcy P TX3.03 (16th 2020)
[4] IRC §6651(a)(1) provides for a penalty for failure to file any return required, while IRC §6651(a)(2) provides for a penalty for failure to pay; however both of these subsections provide that the assessment of a penalty may be excused if the “failure is due to reasonable cause and not due to willful neglect.” Id.
