By Henry E. Geberth, Jr., Esq., Hendel & Collins, P.C.
An individual debtor seeking relief under Chapter 7 or 11 of the Bankruptcy Code has a unique opportunity to engage in both pre- and post-filing tax planning. Failure to consider this opportunity may have serious and potentially long-term negative consequences on the debtor’s financial future.
When an individual files a bankruptcy case all of their property and their interests in property become assets of the Bankruptcy Estate. The Bankruptcy Estate also accedes to the individual’s pre-filing tax attributes, including net operating losses, credit carryovers, basis in property and capital loss carryovers. In Chapter 7 and Chapter 11, a new tax entity is created, the Bankruptcy Estate.
Individual debtors in a Chapter 7 or Chapter 11 case (but not Chapter 13) have the option of electing to end their tax year on the day before the case is commenced, thereby affording them one last opportunity to use any valuable tax attributes before they pass to the Bankruptcy Estate and are lost to the individual. Through the short year election, the individual divides his or her year into two tax periods. The first tax year commences on January 1st and ends the day before the bankruptcy case is filed. The second tax year begins on the filing date and ends on December 31st. The election to terminate the tax year must be made on or before the 15th day of the fourth full month following the close of the first tax year (the date of the bankruptcy petition). The election is made by filing a timely return inscribed with the caption “short year election”. The ability to make the short year election is limited to asset cases. Since asset cases can be created simply by failing to use all of the exemption otherwise available to the debtor, this restriction should not cause undue problems.
Because a non-debtor spouse has the ability to join in the election or may seek relief in their own Chapter 7 or 11 case later in the year, a married couple conceivably could have several returns filed during the same calendar year.
By availing themselves of the short year election, a debtor opens up both pre- and post-filing tax planning opportunities. Through the use of the election, a debtor has one last opportunity to use any favorable tax attributes to reduce their personal tax liability, by offsetting any income earned during the first tax year. Because these tax attributes pass to the estate upon commencement of the case, the failure of the debtor to avail themselves of the short year election might leave the debtor at the end of the calendar year with substantial tax liabilities and without any assets to satisfy those obligations. Should the opportunity to take a short year election be overlooked, any tax liability generated pre-petition would be deemed to have arisen post-petition and will not be discharged in the bankruptcy case or constitute a valid claim against the Estate.
Overlooking the opportunity to end this tax year may have particularly serious consequences on a Chapter 11 Debtors. Amendments to the Bankruptcy Code in 2005, include property acquired post-petition by an individual Chapter 11 debtor. The debtor-in-possession, being a new tax entity, cannot use estate assets to satisfy post-petition tax liabilities of the individual. In such case, the individual would be forced to use exempt assets to satisfy their tax liability.
A well-counseled debtor using the election has the opportunity to reduce the tax liability by offsetting the income earned pre-petition by using advantageous tax attributes, including the use of a depreciation deduction. Better still, because the tax liability created by the short year election is a pre-petition debt, the tax becomes a priority claim that will be paid through the Bankruptcy Estate. Because recent tax claims are afforded a payment priority by the Bankruptcy Code, the effect of the election is to push the individual’s short year tax liability on to the Bankruptcy Estate thereby reducing the amount post-petition non-dischargeable debt and the amount available for distribution to creditors of the estate.
Because of the benefits, as well as the potentially disadvantageous consequences facing an individual debtor, consideration of the use of this planning opportunity is a critical to provide the debtor a fresh start.